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Project GCP/SYR/006/ITA Phase II FAO-ITALIAN GOVERNMENT COOPERATIVE PROGRAM ASSISTANCE IN CAPACI TY BUILDI NG THROUGH ENHANCI NG OPERATION OF THR NATIONAL AGRICULTURAL POLICY CENTER SYRIA

Intensive Training Program

NOTES OF THE COURSE IN

AGRICULTURAL ECONOMICS

Prof. Alessandro Corsi


(University of Turin Italy)

May-June 2002

Notes of Agricultural Economics ____________________________________________________________

These notes are intended as an handout of the lectures. They do not substitute for more structured readings of basic textbooks. The basic references for the contents of the course are: Colman D., Young T.: Principles of agricultural economics: M arkets and prices in less developed countries, Cambridge University Press, Cambridge, 1989 Ellis F.: Peasants economics: Farm households and agrarian development, Cambridge University Press, Cambridge, 1988

An useful additional reference is: Harrigan J., Loader R., Thurtle C: A gricultural Price Policy: Government and the M arket, FAO, Training materials for Agricultural Planning, N. 31

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1. INTRODUCTION AGRICULTURE has one basic characteristic in common with other sectors: produces (in general) for the market

therefore: utilises factors of production: provided by firms: - intermediate inputs (fertilisers, seeds, pesticides, fuel, etc.) - capital goods (tractors, harvesters, etc.) provided by households: - labour - capital - land and produces: consumers goods for consumers production goods (intermediate inputs, e.g. seeds, fibres; capital goods, e.g. dairy cows) for firms

AGRICULTURE has also specific characteristics of its own: 1. TECHNOLOGICAL SPECIFIC CHARACTERISTICS: tight link to land (a scarce and not producible factor) length of the production process irreversibility of the production process dependence on (uncertain) biological cycles dependence on uncontrolled factors (weather) As a consequence: - asset fixity - seasonality - difficult standardisation - risk and uncertainty

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2. SOCIO-ECONOM IC SPECIFIC CHARACTERISTICS: In most countries, agriculture is composed in the largest majority by SM ALL FIRM S, FAMILYOPERATED. (even the largest farms have a small dimension relative to the overall production) Two reasons have been indicated for this: - lack of economies of scale - supervision costs of waged labour

Consequences: - agricultural production is highly fragmented - many costs are not explicit (e.g. costs for family labour)

3. HETEROGENEITY OF AGRICULTURAL PRODUCTION Diversity as to: - farming systems (different location, weather, climate, soil, etc.) - farm structures: - farm size and size distribution - land tenure system (ownership, rent, sharecropping) - farm/labour relationship (family work, waged work)

4. CHARACTERISTICS OF THE DEMAND FOR AGRICULTURAL PRODUCTION Agricultural production can be destined for: - food - non-food (fibres, like cotton etc., or raw materials, like rubber etc.) self consumption the market fresh product processing

The different destinations imply different characteristics of the demand, and the short- and longterm trends are different. For instance, in general the demand for food: - depends on the amount of population - depends also on consumers income, but does not increase much when income increases - the demand for fresh food is less responsive to income than the demand for processed food The demand for non-food products depends much more on general economic development.

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5. MAIN PROBLEM S CHARACTERISING THE AGRICULTURAL SECTOR price fluctuations, due to: - weather, diseases, etc. - effects of international production changes on the local market - time lags between the decision to produce and the realisation of the final output income fluctuations declining long-term terms of trade - food demand scarcely responsive to income - less concentration in agriculture than in many other sectors, and little market power - sectors outside agriculture (input production, food industry, marketing sectors) are more concentrated and have more market power scarce factor mobility (land, machinery, labour): adjustment to market changes are slow hence: agricultural incomes are often lower than in other sectors

6. ROLES OF AGRICULTURE IN ECONOM IC DEVELOPM ENT Historically, in western countries, agricultural development has been a prerequisite for the industrial revolution: - providing food for the industrial labour force - providing raw materials for the industry (cotton, wool, etc.) - providing labour for the industry - providing the capitals for the first industries - providing a market for industrial goods (tools, machinery, chemical fertilisers) In the other countries, agricultural development has important roles too: - provides labour for the other sectors - creates an internal market - may be a source of capital formation - may provide raw materials for a domestic processing industry - may provide foreign currency when the agricultural output is exported

5. MARKET EFFIC IENCY AND MARKET FAILURES


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Policy measures change the market conditions. Whenever some change is introduced, most of the times someone is losing and someone is gaining. Is it possible to give an evaluation of the changes from an economic point of view? In general, economics states that utility is an individual matter, so that gains and losses in terms of utility among different persons cannot be compared. Nevertheless, a widely acceptable criterion to evaluate the effects of any change is the following: if at least someone is made better off by a change without making anybody else worse off, then the change is an improvement. This is a very general criterion of efficiency, called Pareto efficiency. Any change that meets this criterion is called a Pareto improvement. When no change making someone better off is possible without making someone else worse off, then a situation of Pareto optimality is reached. any exchange on a market is a Pareto improvement if the seller were not made better off by the exchange, he would not sell if the buyer were not made better off by the exchange, he would not buy by implementing the exchange, a Pareto improvement is achieved

Nevertheless, any Pareto optimal situation depends on the distribution of resources: there exist infinite Pareto equilibria. If a very rich person trades with a poor person, they may improve their situation, but the difference in income may nevertheless be judged as unfair. Therefore, there may exist another reason for intervening with policy measures, a reason that is termed equity criterion: it may be considered that a redistribution is needed, so that necessarily someone will gain and someone else will lose. Apart from equity reasons, it is nevertheless important to explore whether it is possible to improve the existing situation from a Pareto efficiency point of view. From this point of view, competitive markets are a powerful tool to reach efficiency. It can be shown that, if some conditions apply, then a competitive market equilibrium is Paretooptimal since it satisfy 3 conditions: 1. it is not possible to increase the utility of any consumer by trading goods among them: this condition is satisfied if for any consumer the M RS between two prices is equal to the price ratio; since prices are the same for all consumers, none of them wants to change his optimal combination of goods 2. it is not possible to increase the output by trading inputs: this corresponds to the condition that the M RS between two inputs is equal to the price ratio; again, since prices are the same for all producers, none of them wants to change his optimal combination of inputs 3. it is not possible to increase utility by changing the combination of goods produced: since for every producer the M RT is equal to the price ratio (and the M C is equal to the price), and since the price ratio is the same for all consumers, no change in the combination of products might increase the utility of consumers. So, markets are an efficient way to increase the utility associated with the economic activity.

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The above conditions apply to competitive markets. There are nevertheless several cases in which the requisites of competitive markets are not met. In these cases, markets fail to allocate efficiently resources. The reasons for market failures are: Existence of a market power It is the case of monopoly and of all non-competitive markets. In such markets, operators dont produce at the point where the MC is equal to the price, but where M C=M R. The result is a lower output than in a competitive market (or a lower input use, for a monopsony). So, more could be produced, and at a lower price. Lack of markets M arkets for some goods or resources do not exist or may be incomplete or fragmented. Examples include the land market, the labour market, the capital market. If, for instance, there is no market for labour, then wage is subjective: labour may be cheap for a poor farmer, and expensive for a wealthy one: the allocation of labour is therefore not optimal. Externalities Externalities are costs borne by someone other than the one who produces (negative externalities) or benefits received by someone other than the one who produces. A typical example of negative externality is pollution: residuals of pesticides are run off with the water, damaging the activity of fishermen, or making more costly the provision of drinking water. This are cost involved in the agricultural production, but not paid by farmers, but by others. An example of positive externality is soil protection by farmers in hilly or mountainous areas, connected with agricultural production: by their activity, they prevent soil runoff, and avoid floods, but they receive no benefit for this action. Since the costs connected with a negative externality are not borne by the polluter, his private costs are lower than the social costs: by equating his private M C to the price, the polluter will produce too much as compared with the social optimum. If there is a positive externality, the producer will not receive a return for it, so that his production is too low as compared to the social optimum.

Public goods What in economics is called a public good is not a good produced by the public sector: a public good is such if it is: - non-rival in consumption: if it is consumed by one person, it remains available for other persons. For instance, the technological knowledge used by one person does not detract from the possibility for another person to use it - non-excludable: it is not possible or it is too costly to prevent the use for those who do not pay. An example is a natural landscape: unless it is visible only from one place, there is no way to have tourists pay for its view The two characteristics can be combined, so there are four categories of goods: - pure private goods: excludable and rival in consumption (e.g., a bottle of mineral water) - open access resources: rival in consumption but not excludable (e.g., marine fish resources) - club goods: excludable but not rival in consumption (e.g., a non-crowded highway) - pure public goods: non-rival in consumption and non-excludable (e.g., controls to prevent importation of animal and plant deseases)
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The problem with pure public goods is that the market would not produce them, though all those that might use them would be better off paying for them and having the good provided. This is a problem of free-riding : many would not pay, since there would be no way to exclude them from consumption. This is why pure public goods are provided by the public sector, by imposing a compulsory payment through taxes. This realises a Pareto improvement that the market cannot reach. Even for club goods, which are excludable, a Pareto improvement would be possible, since users not willing to pay the price would increase their utility if they were allowed to use them for free, and no one else would be made worse off, since they are non-rival. Finally, for open access resources, the problem is connected with their overuse. If no regulation is introduced, they will be exploited exceedingly, and there will be a damage for everyone.

Information problems If there is not full information, both technical and on the market conditions, operators are not able to achieve technical and allocative efficiency. M oreover, if there is risk, unless there are insurance markets for all risks, operators may not make the most efficient choices.

In all these cases, markets fail to efficiently allocate resources. All these problems call for policy interventions for correcting market failures.

Policy interventions may also be implemented for equity reasons. But all interventions modify the welfare of some groups, so that someone gains and someone else loses. There is no objective measure for such gains and losses, since utility is subjective. Nevertheless, another criterion widely used to evaluate changes in social welfare is Kaldors compensation principle: it states that a change is desirable if the gains of the gainers are large enough to compensate the losers for their losses. This principle does not require that the compensation be actually paid to the losers. What it implies is that the policy-maker considers the total welfare of the society, regardless of whom receives gains or losses. Gains and losses of welfare by consumers and producers can be measured through consumer and producer surplus. Consumer surplus Consider a market with equilibrium price P* and equilibrium quantity Q*. All consumers pay the same price, P*. But some consumers were willing to pay a higher price: for instance, consumers located at quantity Q1 were prepared to pay a price P1. So, they benefit from having the good at price P*, so that they gain a surplus, equal to the difference (P1 - P*) between the price they were willing to pay and the actual price. In the same way, consumers located at quantity Q2 were willing to pay a price Q2, but actually paid P*, so they gain a surplus P2 P*. Summing up all surpluses for all purchased units results in the triangle AEP*, which represents the consumer surplus.

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Consumer surplus
Price

A S

P1

P2 E

P*

Q1

Q2

Q*

Quant ity

Producer surplus
Price

P*

P3 D C O Q3 Q* Quantity

Producer surplus In a similar way, producer surplus can be identified. All producers receive the same price, P*. The supply curve is the sum of the M C curves of all producers. At any quantity produced, for instance quantity Q3, the difference between the price P* and the price P3 represents the difference between the additional revenue from the last unit produced and the additional variable costs for producing it.
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Summing all the differences for all output levels results in the area CEP*, that represents the producer surplus

Consumer surplus and producer surplus allow evaluating the welfare effects of some change in market conditions on consumers and producers. For instance, suppose that the conditions for the wholesaler monopsony described above are removed, for instance by creating a commercial structure where producers can sell their product directly to consumers. A competitive equilibrium can exist, at price P* and quantity Q*. The increase in consumer surplus is PsCFP*, the increase in producer surplus id PpBFP*.

Changes in consumer and producer surpluses by removing a monopsony

Price

MFC Supply

Ps

P* E Pp B

Demand MR O A Q* Quantity

Similar exercises can be done also for any change in market conditions, for instance for analysing the effects of shifts of the demand or supply curve. 2. ECONOMICS OF AGRIC ULTURAL PRODUCTION

Theory of the firm (revision) 3 problems: - how to produce (optimal combination of inputs) - how much to produce (optimal output level) - what to produce (optimal combination of outputs)
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Assumptions: - certainty - availability of inputs - divisibility and homogeneity of inputs - goal of the entrepreneur: profit maximisation (profits = revenues costs) (alternative hypotheses will be considered later)

2.1 OPTIMAL COMBIN ATION OF INPUTS a) one product, one factor Starting point: physical factor-product relationship Production function: Q = f(X1, X2, , Xn) Short-term production function (some factors are fixed, e.g. land, machinery): Q= f(X1, X2, , Xm | Xm+1, Xm+2,, Xn) Alternative forms: fixed and flexible coefficients - fixed coefficients: the amount of a factor necessary for each unity of product is the same, regardless of the production level (e.g., iron for producing each car) - flexible coefficients: the amount of a factor necessary for each unity of product depends on the production level (e.g. fertiliser per each ton of wheat) We examine now the case of flexible coefficients How to use one factor (all other factors held constant) Q= f(X1 | X2, X3,, Xn)

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TOTAL PRODUCT CURVE:

Tota l product 800 700 600 500 400 300 200 100 0 0 5 See ds (kg) 10 15 Maize (q) 1st stage 2nd stage 3rd stage

Total product

Remark: the total product curve depends on the level of the fixed factors and on the state of technology 3 STAGES: st - 1 stage: the product increases more than proportionally to the input increase (may not exist) - 2nd stage: the product increases less than proportionally to the input increase (must exist) rd - 3 stage: the product decreases when increasing input usage (or remains at the same level) Law of diminishing marginal returns: given the fixed factors, the product cannot increase indefinitely increasing just one factor CONCEPT OF MARGINAL PRODUCT: M arginal product = the increase in output resulting from a small change in the variable input, expressed per unit of input For a discrete change: MPX1= Q/ X1 Or, for an infinitesimal change: MPX1= Q/ X1 (= the slope of the total product curve at the relevant point) If you imagine to increase input use one unit at the time, then the MP is the output from the last unit of input.

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The three stages correspond to: 1st stage: positive and increasing M P nd 2 stage: positive and decreasing M P rd 3 stage: negative and decreasing M P

CONCEPT OF AVERAGE PRODUCT: Average product = the total output resulting on the average from each unit of the variable input, i.e. the total product divided by the amount of variable input: APX1= Q / X1 If you imagine to increase input use one unit at the time, then the AP is the average output from each unit of input. AP reaches its maximum when it is equal to the MP: if you imagine to increase input use one unit at the time, if the MP (the product from the last unit) is higher than the AP (the average product of all units of input), then the average increases; when the product from the last unit (the M P) becomes lower than the average (the AP), then the average decreases. Graphical representation of the MP and of the AP

Marginal and average product


120.00 100.00 80.00 60.00 40.00 20.00 0.00 -20.00 0.0 -40.00 Seed 2.0 4.0 6.0 8.0 10.0 12.0 14.0 AP MP

rd Just from a technical point of view, it can be excluded to use the variable input in the 3 stage (TP decreases or remains unchanged when using more input).

Maize/seed

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But, to make a decision on how much variable input to use, we need to make an economic reasoning. We need to know: - the price of the variable input - the price of the product M ultiplying the amount of TOTAL PRODUCT by its price we obtain the TOTAL REVENUE (TR): TR = TP * PQ M ultiplying the amount of MARGINAL PRODUCT by the price of product we obtain the VALUE OF THE M ARGINAL PRODUCT (VM P): VMP = MP * P Q M ultiplying the amount of AVERAGE PRODUCT by the price of product we obtain the VALUE OF THE AVERAGE PRODUCT (VAP): VAP = AP * PQ

The graphical representation of the VM P and of the VAP is the same as M P and AP The optimal use of one factor is when the VM P is equal to the factor price: - increasing by one unit the use of the factor is profitable if the increase in the total revenue resulting from the increase in input (= the VM P) is higher than the increase in cost (i.e., the price PX1 which is paid for one unit of the factor); - this applies up to the amount of input for which VMP = PX1 (in the decreasing part of the VM P curve); - VAP must be higher than p X1 (otherwise, no input use is profitable) What happens if prices change? - if input price decreases: - it is profitable to increase input use (now a one unit increase in input has a lower cost, lower than the increase in revenue) - this applies up to the amount for which the new input price is equal to the VM P - the new optimal input use will be larger than before if input price increases: - it is profitable to decrease input use (now the decrease in costs resulting from a one unit decrease in input is larger than the decrease in revenue resulting from the lower production) - this applies up to the amount for which the new input price is equal to the VM P - the new optimal input use will be smaller than before - if input price becomes higher than the maximum VAP, no input use is profitable (the cost for using each unit of input exceeds the revenue that results from each unit of input)

This defines the firms demand curve for that input (= the amount of that input that is bought by that firm for each input price, holding all other things constant). It corresponds to the decreasing part of the VM P curve, below the point of crossing with the VAP curve if output price decreases: - the VM P and VAP curves shift downward (M P and AP remain unchanged, but they are multiplied by a lower output price) - it is profitable to use less input (now the decrease in costs resulting from a one unit decrease in input is larger than the decrease in revenue resulting from the lower production)
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this applies up to the amount for which the input price is equal to the new VM P the new optimal input use will be smaller than before the firms demand curve for that input is shifted to the left the maximum VAP is now lower; the firm will now buy no input (its demand of input is zero) for a lower input price than before

if output price increases: - the VM P and VAP curves shift upward (M P and AP remain unchanged, but they are multiplied by a higher output price) - it is profitable to use more input (now the increase in revenue resulting from a one unit increase in input is higher than the additional cost of that unit) - this applies up to the amount for which the input price is equal to the new VM P - the new optimal input use will be larger than before - the firms demand curve for that input is shifted to the right

Therefore, the firms demand for that input is: - negatively related to its own price - positively related to output price (for instance, it is expected that fertilisers demand decreases if their price increase, but that it increases if the price of crop increases)

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Exercise Here is one example of calculation of M P, AP, VM P, and VAP. Check what is the optimal use. You will be given an Excel file with the data on input and output. You have to: Calculate M P, AP, TR, VMP and VAP using Excel (you can check the results on this table).

Find the optimal use when py = 100 and px = 6425


Find the optimal use when py = 120 and px = 4075 Total product, marginal and average product Optimal use of one input PHIS ICAL RELATIONS HIPS ECONOMICAL RELATIONS HIPS
Py (SP/q.)= Seed Mai ze

COS TS AND PROFITS

100
Px= 3200

x
(kg)

TP
(q.)

MP
q.m./kg seed

AP
q.m./kg seed

TR
SP

VMP
SP/kg seed

VAP
SP/kg seed

COS TS
SP

PROFITS
SP

0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5

0.000 10.875 29.000 53.625 84.000 119.375 159.000 202.125 248.000 295.875 345.000 394.625 444.000 492.375 539.000 583.125 624.000 660.875 693.000 719.625 740.000 753.375 759.000 756.125

21.75 36.25 49.25 60.75 70.75 79.25 86.25 91.75 95.75 98.25 99.25 98.75 96.75 93.25 88.25 81.75 73.75 64.25 53.25 40.75 26.75 11.25 -5.75

21.75 29.00 35.75 42.00 47.75 53.00 57.75 62.00 65.75 69.00 71.75 74.00 75.75 77.00 77.75 78.00 77.75 77.00 75.75 74.00 71.75 69.00 65.75

1087.5 2900.0 5362.5 8400.0 11937.5 15900.0 20212.5 24800.0 29587.5 34500.0 39462.5 44400.0 49237.5 53900.0 58312.5 62400.0 66087.5 69300.0 71962.5 74000.0 75337.5 75900.0 75612.5

2175.0 3625.0 4925.0 6075.0 7075.0 7925.0 8625.0 9175.0 9575.0 9825.0 9925.0 9875.0 9675.0 9325.0 8825.0 8175.0 7375.0 6425.0 5325.0 4075.0 2675.0 1125.0 -575.0

2175.0 2900.0 3575.0 4200.0 4775.0 5300.0 5775.0 6200.0 6575.0 6900.0 7175.0 7400.0 7575.0 7700.0 7775.0 7800.0 7775.0 7700.0 7575.0 7400.0 7175.0 6900.0 6575.0

1600.0 3200.0 4800.0 6400.0 8000.0 9600.0 11200.0 12800.0 14400.0 16000.0 17600.0 19200.0 20800.0 22400.0 24000.0 25600.0 27200.0 28800.0 30400.0 32000.0 33600.0 35200.0 36800.0

-512.5 -300.0 562.5 2000.0 3937.5 6300.0 9012.5 12000.0 15187.5 18500.0 21862.5 25200.0 28437.5 31500.0 34312.5 36800.0 38887.5 40500.0 41562.5 42000.0 41737.5 40700.0 38812.5
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12.0

744.000

-24.25

62.00

74400.0

-2425.0

6200.0

38400.0

36000.0

2.2 OPTIMAL COMBIN ATION OF INPUTS b) one product, two (or more) factors The production function is now: Q = f(X1, X2 | X3,, Xn) CONCEPT OF ISOQUANT

Isoquants
12 10 8 200
X2

6 4 2 0 0 2 4
X1

351.75 500

The same output level can be achieved with different combination of inputs (e.g., more fertiliser and less irrigation) Q = f(X1, X2 | X3,, Xn) There are infinite isoquants (each for every output level) M oving along the isoquant means achieving the same output level using more of one input and less of the other: in other words, substituting one input for another, keeping output level constant.

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CONCEPT OF MARGINAL RATE OF SUBSTITUTION (M RS): M RS of X2 for X1 = X2 / X1 = X2 / X1 (holding output level constant) It can be shown that: M RS of X2 for X1 = X2 / X1 = - M PX1 / MPX2 The M RS is: - negative (if it is positive, there is technical inefficiency: to keep the output level constant, one input has to be increased when decreasing the other one) - decreasing in absolute terms (if the M P of inputs are decreasing) (Other cases: constant M RS for the fix coefficients production function; zero M RS for complementary inputs)

How to choose the combination of inputs?


This is an economic problem, that can be addressed as the question: Which is the least-cost combination of inputs for a given output level? (in other words, you want to produce a given output Q at the least cost: how to do?). If you have a given sum C0 to spend for buying X1 and X2, you can: - spend all the sum for X1 and get C0 / p X1 of it (p X1 is the price of X1) - spend all the sum for X2 and get C0 / p X2 of it (p X2 is the price of X2) - spend the sum for a combination of X1 and X2: C0 = X1* p X1 + X2* pX2 or: X2 = C0 / p X2 (pX1 / pX2 )* X1 This equation represents an ISOCOST: all possible combinations of the inputs that can be purchased at a given cost. - there exist infinite isocosts (each for any possible cost) - all isocost are parallel, with slope (pX1 / p X2 ) - isocosts farther from the origin indicate higher costs The problem then becomes choosing the isocost closest to the origin that permits to reach the output level Q . This is the isocost tangent to the isoquant, and the optimal combination is found on the tangency point.

At the tangency point, the slope of the isocost is the same as the slope of the isoquant; therefore, the optimal solution is when: M RS of X2 for X1 = (p X1 / pX2 ) Since M RS of X2 for X1 = - M PX1 / MPX2, the solution can also be written as: MPX1 / M PX2 = p X1 / p X2
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or: MPX1 / p X1 = MPX2 / p X2 The optimal solution is the same if you ask the question: which is the combination of inputs that results in the maximum output for a given cost? (in this case, you have to choose the isoquant farthest from the origin which is compatible with one isocost; again, the solution is the tangency point between the isocost and an isoquant).

Isoquant-Isocost
12 10 8 X2 6 4 2 0 0 2 4 X1 6 8

200 351.75 500 Isocost

The economic meaning of the optimal solution is as follows: - if one dollar more spent for purchasing X1 results in an increase in production (M PX1 / p X1) larger than the decrease in production resulting from spending one dollar less for purchasing X2 (MPX2 / p X2), it pays to shift one dollar from purchasing X2 to purchasing X1 (the cost is the same, the output increases); - by doing so, the M P of X1 decreases, the M P of X2 increases; for the next dollar, the shift is less profitable; - at one point, when M PX1 / p X1 = MPX2 / p X2, no further shift is profitable. This is exactly the tangency point. Remark that, repeating this exercise, it is possible to determine: - the optimal combination of inputs for each output level - the minimum cost associated to each output level
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What happens if input prices change? if both prices change by the same proportion (e.g., both increase by 5%): - the slope of the isocost remains the same (p X1 * 1.05 / p X2 * 1.05 = p X1 / p X2) - the isocost shifts to the left (at the same cost, it is now possible to buy less inputs) - the same isocost will be tangent to a lower isoquant (or, the same isoquant will be tangent to a higher isocost) - profits will decrease (same cost for a lower production, or same production at higher costs) - the opposite is true if prices decrease by the same proportion if one price change (e.g., p X1 increases): - the slope of the isocost changes (becomes steeper, in this example) - the same isocost will be tangent to a lower isoquant (or, the same isoquant will be tangent to a higher isocost) - profits will decrease (same cost for a lower production, or same production at higher costs) - the proportion between the inputs will change: the ratio X2 / X1 will increase - the opposite is true if the price decreases

M ore generally, a change in the proportion results from any change in relative prices (p X1 / p X2): for instance, if p X1 increases by 5% and pX2 by 3%, there will be an increase in the ratio X2 / X1. 2.3 OPTIMAL OUTPUT LEVEL

(one product)
Solving the problem of the optimal combination of inputs, it is possible to determine the minimum cost (for variable costs) associated to each output level. Costs on the short run: fixed costs (FC): are not influenced by the level of output (e.g. rents, depreciation, etc.) variable costs (VC): depend on the level of output (e.g. fertilisers, fuel, etc.) total costs (TC) are the sum of variable and fixed costs: TC = FC + VC

Fixed costs, by definition, are constant for all output levels Variable costs: - in a first phase, they increase less than proportionally to production (due to increasing returns) - in a second phase, they increase more than proportionally to production (due to decreasing returns), and become very high when the output level approaches the limit given by the plant

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Fixed, variable, total costs


140 120 100 80 60 40 20 0 0 5 Output
CONCEPT OF MARGINAL COST: M arginal cost is the increase in variable (or total) cost associated to a unit (or infinitesimal) increase in production: M C = TC / Q = VC / Q = the slope of the TC curve = the slope of the VC curve If you imagine to increase production one unit at the time, then the M C is the cost of the last unit produced. The two stages correspond to: st - 1 stage: decreasing M C - 2nd stage: increasing M C

Costs

VC FC TC

10

15

CONCEPT OF AVERAGE COST: Average cost is the cost associated with each unit of production. One needs to distinguish between Average variable cost (AVC) and Average total cost (AT): AVC = VC / Q AC = TC / Q If you imagine to increase production one unit at the time, then the AVC is the variable cost of each unit produced up to then, and the AC is the overall cost of each unit produced up to then. AVC and AC reach their minimum when they are equal to the M C: if you imagine to increase production one unit at the time, if the M C (the cost of the last unit) is lower than the AC (the
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average cost of all units produced), then the average decreases; when the cost of the last unit produced (the M C) becomes higher than the average (the AC), then the average increases.

Marginal and average costs


60 50 Unit costs 40 30 20 10 0 0 5 Output 10 15 MC AVC AC

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The economic problem is: which is the output level for which profits are maximised? Lets assume that the firm is price-taker, i.e. cannot influence the market price, but can sell any quantity of the product at the current market price (this is true if the firm is small in relation to the whole market, which is almost always true for farms). In this case: - Total Revenue (TR) is equal to output multiplied by the market price: TR = Q * P - M arginal Revenue (M R, i.e. the increase in revenue resulting from a unit increase in output, M R = TR / Q) is equal to price: M R = P (note: this is true only if the firm is a price-taker!) The optimal output is when the M C is equal to the output price: - increasing by one unit the output is profitable if the resulting increase in total revenue (the M R = the price) is higher than the increase in cost (i.e., the M C); - this applies up to the amount of output for which M C = P (in the increasing part of the M C curve); - the AC must be lower than P (otherwise, there are losses, not profits)

Marginal and average costs


60 50 Unit costs 40 30 20 10 0 0 5 Output 10
profits MC output price AC AVC optimal output

MC AVC AC

15

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What happens if prices change? - if output price increases: - it is profitable to increase output (now a one unit increase in output gives a higher increase in revenue, which is now lower than the increase in cost) - this applies up to the amount for which the new output price is equal to the M C - the new optimal output will be larger than before if output price decreases: - it is profitable to decrease output (now the decrease in costs resulting from a one unit decrease in output is larger than the decrease in revenue resulting from the lower production) - this applies up to the amount for which the new output price is equal to the M C - the new optimal output will be smaller than before - if the output price becomes lower than the minimum AC, no output level is profitable (the cost for producing each unit of output exceeds the revenue that results from each unit of output) - if the output price becomes lower than the minimum AC, for a firm is already operating it is still better to produce, until the price falls below the minimum A VC (recovering the variable costs, and part of the fixed costs, is better than losing all fixed costs)

This defines the firms supply curve (= the amount of output that is produced by that firm for each output price, holding all other things constant): it is the increasing part of the M C curve, above the crossing with the AC curve. if costs increase (e.g., because input prices increase): - the M C and AC curves shift upward - it is profitable to reduce the output (now the decrease in revenue from a one unit decrease in output is lower than the resulting decrease in costs) - this applies up to the amount for which the output price is equal to the new M C - the new optimal output will be smaller than before - the firms supply curve is shifted to the left - the minimum AC is now higher; therefore, the firms supply becomes zero (it produces no output) for a higher output price than before if costs decrease (e.g., because input prices decrease): - the M C and AC curves shift downward - it is profitable to increase the output (now the increase in revenue from a one unit increase in output is higher than the resulting increase in costs) - this applies up to the amount for which the output price is equal to the new M C - the new optimal output will be larger than before - the firms supply curve is shifted to the right - the minimum AC is now lower; therefore, the firms supply becomes zero (it produces no output) for a lower output price than before -

Therefore, the firms supply is: - positively related to output price - negatively related to input prices (for instance, it is expected that farmers increase wheat supply if its price increases, but that they decrease it if the price of fertilisers increases)

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Here is one example of VC, FC, and TC, and of calculation of M C, AVC, AC. Check what is the optimal use. Find the optimal use when py = 15 Find the optimal use when py = 20
O ptimal output py=SP13/unit 000 SP 000 SP TR Profits 13 26 39 52 65 78 91 104 117 130 -37 -31 -23 -14 -5 2 6 6 0 -15

1000 units 000 SP y VC 0 0 1 10 2 17 3 22 4 26 5 30 6 36 7 45 8 58 9 77 10 105

000 SP FC 40 40 40 40 40 40 40 40 40 40 40

000 SP TC 40 50 57 62 66 70 76 85 98 117 145

SP/unit MC 10 7 5 4 4 6 9 13 19 28

SP/unit AVC 10.00 8.50 7.33 6.50 6.00 6.00 6.43 7.25 8.56 10.50

SP/unit AFC 40.00 20.00 13.33 10.00 8.00 6.67 5.71 5.00 4.44 4.00

SP/unit AC 50.00 28.50 20.67 16.50 14.00 12.67 12.14 12.25 13.00 14.50

2.4 OPTIMAL COMBIN ATION OF OUTPUTS

(two -or more- products)


The problem: - a farmer can produce two products (e.g., wheat and maize) - he has given resources (a certain amount of land, of capital, of machinery, etc.) - how much wheat and how much maize should he produce to maximise his profits? There are two production functions, for wheat and maize respectively: Qw = f1(X1, X2, , Xn) Qm = f2(X1, X2, , Xn) With given resources, a farmer can: - produce only wheat (a quantity w0) - produce only maize (a quantity m0) - produce a combination of wheat and maize All combinations of wheat and maize technically feasible with the given resources form the production-possibility frontier (or transformation curve).

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Production possibility frontier


5 4
Wheat

3 2 1 0 -1 Maize

Along the production-possibility frontier, if the farmer produces more maize, he has to reduce the production of wheat. The quantity of wheat he has to give up to produce one more unit of maize is the M ARGINAL RATE OF TRANSFORMATION (MRT) of maize for wheat: M RT of maize for wheat = Qw / Qm = the slope of the production-possibility frontier It can be shown that: M RT of Qm for Qw = Qw / Qm = - M CQm / M CQw

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The M RT: - is negative (to increase maize production, wheat production has to be decreased, and vice versa) - is increasing in absolute terms (if the M Cs are increasing) - represents the opportunity cost of producing maize in terms of wheat: i.e., what is the cost of producing one more unit of maize, in terms of wheat given up If the resources are given, their cost is given too; then, the maximum profit is found by maximising total revenue. Total revenue is the sum of the revenue from wheat and of the revenue from maize: TR = Qw * pw + Qm * pm (p w is the price of wheat, and p m is the price of maize) To reach a particular TR0, the farmer can: - produce only wheat (a quantity TR0/p w) - produce only maize (a quantity TR0/pm ) - produce a combination of wheat and maize All combinations of wheat and maize which yield the same revenue TR0 form an ISOREVENUE LINE: TR0 = Qw * pw + Qm * pm or: Qw = - (pm / p w)* Qm + TR0 / p w there exist infinite isorevenue lines (each for any possible revenue) all isorevenue lines are parallel, with slope (pm / p w) isorevenue lines farther from the origin indicate higher revenues

The problem then is to choose the isorevenue line farthest from the origin which is compatible with the production-frontier curve. This is the isorevenue line tangent to the production-frontier curve, and the optimal combination is at the tangency point.

Product-product equilibrium
4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 0

tangency point isorevenue lines

y2

0.2

0.4

0.6 y1

0.8

1.2

1.4

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At the tangency point, the M RT is equal to the slope of the isorevenue line: M RT of Qm for Qw = Qw / Qm = (pm / p w) Or: Qw * p w = - Qm * pm The economic meaning of the optimal solution is as follows: - if producing less Qm results in a decrease in revenue (- Qm * pm ), but allows an increase in Qw (Qw) which gives a larger increase in revenue ( Qw * p w), then it is profitable to shift resources from producing maize to producing wheat (the cost is the same, the revenue increases); - by doing so, the M RT decreases: for a further equal decrease in Qm , the increase in Qw is smaller, and the shift is less profitable; - at one point, when Qw * p w = - Qm * pm , no further shift is profitable. This is exactly the tangency point.

What happens if output prices change? if both prices change by the same proportion (e.g., both increase by 5%): - the slope of the isorevenue remains the same (p m * 1.05 / p w * 1.05 = pm / pw) - the isorevenue shifts to the left (it is now possible to reach the same revenue producing less) - the transformation line will be tangent to a higher isorevenue - profits will increase (same cost, and a higher revenue) - the opposite is true if prices decrease by the same proportion if one price change (e.g., p m increases): - the slope of the isorevenue changes (becomes steeper, in this example) - the transformation line will be tangent to a higher isorevenue - profits will increase (same cost, and a higher revenue) - the proportion between the products will change: the farmer will produce more maize and less wheat, and the ratio Qm / Qw will increase - the opposite is true if the price decreases

M ore generally, a change in the proportion between the products results from any change in relative prices (p m / p w): for instance, if p m increases by 5% and p w by 3%, there will be an increase in the ratio Qm / Qw. This is why the supply of a product is inversely related to the price of alternative products: e.g., if the price of wheat increases, the farmers will produce more wheat, and the supply of maize will decrease. 2.5 PRODUCTION FUNCTIONS Talking of the production function: Q= f(X1, X2, , Xn)

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we defined the short-term production function (some factors are fixed, e.g. land, machinery): Q= f(X1, X2, , Xm | Xm+1, Xm+2,, Xn) and we talked of alternative forms: fixed and flexible coefficients We examined the case of flexible coefficients - flexible coefficients: the amount of a factor necessary for each unity of product depends on the production level (e.g. fertiliser per each ton of wheat) - flexible coefficients production functions can have an algebraic formulation We examine now the case of fixed coefficients - the amount of a factor necessary for each unity of product is the same, regardless of the production level (e.g., iron for producing each car) - there is a limited substitutability of one factor for another: i.e., there is a limited number of techniques - each technique is characterised by specific coefficients for each factor: this means that for producing one unit of output with a particular technique it is necessary to use fixed amounts of each variable factor It is often convenient to use fixed coefficient production functions even when (like in agriculture) flexible coefficients production functions are theoretically more appropriate: - farmers may know only few techniques, even if there are many others - fixed coefficient production functions are easily tractable on personal computers Here is an example of how 3 possible techniques are listed in a matrix, corresponding to 3 different machines:

Techniques
Factors
Seeds Fertiliser Fuel Labour

T1
5 3 4 2 1

Output

T2 5 3 3 4 1

T3 5 3 2 7 1

Each column lists the production coefficients: for example, to produce 1 unit of output with the first technique, one must use 5 units of seeds, 3 of fertiliser, 4 of fuel, 2 of labour. To produce 2 units of output, one must use 10 units of seeds, 6 of fertiliser, 8 of fuel, 4 of labour; and so on. With the second technique, 5 units of seeds, 3 of fertiliser, 3 of fuel, and 4 of labour are needed to produce one unit of output, the double to produce 2 units, and so on.

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Assume you are using technique 2. You have 12 units of labour available, and 20 units of fuel, and all the fertiliser and the seeds you need. Here are the results of using more inputs:

Technique 2
Factors Seeds Fertiliser Fuel Labour Output Units available all all 20 12 Used Used Used Used Used Used Used amounts amounts amounts amounts amounts amounts amounts 5 10 15 20 25 30 35 3 6 9 12 15 18 21 3 6 9 12 15 18 20 4 8 12 12 12 12 12 1 2 3 3 3 3 3

When 3 units of output are produced, all available labour is used: - it is then impossible to increase the production, even if more fuel and other inputs are available - fuel, seeds and fertilisers are useless if the labour required together with them is not available - labour is in this case a limiting factor.

Remark: if another technique is chosen, the limiting factor may be different; for instance, with technique 1, the situation is the following:

Technique 1
Factors Seeds Fertiliser Fuel Labour Output Units available all all 20 12 Used Used Used Used Used Used Used amounts amounts amounts amounts amounts amounts amounts 5 10 15 20 25 30 35 3 6 9 12 15 18 21 4 8 12 16 20 18 20 2 4 6 8 10 12 12 1 2 3 4 5 5 5

With this technique: - a greater production is possible - the limiting factor with this technique is fuel

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The Total product graph is:

Output

Technique 2 Technique 1

Fuel

The M arginal Product is: - constant up to the maximum output (with technique 2, each additional unit of fuel increases the output by 0.33 units) - equal to zero for further input units (no additional output is possible by increasing the use of fuel) - equal to the Average Product up to the maximum output (each unit of fuel produces on the average 0.33 units of output)

The VM P and VAP follow the same pattern. If the price of the input is lower than the VM P (and VAP) the optimal use of the input is the one that allows the maximum output: in the example, with technique 2 the optimal use of fuel is 9, which allows the maximum output of 3.

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OPTIMAL COMBIN ATION OF INPUTS (fixed coefficients) As usual, lets assume two variable inputs The ISOQUANT in the case of fixed coefficients: - the same output level can be achieved with different combination of inputs corresponding to the different techniques - the isoquant is formed by different points (one for each available technique), not a continuous line - the output levels are proportional to the distance from the origin on the half-lines corresponding to each technique (to get a double production, the double of inputs is needed, and so on) The ISOCOSTS are the same as in the case of flexible coefficients. The least-cost combination of inputs for a certain output level will be where the lowest isocost (red isocost 1) passes through a point on the isoquant (point B). This means that one technique (T2) is chosen. What happens if an input price change? - the slope of the isocost changes - the profits increase when the input price decreases, and vice versa - it is possible that the optimal combination remains unchanged (and the same technique is chosen), if the lowest new isocost still passes through the same point (blue isocost, number 2) - or, a new technique is chosen, if the lowest new isocost passes now through a point of the isoquant corresponding to another technique (green isocost, number 3; point C)

Optimal combination of inputs - fixed coefficients X2

T1

T2 1 A 2 B 3 C X1 T3

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OPTIMAL OUTPUT LEVEL (fixed coefficients) Variable costs are proportional to output (to get a double production, the double of inputs is needed, and, hence, variable costs double) the M arginal Cost is constant the Average Cost is decreasing

If the output price is higher than the marginal cost, the maximum profit is achieved with the maximum output. The production for which TC is equal to TR is called the break-even point: for a larger production, there are profits; for a lower production, there are losses.

Break-even point

Profits, costs

TR

Profits TC

Break-even point

Losses

Output Maximum output

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OPTIMAL COMBIN ATION OF OUTPUTS (two -or more- products - fixed coefficients )

The problem is the same as in the case of flexible coefficients: - a farmer can produce two products (e.g., wheat and maize) - each of them is produced with a particular technique - the farmer has given resources (a certain amount of land, of capital, of water, of labour etc.) - how much wheat and how much maize should he produce to maximise his profits? These are the techniques for producing wheat and maize:

Factors
Land Water Capital Labour Ha / ton m3 / ton $ / ton days / ton Tons Output

Wheat 0.25 300 30 4 1

Maize 0.125 1,500 35 6 1

For instance, the first row means that to produce 1 ton of wheat, 0.25 ha are needed (i.e., the yield is 4 tons/ha); and, to produce 1 ton of maize, 0.125 ha are needed (i.e., the yield is 8 tons/ha). Assume the farmer has available 10 ha of land, 60,000 m3 of water, 1,800 $, and 400 labour days. Each of these resources can be used to produce only wheat, only maize, or a combination of both. If the resources are used for only one product, the maximum outputs allowed by each resource are indicated by the following table:

Factors

Units available Ha mc $ Days 10 60,000 1800 400

Maximum output Wheat Maiz e


40 200 60 100 80 40 51.4 67

Land Water Capital Labour

all factors must be used according to the proportions indicated by the technique there is therefore a limiting factor for each product: for instance, if only wheat is produced, there is enough water to produce 200 t. of wheat, but not enough land: with the available land, it is only possible to produce 40 t. of wheat likewise, if only maize is produced, the maximum output is 40 t., due to available water

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It is also possible to produce a combination of the two products: - in this case, the resources are allocated to the two products: - the possibilities are indicated by the constraint lines: - for land: 10 = 0.25 * Qw + 0.125 * Qm - for water: 60,000= 300 * Qw + 1,500 * Qm - for capital: 1800 = 30 * Qw + 35 * Qm - for labour: 400 = 4 * Qw + 6 * Qm The production-possibility-frontier line is the broken line ABCD formed by the lowest constraint lines (i.e., by the combinations that are compatible with all constraints); remark that in this example labour is never a limiting factor.

Production-possibility frontier (fixed coefficients)

Maize

100

50

A B C

w ater

land
D

capital labour
50 100 150 200

Wheat

With given resources (i.e., with a given cost), the maximum profit is reached by maximising total revenues. TR are given by the sum of the revenue from wheat and from maize. All combinations of wheat and maize which yield the same revenue TR0 form an ISOREVENUE LINE (this is the same as in the case of flexible coefficients): TR0 = Qw * pw + Qm * pm or: Qw = - (pm / p w)* Qm + TR0 / p w The problem then is to choose the isorevenue line farthest from the origin which is compatible with the production-frontier curve. The optimal combination is the vertex of the production-frontier broken line touched by the isorevenue line farthest from the origin.

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Optimal combination of products (fixed coefficients)

Maize

100

50

B C

water

land
D

capital labour
50

Isorevenue
100 150 200

Wheat

There is not an analytical solution to this problem (at the tangency point, it is NOT true that the M RT of Qm for Qw = (pm / pw)). To solve this problem, a method called LINEAR PROGRAMM ING is employed. LINEAR PROGRAMMING is a more general tool: - it is based on the maximisation of a goal function (in this case, total revenue), subject to constraints (in this case, the constraint lines corresponding to the given resources) - it is possible to take into consideration factors not subject to constraints (e.g., fertilisers that can be freely purchased) - it is possible to take into consideration relationships internal to the farm (e.g., production of fodder to be used in livestock production). 2.6 PEAS ANT AND AGRIC ULTURAL HOUS EHOLDS The preceding analysis of the farm assumes a profit-maximising behaviour This implies an entrepreneur who is looking for profit, and purchases labour, land and capitals on the market. In reality, the situation is quite different: - farms are mostly operated as family farms; - there are often limitations in the availability of resources (e.g., credit constraints) This has several implications: - much, or all of the basic resources are contributed by the household: labour, land, capital - the household is in the same time a production unit and a consumption unit - if there are constraints in resource availability, the farm has to rely on household resources Hence the economic definition of peasant:
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farm households utilising mainly family labour partially integrated in imperfect markets

Is the behaviour of peasants different from the behaviour of classical firms? - in the past, a view of peasants as irrational, or backward, or traditional, or subject to noneconomic rules - more recently, an effort to understand the rationality of peasant behaviour Different theories: the theory of poor but efficient peasants: - peasants are neither irrational nor inefficient, they maximise profits - several studies trying to assess the efficiency of farmers, with mixed results - historically important for further efforts to understand the economic rationale of peasant behaviour

All alternative theories assume that farmers have goals different from profit. Partly, this arises from the consideration that farmers cannot know exactly their profits - if some resources are contributed by the farmer, they have no explicit cost (for example, a farmer owning his land does not explicitly pay a rent) - total revenue minus all explicit costs and depreciation is NET FARM INCOM E (NFI) - NFI includes all returns to resources contributed by the farmer, plus profits - returns to own resources means the remuneration of own land (rent for own land), of family labour (the wage for family labour), of own capital (the interests for own capital) - it is nevertheless impossible to know exactly how much of NFI is rent, wage, interests, and profits - returns to own resources can be estimated as OPPORTUNITY COSTS (an opportunity cost is the income foregone by using own resources on the farm): - the opportunity cost of own land is the rent that the farmer would get by renting out his land - the opportunity cost of family labour is the wage that family members would earn if they worked elsewhere - the opportunity cost of own capital is the interest that would be earned by lending it to someone else this is only true if it is actually possible to use these resources off the farm (for instance, if it is possible to find an off-farm job); if not, then there is no opportunity cost, but a subjective cost. It is therefore possible to know exactly profits if: - there are markets for all resources - the farmer has no preference for using his resources on the farm rather than off the farm (i.e., if he evaluates the remuneration of his labour as equal to the market wage, the remuneration of his capital as equal to the market interest rate, the remuneration of his land equal to the market rent) It is moreover not appropriate to assume that farmers try to maximise their NFI: - NFI can be increased by increasing the use of own resources on the farm (for instance, using more family labour or more capital) - but this has a cost: - an opportunity cost, if there is a market for these resources - a subjective cost, if there is not a perfect market for these resources, or if the farmer has a preference for using them on his farm
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the farmer has always to compare the increase in NFI and the increase in the (opportunity or subjective) cost

Two extreme cases are: - no external market for own resources - perfect markets for all resources (perfect markets means competitive markets, where everyone can buy or sell the relevant good at the market price, and no one has a market power)

a) no external market (e.g., it is neither possible to find an off-farm job, nor to hire waged labour) If the other resources are given, then it is possible to increase the output (or income) by increasing family labour use till its available quantity. This is the family income curve (curve O SR). Due to the law of decreasing marginal product, the increase is less than proportional. The slope of the curve is the value of marginal product of labour. M ore labour therefore implies more income, which makes the farmer happier; on the other hand, work is hard, and working more makes the farmer less happy. There is therefore a trade-off between the satisfaction of income and the pain of work, that can be represented by income-work indifference curves. An indifference curve depicts all combinations of work and income which give the farmer the same welfare. Higher indifference curves indicate an higher welfare (which in economics is called utility). The M arginal Rate of Substitution (M RS) of income for work (the slope of the indifference curve) represents the increase in income that is needed to make the farmer indifferent to work one more hour: - it is therefore the subjective wage level - for the same income, it is higher and higher as work increases (when the farmer has worked much, he needs a larger increase in income to be willing to work one more hour) - for the same amount of work, it is lower and lower as income decreases (when the farmer is poorer, he strongly needs money, and is willing to work one hour more for a lower increase in income) The maximum utility for the farm household is reached where the indifference curve is tangent to the family income curve. In this point, the M RS (the subjective wage level) is equal to the value of the marginal product: in other words, for levels of labour lower than OA, the utility from the increase in income resulting from an increase of labour is higher than the decrease in utility due to the increased work; for higher levels of labour, the increase in income would not be worth the decrease in utility resulting from the additional work. The amount of farm labour is OA, the total family income is OG.

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Fa rm household equilibrium in isolation from the labour market

I3 I2 I1 R G S

Total available family labour O A

Changes in the composition and size of the household: - modify the family income curve (for instance, when children grow up and can work, the available labour is larger) - modify the utility of income: larger families have more income needs, the utility of income increases, and the subjective wage is lower

Changes in output prices (for instance, an increase) have an indeterminate effect on labour use, and, hence, on the output level: - the family income curve is shifted upward, and the tangency is on a higher indifference curve - the VM P is increased, so from this point of view it is more profitable to increase labour use - on the other hand, the household is now richer, and the need for income is lower: this tends to reduce labour use - the final effect depends on these two contrasting effects (called substitution effect and income effect, respectively) - implication: - there is no theoretical prediction of the final effect on supply of an increase in output price - in any case, a situation of isolation from the labour market makes supply less responsive to prices than when the household is integrated in the labour market (This theoretical model is called the drudgery-adverse peasant, or non-separable household model)

b) perfect external markets (e.g., it is always possible for family members to find an off-farm job, and to hire waged labour)

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If the farmer has the possibility to work off the farm, the market wage represents the opportunity cost of family labour. if the value of the marginal product of labour on the farm (the slope of the family income curve) is higher than the market wage (the slope of the ww line), working on the farm gives an higher income than working off the farm if the market wage is higher than the value of the marginal product of labour on the farm, working off the farm gives an higher income than working on the farm with income-work indifference curves as indicated in the graph, the farmer works on the farm up to the quantity of labour for which the value of the marginal product of labour on the farm is higher than the market wage; then he works off the farm up to the point for which the market wage is equal to the M RS of work for income (i.e., to the tangency point of the market wage line ww with an indifference curve I1) the quantity of on farm work is OA, i.e., the quantity for which the VMP of labour is equal to the wage (its price) the quantity of off-farm work is AB the income from farming is OC, the income from off-farm work is CD working partly off the farm gives an higher utility (I1) than only working on the farm (I2)

Fa rm household equilibrium in the labour market: off-fa rm work

I1

w' L D I2

R C S

Total available family labour O A B

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If the farmer can hire workers at the market wage, it is possible than a part of the farm labour is contributed by hired workers. The farmer has therefore also the choice between working on the farm and making the hired worker work for him. Again, the total amount of farm labour is OA, i.e., the quantity for which the VM P of labour is equal to the market wage (its price) with income-work indifference curves as indicated in the graph, the farmer works on the farm up to the quantity of labour for which the market wage (his opportunity cost of labour) is equal to the M RS of work for income (i.e., to the tangency point of the market wage line ww to an indifference curve I1): the farmers quantity of labour is OB the rest of the labour (BA) is contributed by the hired workers the total farm income is OC, but the farmer has to pay the wage to his workers, which is CD: so, farmers income is OD this is a lower income than OC, which is the income he would earn if he hired no worker; but he is happier to have a lower income, but to work less. This is shown by the indifference curve I2, passing through point S (the work-income combination if the farmer did not hire labour), which is lower than I1

Fa rm household equilibrium in the labour market: hired labour

w'

I1 I2 R C S D E w

Total available family labour O B A

Changes in output prices (for instance, an increase) have a predictable effect on labour use, and, hence, on the output level: - the family income curve is shifted upward; - the VM P is increased, and the tangency with the wage line is at larger amounts of labour; - regardless of who contributes the labour (the farmer or the hired workers) the final effect is a larger output level;
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the amount of labour used on the farm (and, hence, the output level) only depends on the market wage, not on the preferences of the household (there is separability between farm decisions and household decisions); implications: - the farm behaves as a profit-maximising firm, equating the VM P of labour to its price (the market wage); - the impact of a change in output price is theoretically predictable: an increase in output price increases the output, a decrease in output price decreases the output; - the preferences and the demographic changes in the household have no impact on the agricultural production; they only determine the amount of family labour, on the farm and off the farm.

(This theoretical model is called separable farm household model)

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In the real world, there are many situations that are in between the two theoretical models: - imperfect labour markets (it is possible to find off-farm jobs but only in certain seasons, or for a certain amount of time; it is not always easy to find hired labour as desired, etc.) - it is also quite possible that certain family members are in the labour market, and others are not (for example, persons above a certain age cannot easily find a job; there may be discriminations against womens work, etc.) - in these cases the results are mixed: but in general any situation that isolates partially or totally the farm household from the labour market makes the farm output less responsive to market signals Finally, remark that in the non-separable model the farmer is assumed to be indifferent between farm and non-farm work. If, by contrast, he has different preferences for any of them (for instance, if he prefers to work on the farm, because on the farm he has no boss) then the behaviour is again non-separable: preferences do have an impact on agricultural output. 2.7 FARMERS AND RIS K All preceding analyses assumed certainty of all variables. In real life, this is almost never true: - due to the biological nature of agricultural production, there is a variability in the output resulting from the same amount of inputs - there are also natural hazards (weather, pests, and deseases) which cannot be controlled, or can be only partially controlled - prices of outputs are almost never known at the time the decision of producing is made; the problem is more severe for perennial crops and for animal productions that take time from the beginning of the production process to the final output - in more general terms, farmers often do not have full information on the variables that are influencing their activity So, farmers operate in an uncertain environment. Although the term uncertainty has been associated to situations where no objective probability can be associated to events (for instance, there is no known probability for a war in a particular area), it more generally refers to situations where events are uncertain. The term risk has a narrower sense: - risk include situations where objective probabilities can be attached to events (for instance, if weather time series show that a drought occurs on the average every 10 years, the probability of drought is 1/10); - but, since what is important is the perception that farmers have, the term risk is also used for situations where subjective probabilities are attached to events (for instance, when a farmer thinks that a drought can occur every 5 years, his subjective probability for the drought is 1/5) - the subjective probabilities are more relevant for decision-making of the farmers, since they make their decisions based on them

If there is a variability in the results of economic activity, the farmer might nevertheless make efficient choices on the average. For instance, suppose the farmer has to decide fertiliser use. The output results depend also on weather conditions in the following of the year, that the farmer does not know when he makes his decision.

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Assume that weather may only take two possibilities: good year, with higher yields, and bad year with lower yields. The VM P1 and VM P2 curves depict the two situations, respectively: in good years, the yields are higher, and the VM P curve is therefore higher, than in bad years. In good years, the optimal input use is OA, in bad years it is OB. Assume that bad years occur every 4 years (or that the farmer believes that a bad year occurs every 4 years): then the (objective or subjective) probability of a good year is , the probability of a bad year is . The expected VM P (what it is on the average, or what the farmer expects it to be, based on his knowledge or beliefs on the likelihood of occurrence of bad and good years) is the weighted average of the VM P of good and bad years: E(VM P) = VM P1 + VM P2 The E(VM P) curve lies between the VM P1 and VMP2 curve. A similar situation applies to VAP. A rational behaviour for the farmer would be to use the quantity of input (OC) that makes the expected VM P equal to the input price: by doing so, he would use too much input in the bad years, and too little input in the good years; but, on the average, he would obtain the best profits.
Behaviour of farmers under risk and safety-first approach

VMP, VAP, input price

VMP1

VAP1 E(VMP)

VMP2 VAP2 P1

E(VAP)

Input

Nevertheless, such an approach neglects some basic points: - farmers may have some income goals that they have to reach first - farmers have their attitudes towards risk
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Two approaches to the analysis of farmers behaviour under uncertainty reflect these points: - the safety-first (or disaster-avoidance) approach - the expected utility approach

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The safety-first approach The idea behind this approach is that farmers have the primary goal to avoid that some variable goes below a minimum value which would result in a disaster. - for instance, first of all they may want to reach each year at least the minimum output which is needed for their survival; - even if on the average of the different years they were to get an higher income, if they could not reach the survival output in one year they would starve to death. In our example, if the farmer has the constraint of not having losses in any year, he cannot choose the optimal solution (the amount of input OC for which E(VM P) is equal to input price). If he did so: - he would maximise profits on the average; - but, if a bad year occurs, he would fall below the zero-profits level - in a bad year his VAP would be lower than the input price, and he would suffer losses As a result, he has to remain in the vicinity of OB, in order to avoid the disaster that would occur in the bad year. A variant of this model is the assumption that the farmer is unwilling to risk obtaining profits below a given level, unless the relevant probability is very low.

The expected utility model The preceding models assume that farmers have a primary goal, defined as a constraint. Another approach assumes that they have positive preferences for income, but negative preferences for risk. Therefore, there is a trade-off between more income and the higher risk that it would entail. For an example, suppose a farmer can plant a crop which will give an income of 1000 in case of a good year (which occurs 3 years over 4, i.e., with a probability of ), but a loss of 200 in case of a bad year (which occurs 1 years over 4, i.e., with a probability of ). The expected income (called in general the Expected M oney Value, EM V), is the weighted average of the two outcomes: EM V = 1000 * + (-200) * = 750 - 50 = 700 Now assume that he is given the choice to plant another crop at no risk. If the new crop gives a certain income of 600, and the farmer is indifferent between the certain income 600 and the uncertain outcome of the risky crop, 600 is said to be the certainty equivalent of the uncertain income: it is the amount of money that would make the farmer as happy, or indifferent, to taking the chance of the two different income outcomes in good and bad years. In this example, the certainty equivalent is lower than the EM V: this reflects the fact that the farmer is prepared to get a lower income than the one he would get on the average, in order to be sure of the income he gets. This farmer is said to be risk-adverse: he prefers to have a lower certain income than having on the average an higher but uncertain income. The difference between the EM V and the certainty equivalent is called the insurance premium that the farmer is prepared to pay to be certain of his income. If the EM V is equal to the certainty equivalent, then the farmer is said to be risk-neutral: he is indifferent between a certain income and the same expected value of the two uncertain incomes.
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Finally, if the certainty equivalent for the farmer is higher than the EM V, then he is said to be risktaker: in other words, he is a gambler, who is willing to accept a lower income on the average than a certain income because he likes risk and prefers to take the gamble. The difference between the certainty equivalent and EM V is the premium he is prepared to pay to have the chance to gamble. According to this approach, the farmer makes his choices according to certainty equivalent of each alternative. Taking again the example of fertiliser use, assume that the choices are only the lower and higher fertiliser usage (OB or OA). According to the events or states of nature (good or bad year), the following incomes result: - with choice A (more fertiliser), an income of 1000 (area PFEM ) in case of good year (when the actual VAP is VAP1), and a loss of 500 (area PFDT) in case of bad year (when the actual VAP is VAP2); - with choice B (less fertiliser), an income of 700 (area PLHK) in case of good year (when the actual VAP is VAP1), and a income of 50 (area PLGS) in case of bad year (when the actual VAP is VAP2)
Behaviour of farmers under risk and the expected utility approach

VMP, VAP, input price

VMP1 K M H VAP1 E

VMP2 S P G F L VAP2 T D

Input

Assume that the certainty equivalent for choice A and B are, respectively, 460 and 500. The following table summarises the outcomes, the EM Vs and the certainty equivalents corresponding to the choices.

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Analysis of a risky decision problem


Actions

A: More fertiliser

B: Less fertiliser

Events
Good year Bad year EMV Certainty equivalent

Income Probability Income*prob Income Probability Income*prob 1000 0.75 750 700 0.75 525 -500 0.25 -125 50 0.25 12.5 625 537.5 460 500

In terms of Expected M oney Value, choice A would be preferable, since the average income that the farmer should expect is 625, as compared to 537.5 with choice B. Nevertheless, since choice A implies a loss of 500 in case of a bad year, it has a low certainty equivalent, so that the farmer prefers choice B. In other words, the farmer maximise the utility he expects from uncertain events. The result of a risk-adverse behaviour, both within a disaster-avoidance approach and an expected utility approach, is that the farmer may not use resources at the optimal level. Several studies support the hypothesis that: - farmers are risk-adverse - cropping pattern are chosen to increase family security rather than maximise profits - risk aversion is stronger among poor farmers - risk aversion can create an obstacle to the diffusion and adoption of innovations Policy implications: Several policies can be designed to reduce uncertainty: - irrigation schemes decrease the uncertainty in output due to rainfall variability - diffusion of pest-resistant varieties can stabilise yields - price stabilisation schemes can reduce price variability - spreading technical and market information can reduce uncertainty due to lack of information.

2.8 EFFIC IENCY AND TECHNOLOGICAL CHANGE CONCEPTS OF EFFIC IENCY Two concepts of efficiency are relevant in economics: - technical efficiency - allocative efficiency Technical efficiency means achieving the maximum level of output for given levels of inputs (or the minimum input usage for a given level of output). In this sense, a farmer is not efficient if he does not follow the best practices which are available. Allocative efficiency (or price efficiency) means using factors and producing products in proportions that maximise profits, i.e., that reflect relative prices.
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Economic efficiency means achieving both the technical and the allocative efficiency. The following Graph 1 shows the Total Product (in value) curves and the input usage of a group of farms with the same resources other than the relevant input. - the TP1 curve is higher than the TP2 curve: so, farms on TP1 are technically efficient, in the sense that they achieve the highest output level with the amount of input they use; - farms on TP2 curve are technically inefficient; - farms using the input amounts for which their VM P (the slope of the TP curves) are equal to the input price (the slope of the straight lines) are price efficient: they maximise profits subject to their technical abilities; - farm D displays both technical and allocative inefficiency; - farm C displays technical inefficiency, but allocative efficiency; - farm B displays technical efficiency, but allocative inefficiency; - farm A displays both technical and allocative efficiency; it is the only one that is economically efficient. Graph 2 shows similar situations with reference to the use of two inputs: points on isoquant Q2 are technically inefficient, since they require larger amounts of inputs for the same output. The situations of the farms are the same as above. Graph 3 illustrates the Production Possibility Frontiers for two products with the same resources: points on PPF2 are technically inefficient, since they indicate lower levels of both products with the same resources.

Graph 1: Technical and allocative efficiency in using one input

Output value

TP1

*
TP2 B

*D

Input

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Graph 2: Technical and allocative efficiencyin usi ng two inputs, and effici ency indices

* *E
R

C A

* * B

Q2=100

Q1=100

Graph 3: Technical and allocative efficiency in producing two products Q2

**
D

B A

* *C

PPF1 PPF2 O Q1

Some indices for measuring technical inefficiency have been proposed by Farrell. With reference to Graph 2, a measure of technical efficiency for farm D is the ratio OE/OD: if it were for instance 80%, the farmer might decrease both inputs by 20%, without a decrease in output.
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The lowest isocost passing through point A indicates the lowest possible cost for producing 100 units of output; therefore for a farm technically efficient (i.e., producing along the lowest isoquant) but not producing in A, say E, a measure of allocative efficiency is the ratio OR/OE: if it were for instance 90%, the farmer might decrease his costs by 10%, without a decrease in output, by allocating better his inputs. The overall economic efficiency can be measured by OR/OD, that can be decomposed as: OR/OD = OE/OD * OR/OE or: economic efficiency = technical efficiency * allocative efficiency.

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TECHNOLOGIC AL CHANGE The largest part of the increase in agricultural output during the last centuries has to be attributed to technological change. Technological change is a change in existing knowledge on the methods of production. Technological change allows to: - produce more output with the same quantity of inputs - produce the same output with lower quantities of inputs Graphs 1, 2 and 3 can also be used for illustrating technological change: - in Graph 1, if you assume that the existing technology is TP2, then the TP1 curve shows the result of a technological change: more output can be produced with the same input levels, or the same output can be produced with less input; - in Graph 2, if you assume that the isoquant Q2 depicts the existing technology, the effects of a technological change are shown by isoquant Q1: less inputs are needed for reaching the same output level; - in Graph 3, if PPF2 shows the production possibilities of two products with the existing technology, PPF1 indicates that more of both products can be produced with the same resources.

Technological change can be distinguished between: - neutral, when, at given input prices, the optimal ratio of the inputs is the same after the technological change; - biased, when, at given input prices, the technological change modifies the optimal ratio of the inputs. In Graph 4, the isoquant is shifted downward by the technological change, but the input ratio (K/L) remains the same. This indicates a neutral technological change. In Graph 5, a technical change biased in favour of capital and against labour is shown: the isoquant has moved, but in such a way to make the K/L ratio higher. The technological change is labour saving and capital-intensive.

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Graph 4: Neutral technological change

Capital

*
B

Q1=100

Q2=100

K/L O Labour

Graph 5: Biased technological change

Capital

B'

A Q1=100 Q2=100

K/L2 K/L1 O Labour

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Technological change can be: - labour-saving: e.g., innovations in mechanisation, chemical weed control - land saving: e.g., High Yield Varieties, new agronomic practices, pesticides Sources of technological change are: - learning-by-doing - public research and development - private research and development - imported research and development Farms are too small to implement R&D activities by themselves. So, private research is often embodied in new inputs produced by manufacturing companies. One important feature is whether the innovations are potentially proprietary or not: - no private firm will do research and development on innovations that cannot be patented or somehow appropriated; - only public bodies will do research potentially non proprietary.

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The theory of induced innovation According to this theory, innovation is induced as a response to changes in relative prices, that push firms to produce innovations in order to use less of the resource which has become more expensive. The theory can be described as follows: - agriculture develops over time and, in different countries, particular resources become scarce, so that their relative price increases (e.g., in Europe land became scarce and expensive, so its price relative to labour increased; in the USA, land is abundant, so its price relative to labour declined); - there is therefore a potential demand for innovations saving the expensive resource; - manufacturing firms are therefore induced to look for new products saving that resource; - public research bodies also respond to the potential demand, or to political pressures by the farmers; - in labour-scarce, land-abundant economies, research takes the path of labour-saving technologies; - in land-scarce, labour-abundant economies, research rather directs towards yield-increasing technologies (induced innovation change is different from adjustment to changing relative prices with a given technology) In Graph 6 the effects of an induced innovation changes are shown: - the original situation is point A, on isoquant I1, given the land-labour price ratio P1. - A belongs to an innovation possibility curve IPC1 (all possible techniques that could be developed with present knowledge) - a change in the land-labour price ratio to P2 makes the farmer shift on the short-term to point B (this is the usual substitution effect of a relative price change with existing technology); - nevertheless, this is not the most efficient technique that could be developed with existing knowledge IPC1; - but the new land-labour price ratio induces further research in labour-saving technologies, with the result of shifting inward the IPC to IPC2; - a new equilibrium is reached at point C, where the new isoquant I2 is tangent to the price line P2.

This theory explains the different technological path that has been historically followed in the USA vs. the one that has been followed in Europe and Japan. Nevertheless, some more elements should be considered: - there are further differences in the demand for technological change between small and large farms; - small and large farmers differ in their possibility to influence public research; - the theory does not consider imported technology and its impact on existing agriculture Finally, the question of property rights on innovation is crucial: - non proprietary innovation may basically be developed by public research networks, that in developing countries are weak; - private research is usually not interested in developing innovations addressed to small numbers of farmers, specially if they have low incomes; - this issue is particularly relevant for biotechnological innovations.
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3 ECONOMICS OF AGRICULT URAL MARKETS


3.1 PRODUCT S UPPLY What is a market?
Labour

Graph 6: Induced tech nol ogical change

A market is a way to organize exchanges, based on voluntary agreements: someone is willing to B something else, and someone else is willing to accept the exchange. give something in exchange for I1 This is also true for a barter economy, when there is no money: Person A gives a cow to person B, who in exchange gives A 5 goats. IPC1 The ratio with which goods are exchanged is called a relative price: P2 - the price of 1 cow is 5 goats - the price of 1 goat is 1/5 of a cow I2
C IPC2

Using money is much easier: all goods are sold for units of a currency. But remark that relative prices are the same. For instance: P2 P1 a cow is $ 500 - the price for Land O - the price for a goat is $ 100 - the price of one cow is five times the price of one goat, so the relative price of a cow is still 5 goats - the price of one goat is one fifth of the price of one cow, so the relative price of a goat is still 1/5 of a cow In money economy, almost all exchanges take place through money, for a price; - many operators are selling and buying in the same time the same good; - the total quantity of a good that operators are willing to sell for a given price is called market supply (as opposed to individual supply = the total quantity of a good that a particular operator is willing to sell for a given price) - the total quantity of a good that operators are willing to buy for a given price is called market demand (as opposed to individual demand = the total quantity of a good that a particular operator is willing to buy for a given price) market supply is different for each price; likewise, market demand is different for each price - a market is in equilibrium (and the price is called an equilibrium price) when sellers can sell for that price exactly the quantity they wished to sell, and buyers can buy exactly the quantity they wished to buy for that price (well return on this) There are different markets for different goods, and different markets for the same good: product vs. factor markets: - in product markets, the demand comes from consumers (e.g., consumers demand apples) - in factor markets, the demand comes from firms (e.g., a car industry demands iron) - remark that the same good can be both a product and a factor (consumers demand apples as a product, but jam industries demand apples as a factor) producers/wholesale/retail markets for the same good: agricultural products are purchased at the farm gate level: then they are traded in a wholesale market; food shops that sell them to final consumers. Each of these markets has characteristics of its own: the number of operators is different; the market power of operators is different; the price is different
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spot/future markets for the same good: - some agricultural goods (specially the internationally traded ones) can be sold and purchased in a particular moment (this is called the spot market) - they can also be traded for a given time in the future (this is called a future market): o in simple terms, one can buy today the right to buy a quantity of the good at a given price in the future, or can sell today the promise to sell a quantity of the good at a given price in the future o this is done based on the price expectations in the future: for instance, if Im afraid that prices will grow, I want to be sure I can buy at a given price when Ill need the good geographically differentiated markets for the same good: for instance, wheat is traded in Syria and in Italy, but these are different markets the reasons for geographical differentiation are: o transportation costs (the lower the transportation costs, the more the markets are connected) o trade barriers (levies, taxes, etc., which prevent the markets to interact) the larger an internal market, the less it is influenced by external markets

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MARKET S UPPLY The market supply is the total quantity of a good that all operators together are willing to sell for a given price. We studied individual supply: the total quantity of a good that a particular operator is willing to sell for a given price. M arket supply is the sum of individual supplies: suppose there are three producers, A, B, and C; when the price is 10, A produces 15, B produces 13.5, and C produces 3: then the market supply for the price 10 is 31.5 (= 15+13.5+3). Each operator supplies different quantities of the good for different prices: these quantities form the individual supply curve . Summing individual supplies for each price results in a market supply curve , which gives the quantity that all operators together are willing to supply for each price. M arket supply increases when the price increases because: - each operator already producing produces more - for an higher price, operators who did not yet produce (because the price was lower than their minimum average cost) now start producing In the following example: - none produces for a price lower than 4; - for price 4, only B produces 4.5; - for price 5, B produces 6, and A starts producing (5): the market supply is now 11 - for price 8, B produces 10.5, A produces 11, and C starts producing (2): the market supply is now 23.5
Individual and market supply Individual supplies A B C
4.5 6 7.5 9 10.5 12 13.5 15 16.5 18 19.5 21 22.5 24 25.5 27 28.5 30 31.5 33

Price 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Market supply A+B+C


4.5 11 14.5 18 23.5 27.5 31.5 35.5 39.5 43.5 47.5 51.5 55.5 59.5 63.5 67.5 71.5 75.5 79.5 83.5 59

5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41

2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5

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The following graph displays the individual and market supply curves

Individual and market supply


25 20 A Price 15 10 5 0 0 20 40 Output 60 80 100 B C A+B+C

The market supply curve displays the relationship between supply of a product and its price, all other factors held constant. A change of the product price induces movements along the curve: - a price increases results in a larger supply - a price decrease results in a smaller supply - the supply curve is therefore upward sloping It is important to measure the response of supply to changes in the price of the product. A convenient measure of the response is the elasticity of supply (more precisely, own-price elasticity of supply). EQ1,P1 = proportionate change in quantity supplied / proportionate change in own price = = (Q1/Q1) / (P1/P1) = (Q1/ P1) * (P1/Q1) = = (Q1/ P1) * (P1/Q1) for an infinitesimal change The own-price elasticity is positive. The supply is said to be: - elastic, if the elasticity is >1: for instance, a 1% increase in price brings forth a 1.5% increase in supply; - unitary elastic, if the elasticity is = 1: for instance, a 1% increase in price brings forth a 1% increase in supply; - inelastic, if the elasticity is < 1: for instance, a 1% increase in price brings forth a 0.4% increase in supply. As explained in the economics of production part (optimal combination of products), output also responds to changes in the prices of competing products: - an increase in the price of a competing product results in a decrease in supply - a decrease in the price of a competing product results in an increase in supply

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For instance, an increase in the price of wheat is expected to decrease the supply of barley, all other things constant: farmers consider that wheat is more profitable, and produce more wheat, so that the production of barley decreases. In graphical terms, this is expressed by shifts of the supply curve: - an increase in the price of a competing product shifts the supply curve to the left: for each price of the relevant product, the supply is now lower - a decrease in the price of a competing product shifts the supply curve to the right: for each price of the relevant product, the supply is now larger The response of the supply of a product to changes in the price of a competing product can be measured through the cross-price elasticity of supply: EQ1,P2 = proportionate change in quantity supplied of Q1/ proportionate change in price of Q2 = = (Q1/Q1) / (P2/P2) = (Q1/ P2) * (P2/Q1) = = (Q1/ P2) * (P2/Q1) for an infinitesimal change The cross-price elasticity for competing products is negative. There are also joint products (i.e. goods that are produced together, like wool and lamb meat, milk and calves, etc.) - an increase in price of a joint product shift the supply curve to the right; - a decrease in price of the joint product shifts the supply curve to the left - the cross-price elasticity for joint products is positive. Also the state of technology influences supply: - as already seen, a technological change shifts the total product curve upwards, or isoquant downward - therefore, more output can be produced from the same amount of inputs - the M arginal Cost and Average Cost curves are pushed downward and to the right - this results in a shift of the individual supply curve to the right and, hence, in a shift of the market supply curve to the right Also the natural environment has an impact on supply: - weather trends may increase or decrease the output (shifting the supply curve to the right or to the left) - this is particularly important as regards the difference between planned and realised output Finally, institutions and policies may influence output, through: - imposition of quotas - planned plantings - (input and output price policies are already implied by the supply curve) Short-term and long-term supply: - supply is more elastic on the long-term - on the short-term, only partial adjustment are possible to price changes, since some factors are fixed: the adjustment is constrained - on the long-term, farmers can fully react to market changes by modifying all factors But even on the short-run, there may be technical constraints that make farmers response to changes in prices slow: e.g. the time necessary to grow animals, crop rotations, etc.
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3.2 THE D EMAND FOR INPUTS The demand for a good is the quantity of that good that a buyer is willing and able to buy at given prices. Firms demand intermediate inputs and capital goods. Consumers demand consumers goods.

THE D EMAND FOR INPUTS (The demand for capital goods is not treated here) The firms demand for one input was derived in the first part: - holding all other things constant, a firm uses the quantity of a particular input that makes the Value of the M arginal Product equal to input price - the firms demand for that input is therefore the downward sloping part of the VM P curve below the maximum VAP The industry demand for that input (the demand of all firms together), nevertheless, is not the simple sum of all individual demands. This is because, if the input price decreases: - more input is employed - the result is a growth in the final product - the price of the final product decreases - the VMP decreases (remind that VMP = MP * output price) and its curve is shifted downward to the left - the input usage by the firm is reduced

Graph 1: demand for a single input

P0 D d1 P1 d2

input price

O FIRM

input

input

INDUSTRY

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In Graph 1, d1 is the firms initial demand curve for the input; - for price P0, the firms demand is Oa; - at the industry level, this corresponds to quantity OA, the sum of input usage of all firms - if the price drops to P1, all firms try to use Ob (demand curve d1); - by doing so, the industry demand would be OB; - but this decreases the output price, resulting in the shift to the left of demand curve from d1 to d2; - as a result, each firm uses Oc, so that the industry demand is OC.

When two (or more) inputs are used, a decrease in price of one input (X1) determines for both inputs two effects: - a substitution effect - an expansion effect

In Graph 2, the initial situation is indicated by point E, at the tangency of isoquant Q1 to the isocost (solid line). A fall in price of the fertiliser changes the slope of the isocost (dotted line) and the new optimal situation is point E, at a higher output level. The substitution effect for the fertiliser is AC, that is, the increase in fertiliser usage that would result from keeping the output at level 80. It depends on the relative price: the fertiliser is now less expensive than the water, and fertiliser is substituted for water. But, as the price has decreased, the marginal cost for producing the output has decreased too, and it is profitable to expand the output to 100: there is a further usage of fertiliser, CB, that represents the expansion effect. For the fertiliser, both expansion and substitution effect have the same direction. For water, the substitution effect is negative (DG), while the expansion effect is positive (GF). In this example, the expansion effect outweighs the substitution effect, so there is an overall increase in its usage. In conclusion, while the demand of one input is inversely related to its price, there is no a priori prediction of the effect of the price of a substitute input on the demand of a particular input. But the more the two inputs are easily substitutable, the more likely it is that the substitution effect is stronger than the expansion effect: in this case, the demand for one input is directly related to the price of the other input (when the price of the other input decreases, the demand for the first one decreases, and vice versa). To summarise, the demand of one input is determined by: - its own price (inversely) - the price of the final product (directly) - the marginal product of the input - the technological change (which shifts upwards the MP) - the prices of alternative inputs (normally, directly) - the quantity of fixed factors

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Gra ph 2: substitution and expansio n effects

F D G

Water

E E''

E' Q2=100

Q1=80

Fertliser

3.3 CONS UMERS DEMAND The basis for the analysis of demand is consumers behaviour. A consumers demand for a good is the quantity of that good that a buyer is willing and able to buy at given prices. The assumptions for analysing consumers behaviour are: - the consumer gains satisfaction, welfare, or utility from the goods - he has limited resources - he is trying to obtain the greatest utility from his resources - he is able to make consistent choices For the consumer to be able to make consistent choices, he only needs to rank consistently bundles (combinations) of goods. This requires few conditions: - completeness: the consumer is able to compare two bundles, and decide whether one is preferred or indifferent to the other; if two bundles are X and Z, then: - either X is preferred to Z - or Z is preferred to X - or X is indifferent to Z

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transitivity: the consumer is consistent in his choices: if he prefers X to Z, and Z to Y, then he prefers X to Y non-satiation: if X contains more of one good, and no less of any other good, than Z, then X is preferred to Z

To illustrate graphically consumers preferences, indifference curves can be used. Take two goods (say, apples and oranges), in a given bundle (point E). Then any bundle that contains more of oranges and apples is preferred, and any bundle that contains less of both makes the consumer worse off: these are areas A and C, respectively, delimited by the vertical and horizontal lines passing through E. Areas B and D define bundles that contain more oranges and less apples, and more apples and less oranges, respectively, than E. In these areas, there are bundles of oranges and apples from which the consumer obtains the same utility as from E: they define the indifference curve. M oving along the indifference curve, the consumer gains utility from the larger quantity of one good, and loses utility from the smaller quantity of the other one. But the utility remains constant. The rate at which one good can substitute for the other, keeping utility constant, is the M ARGINAL RATE OF SUBSTITUTION: M RS of Q2 for Q1 = Q2 / Q1 = Q2 / Q1 (holding utility constant) = slope of the indifference curve The M RS is the increase in quantity of one good that is needed to compensate for a small decrease in the quantity of the other good, to keep the utility constant,. It can be shown that: M RS of X2 for X1 = Q2 / Q1 = - M UQ1 / MUQ2

The M RS is: - negative (if it were positive, the consumer would be inconsistent, being indifferent to smaller or larger quantities of both goods) - decreasing in absolute terms: this indicates that the MU of goods are decreasing, that is, the
Graph 1: Consumer's choices and indifference curve

Apples

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increase in utility from a further unit of a good is smaller and smaller the more of that good the consumer has.

There are infinite indifference curves; an indifference curve farther from the origin indicates an higher utility.
The consumer has an income M 0 available, that he can use for buying one good, or the other, or both. With the given M 0 to spend for buying Q1 and Q2, the consumer can: - spend all the sum for Q1 and get M 0 / p Q1 of it (p Q1 is the price of Q1) - spend all the sum for Q2 and get M 0 / p Q2 of it (p Q2 is the price of Q2) - spend the sum for a combination of Q1 and Q2: M 0 = Q1* p Q1 + Q2* p Q2 or: Q2 = M 0 / p Q2 (p Q1 / p Q2 )* Q1 All combinations of the two goods that he can buy with the given income form the budget line. The slope of the budget line is (-) the ratio of the prices of the two products. The maximum utility is attained by the consumer when the budget line is tangent to an indifference curve (point E, Graph. 2). Points on the budget line other than E are attainable, but are on lower indifference curves, like I1; it is impossible a greater utility (I3). At point E, the M RS is equal to the ratio of the prices: Q2 / Q1 = (p Q1 / p Q2 ) and since: Q2 / Q1 = - MUQ1 / M UQ2 -MUQ1 / M UQ2= (p Q1 / p Q2 ) or: M UQ1 / p Q1 = M UQ2 / p Q2 That is, the increase in utility for a SP more spent for one good is equal to the increase in utility for a SP more spent for the other good.

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Graph 2: The consumer equilibrium

M/pa

Apples

E I3 I2

I1 Budget line O A M/p o Oranges

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Effects of price and income changes: If both prices change by the same proportion (e.g., they both increase by 5%): - the budget line shifts downwards to the left - the slope of the budget line remains the same - a lower level of utility is achieved - the shift is equivalent to the effect of a 5% decrease in income an increase in all prices by the same proportion (= all prices multiplied by a constant) is equivalent to a decrease in real income by the same proportion (= income divided by the same constant); an decrease in all prices by the same proportion (= all prices multiplied by a constant) is equivalent to an increase in real income by the same proportion (= income divided by the same constant)

Changes in income shift the budget line: - the slope of the budget line remains the same - a decrease in income shifts the budget line downwards to the left - a lower level of utility can be achieved - an increase in income shifts the budget line upwards to the right - a higher level of utility can be achieved for each level of income, there is an optimal point. all the optimal points corresponding to different income levels form an income-consumption line the impact of a change in income on the consumption of the goods depends on the particular goods: - goods whose consumption increases when income increases are called normal goods - goods whose consumption increases when income decreases are called inferior goods

Graph 3: Income-consumption curves

Q2

M/p2

Income-consumption line M'/p2

E I3 I2

I1

M'/p1

M/p1

M''/p1 Q1

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Q2

Income- consumption line M/p2

M'/p2

I3 D I2

I1

M'/p1

M/p1

M''/p1 Q1

Q1 is inferior, and Q2 is normal

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If one price changes (e.g., if p1 increases): the slope of the budget line changes accordingly (becomes steeper, in this example: budget line BL2) a new equilibrium is reached by the consumer at the new equilibrium, the utility is lower (I2) the reverse happens when the price decreases (budget line BL3 and indifference curve I3) the different equilibria form a price-consumption line if, when the price of one good increases, the consumption of the other increases, and vice versa, the two goods are substitutes (for instance, orange and apples) if, when the price of one good increases, the consumption of the other decreases, and vice versa, the two goods are complements (for instance, coffee and sugar)

Graph 4: Price-consumption curves

Q2

M/p2

Price-consumption line

E I3 I1

I2 BL2 O A M/p1' BL1 M/p1 BL3 M/p1'' Q1

Q1 and Q2 are complements

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Graph 4 (b): Price-consumption curves

Q2

M/p2 I2 I1 I3

Price-consumption line

BL2 O A M/p1'

BL1 M/p1

BL3 M/p1'' Q1

Q1 and Q2 are substitutes

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The individual demand curve can be plotted from the price-consumption line. The individual demand line displays the quantity of the good that the consumer is willing and able to buy at the different prices

Graph 5: Price-consumption curve and demand

Q2

M/p2

*
E

Price-consumption line

BL2 O B A C M/p1'

BL1 M/p1

BL M/p1'' Q1

p1

p1' p1 Demand curve

p1''

B
.

Q1

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Income and substitution effects


The price-consumption line indicates the change in consumption when a price changes. The change in consumption can be decomposed in two parts: - substitution effect - income effect A price increase determines a fall in real income: the consumer, given his money income, reaches a lower utility. A price decrease determines a rise in real income: the consumer, given his money income, reaches a higher utility.

The total effect of a price change is the total change in quantity demanded from the original equilibrium to the new equilibrium. It depends both on the change in relative prices, and on the change in real income. The substitution effect of a price change is the change in quantity demanded due to the change in relative prices, keeping real income (utility) constant. The income effect of a price change is the change in quantity demanded due to the change in real income, keeping money income constant and price ratio constant at the new level.

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Graph 6: substitution and income effects

Apples L F D G I1 BL2

E E''

E' I2

BL1 O A C B

BL3 Oranges

In this example (Graph 6), the original equilibrium is in E. The price of oranges falls, so that the budget line shifts from BL1 to BL2, and the new equilibrium is in E. If the consumer were kept at his original level of utility, by decreasing his money income (budget line BL3, tangent to the original indifference curve I1), he would choose E. The substitution effect is AC, i.e., the increase in consumption only due to the fact that oranges are now cheaper relative to apples, keeping real income constant. The substitution effect is CB, i.e., the change in consumption due to the fact that his real income has increased, so that he can achieve the level of utility indicated by I2 instead of I1. The total effect is AC.

The substitution effect is always negative, i.e., an increase in price determines a fall in consumption, and vice versa. In this example, oranges are a normal good, so the income effect is negative: a fall in price determines an increase in real income, and hence in consumption, and vice versa.

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If the relevant good is inferior, then the income effect is positive: a rise in price determines a decrease in real income, and consumption increases for this reason. If this is the case, then the total effect is undetermined: it depends on whether the substitution effect outweighs the income effect or not. Nevertheless, the cases where the income effect is stronger than the substitution effect, so that the demand increases when the price increases (these are called Giffen goods), are very rare and this may only happen when the relevant good forms a large share of the consumers expenditure.

The demand curve (also called the M arshallian demand curve) incorporates both the substitution and the income effects. The compensated demand curve (also called the Hicksian demand curve) is the curve depicting the quantities of the good that are demanded at the different prices holding utility constant. It lies below the M arshallian demand curve for prices below the original one, and above for prices above the original one. This is because a fall in prices increases real income, and the compensated demand is therefore lower; by contrast, a rise in prices decreases real income, and if the consumer were compensated for this, he would buy a larger quantity of the good.

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Graph 7: compensated and non-compensated demand curves

Price

Demand curve

Compensated demand curve

To summarise, the individual demand is a function of: the price of the good the consumers income the prices of other products the consumers tastes

Demand function: Q1 = f(p 1, p 2,, p n, M ) The demand curve is the demand function when all variables other than own-price are held constant: Q1 = f(p 1 | p 2,, p n, M)

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The relationship between demand and income, holding all other variables constant, is called the Engel curve: Q1 = f(M | p 1, p 2,, p n)

Gra ph 8: Engel curves

Income

M1 M0

M1 M0

O Normal

Q0

Q1

Income

Q1

Q0

Inferior

The curves expresses the idea that the demand for goods may increase when the income increases (normal goods) or it may decrease when income increases. The cheapest foods are usually inferior goods, that the consumer gives up as soon as he reaches a minimum income. Some basic foods (wheat, rice) are normal goods at low income levels, but may become inferior goods at higher income levels. M ore expensive foods are normal goods.

3.4 MARKET D EMAND


The market demand is the quantity of a good that all consumers together are willing and able to buy for a given price. The market demand is the sum of individual demands. The market demand curve depicts the quantities of the good that consumers are willing to buy for all price levels, holding constant all other relevant variables. It is the sum of the individual demand curves. When the price increases, the market demand decreases because: - some consumers do not consume any more of the good - consumers still willing to buy the good consume less The opposite is true when the price decreases.

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All variable that influence individual demand also influence market demand: - own price - price of other products - income - tastes But, since the market demand curve is the sum of the individual consumer demand curve, the market demand also depends on the total population: - a population growth shifts the market demand curve to the right - a decrease in population shifts the demand curve to the left - more complicated effects depend on the population changes: for instance, young people consume goods differently from older people; since a population change usually entails a different age distribution, this may affect the market demand for the different goods. M oreover, since the demand curve for the individual consumer is conditional on his income, the market demand curve is influenced by income (per capita income), but also by the income distribution. This is because the effect of income on the demand is different at different income levels, as shown by the Engel curves: so the same average income can yield different market demands, if the income distribution is different. The market demand function can be written as: Q1 = f(p 1, p 2,, p n, M , Population, Income distribution, Tastes) The market demand curve is the market demand function when all variables other than own-price are held constant: Q1 = f(p 1 | p 2,, p n, M, Population, Income distribution, Tastes) movements along the curve show the effects of changes in own price shifts of the curve show the effects of the other variables

Shifts to the right of the market demand curve result from: - an increase in the price of substitutes - a decrease in the price of complements - an increase in income, for normal goods - a decrease in income, for inferior goods - an increase in population - a shift in tastes towards the good (for instance, because it becomes fashionable) Shifts to the left of the market demand curve result from: - a decrease in the price of substitutes - an increase in the price of complements - a decrease in income, for normal goods - an increase in income, for inferior goods - a decrease in population - a shift in tastes against the good (for instance, because it is no more fashionable)

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A convenient measure of the response of market demand of a good to changes in its price (holding all other variables constant) is the own-price elasticity of demand (or, simply, price elasticity of demand). EQ1,P1 = proportionate change in the quantity demanded / proportionate change in the price = = (Q1/Q1) / (P1/P1) = (Q1/ P1) * (P1/Q1) = = (Q1/ P1) * (P1/Q1) for an infinitesimal change The own-price elasticity of demand is negative. The demand is said to be: - perfectly inelastic, if |EQ1,P1| = 0: any change in price does not determine any change in demand - inelastic, if 0 < |EQ1,P1| < 1: for instance, a 1% decrease in price brings forth a 0.4% increase in demand - unitary elastic, if |EQ1,P1| = 1: for instance, a 1% decrease in price brings forth a 1% increase in demand - elastic, if |EQ1,P1| >1: for instance, a 1% decrease in price brings forth a 1.5% increase in demand - perfectly elastic, if |EQ1,P1| = : a very small increase of price brings the demand to zero, and a small decrease brings it to infinity.

Some demand curves have the same value of elasticity on all the curve: - a perfectly inelastic demand curve is used to illustrate the case of goods strictly necessary for survival - an unitary inelastic demand curve is possible when the demand function has a specific algebraic form (hyperbolic) - a perfectly elastic demand curve is the case of the demand curve for a price-taker firm: for the firm, the demand is infinite for any price below the market price, and is zero for any price above the market price.

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Graph 1: Price elasticities of demand

Price

Price

D O Perfectly inelastic

Quantity Unitary elastic

Quantity

Price

Quantity Perfectly elastic

In general, nevertheless, the price elasticity is different along the curve; in other words, the elasticity of demand is different for the different prices. This can be seen for a linear demand curve, whose slope is constant. The slope is P1/Q1 which is the reciprocal of Q1/ P1. The elasticity is: E = (Q1/ P1) * (P1/Q1) With a linear demand curve, therefore, since P1/Q1 is constant, the elasticity is large in the upper part of the curve, where the ratio P1/Q1 is large, and is small in the lower part, where the ratio P1/Q1 is small. This can be explained by the fact that when the price is high, there are potentially many consumers who would be willing to buy, but who find the price too high, so that a small relative decrease in price will induce many consumers to buy. If the price is low, most of the consumers already purchased the good, so that a strong relative decrease in price will induce a small relative increase of demand.
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Gra ph 2: Elasticities on a linear demand curve

Price

A Elastic

Inelastic

C O

The elasticity of demand determines the change in total amount spent by the consumers (which is equal to total revenue for producers): - total revenue (total expenditure for consumers) is equal to total quantity times price - if the price falls, more quantity is purchased by consumers, but at a lower price - the change in total revenue (total expenditure for consumers) depends on whether the change is relatively stronger for price or for quantity - this depends on elasticity: - if the demand is elastic, a percentage decrease in price results in a larger percentage increase in quantity sold, so that total revenue increases - if the demand is inelastic, a percentage decrease in price results in a smaller percentage increase in quantity sold, so that total revenue decrease - of course, the opposite happens in case of a rise in price

This is shown by the following numerical example of the effects of the same percentage decrease in price for an inelastic and elastic demand.
Elasticity of demand and total revenue Inelastic demand Price Demand 100 1000 95 1015 % change -5.0 1.5 Elastic demand Price Demand 300 300

TR Elasticity 100000 -0.29 96425

TR 90000

Elasticity -1.86
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% change

285 -5.0

330 10.0

94050

The elasticity of demand is affected by:


1) the availability of substitutes: the more close substitutes the good has, the more elastic its demand: if there is a close substitute, the consumer will easily shift from and to it even for small price changes 2) the number of uses for which the good can be used: in this case, the effects of price changes take place on several markets. 3) the type of use the good has: the demand for goods that respond to basic needs (necessity goods) is less influenced by price changes than the demand for less necessary goods 4) the share of income spent on that good: the larger the share of that good on the consumers budget, the more responsive is the demand to changes in price (the demand curve that are normally considered are not compensated; therefore, it is possible, although rare, that the demand curve is upward sloping; in this case the own price elasticity is positive)

The response of the demand of one good to changes in prices of other goods can be measured by the cross-price elasticity of demand: EQ1,P2 = proportionate change in the quantity demanded of Q1/ proportionate change in the price of Q2 = (Q1/Q1) / (P2/P2) = (Q1/ P2) * (P2/Q1) = = (Q1/ P2) * (P2/Q1) for an infinitesimal change

The cross-price elasticity of the demand of good 1 with respect to the price of good 2 is:
negative, if good 1 and 2 are complements: if the price of coffee increases, the demand for sugar decreases; positive, if good 1 and 2 are substitutes: if the price of apples increases, the demand for oranges increases; zero, if goods 1 and 2 are independent.

(also for the estimation of the cross-price elasticities the effect is normally considered without compensation; therefore, it is possible that the demand of one good is inversely affected by the change in the price of another good, that is a substitute in terms of the substitution effect. In this case, the income effect has outweighed the substitution effect).

The response of the demand of one good to changes in income can be measured by the income elasticity of demand: EQ1,M = proportionate change in the quantity demanded of Q1/ proportionate change in income M = (Q1/Q1) / (M /M ) = (Q1/ M ) * (M /Q1) = = (Q1/ M ) * (M /Q1) for an infinitesimal change

The income elasticity of demand is:


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negative, if the good is inferior: if the income increases, the demand for the good decreases; positive, the good is normal: if the income increases, the demand for the good increases; zero, for some goods whose consumption is not influenced by income (e.g., salt)

Luxury goods are more responsive to income. Some staple foods can be inferior goods, but most food exhibit a positive income elasticity. But food is in general income inelastic, so that the share of food in income expenditure is decreasing, when income increases (Engels law). Nevertheless: - income elasticities for food have been found larger in developing countries than in developed countries; - the income elasticity for some agricultural products is greater than 1 in some LDCs - the income elasticity is larger for livestock products, fruits and vegetables than for cereals. This has important implications for the agricultural sector. When the average income will grow, the expenditure will increase more rapidly for those products with a larger income elasticity, and a shift to the more requested products will be required.

Short-term and long-term price elasticity


also the demands takes some time to adjust to changing prices this is particularly true for durable consumers goods (car, TV sets, etc.) but it is also true for other goods, because of the time needed for changing habits and for perceiving the change in prices as a result, price elasticity is lower in the short than in the long-term

Graph 3: Short-term and long-term demand curves

Price

Short-term

Long-term

Quantity

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3.5 MARKET EQUILIBRIUM


On a market goods are exchanged: supply and demand may find an equilibrium. A market is in equilibrium when (and the price is called an equilibrium price) when sellers can sell for that price exactly the quantity they wished to sell, and buyers can buy exactly the quantity they wished to buy for that price, so that there is no tendency to change. A market equilibrium is shown in the graph: at price P*, the quantity Q* is demanded, and the same quantity Q* is supplied. This are the only price and quantity for which this applies. for prices above P*, like P1, the quantity supplied (Q1S) is larger than the quantity demanded (Q1D): there is excess supply of Q1S - Q1D. Producers will not sell the desired amount of the good for that price, and this will tend to lower the price. for prices below P*, like P2, the quantity supplied (Q2S) is smaller than the quantity demanded (Q2D): there is excess demand of Q2D Q2S. Consumers will not find all the quantity of the good they wished to purchase for that price: this will tend to raise the price only for the quantity Q* and the price P* there will be no tendency to change.

Market equilibrium

Price

Excess supply

P1 P* Excess demand P2 D

Q2S

Q1D

Q*

Q1S Q2D

Quantity

A distinction should be made between: - partial equilibrium: the equilibrium on one market, holding all other things constant. The analysis of a market as a partial equilibrium is acceptable if for the particular market the links

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with other markets are weak, so that what changes in other markets has a negligible impact on this particular one, and what changes on this market has negligible impact on other markets general equilibrium: the equilibrium on all markets. In real world, all markets are linked: a change in price in the market of apples modifies the market of oranges (shifts to the left or to the right their demand curve and their supply curve), the market for inputs, etc.: the changes in these markets will on their turn have an impact on the market of apples, until a general equilibrium is reached.

For the market to be in equilibrium, the supply and demand curves must intersect. If they do not, then the market is not in equilibrium, and the market does not even exist. The following Graph illustrate this case: the minimum price for which there is a positive supply is higher than the maximum price the consumers are prepared to pay for that good, so that no equilibrium is possible.

No market equilibrium

Price

D O Quantity

On a market there may exist more than one equilibrium point. In the following Graph the supply curve is upward sloping at lower prices, and downward sloping at 1 higher prices, so that it intersects the demand curve in two equilibrium points: at price P* , and 1 2 2 quantity Q* , and at price P* , and quantity Q* . (This illustrate a possible situation in the labour market, when at higher levels of wages the labour supply decreases when the wage further rises, because the substitution effect is outweighed by the income effect).
1 1 Nevertheless, only equilibrium at price P* and quantity Q* is stable: 1 - for prices above P* there is excess supply, so that the price tends to fall; 1 - for prices below P* there is excess demand, so that the price tends to rise - the market will tend to the equilibrium 2 2 The equilibrium at price P* and quantity Q* is unstable: - for prices above P*2 there is excess demand, so that the price tends to further rise;

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for prices below P*2 there is excess supply, so that the price tends to further fall; any small movement away from the equilibrium point will tend to draw the market away from the equilibrium

Market equilibrium

Price

S P*2

P*1

Q*2

Q*1

Quantity

A market is in disequilibrium when, for any reason, the price is not the equilibrium price. If this is the case, the market will tend to the equilibrium (if it is stable): - if there is excess supply, producers will tend to lower prices; - a lower price makes the demand increase and the supply decrease - this diminishes the excess supply, but till there is excess supply the tendency will continue - if there is excess demand, consumers will tend to offer higher prices; - a higher price makes the demand decrease and the supply increase - this diminishes the excess demand, but till there is excess demand the tendency will continue till the equilibrium is reached, lower quantities than in equilibrium are traded on the market

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Changes in market equilibrium


When some condition changes in a market, a new equilibrium is reached. One way of analysing this is comparing the initial equilibrium to the new one, without considering the way the new equilibrium is reached (this is called the method of comparative statics). Effects of a shift of the demand curve If there is an increase in demand (e.g., because income grows), the demand curve shifts to the right. The new equilibrium will be at: - a higher equilibrium price - a larger equilibrium quantity
Effects of an increase in demand on market equilibrium

Price

P2 P1

D2 D1 O Q1 Q2 Quantity

The more inelastic the supply is, the larger is the change in price: - on the very short run (when no change in production is possible, e.g., just after the harvest), the supply is perfectly inelastic (S1); - on the short run, farmers can change the level of variable factors, and supply is more elastic (S2); - on the long run, all factors can be modified, and supply is still more elastic (S3); - the more elastic the supply, the smaller the rise in price, and the larger the increase in quantity

A decrease in the demand has opposite effects: - a fall in equilibrium price and a decrease in equilibrium quantity - the more elastic the supply, the smaller the fall in price, and the larger the decrease in quantity

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Effects of an increase in demand on market equilibrium: Different elasticities of supply Very short run Price S1 Short run S2 P1 Long run P2 P3 P0 S3

D2 D1 O Q0 Q2 Q3 Quantity

Effects of a shift of the supply curve If there is an increase in supply (e.g., because of a technological change), the supply curve shifts to the right. The new equilibrium will be at: - a lower equilibrium price - a larger equilibrium quantity

The more inelastic the demand is, the larger is the change in price: - with a perfectly inelastic demand (D1), there is no change in the quantity, and a strong decrease in the price; the new equilibrium is at price P1 and quantity Q0; - with a more elastic demand (D2), there is an increase in the equilibrium quantity, and a smaller decrease in price; the new equilibrium is at price P2 and quantity Q2;

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Effects of an increase in supply on market equilibrium


Price

S0 S1

P0 P1

Q0

Q1

Quantity

Effects of an increase in supply on market equilibrium: different elasticities of demand

Price

D1 D2 S0 S1

P0 P2 P1

Q0

Q2

Quantity

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Interventions on the markets


Governments sometimes intervene on markets introducing price regulations, to achieve policy goals. Price ceilings (maximum levels of price allowed) are introduced to protect consumers when the market equilibrium price is considered too high. The effects of a price ceiling (if it is lower than the equilibrium price) are: - supply becomes smaller than at the equilibrium level, and demand larger - there is an excess demand (Q1D-Q1S) - methods other than the price are needed to distribute the available supply among the consumers (ration cards, coupons, etc.) - nevertheless, an upward pressure on price remains - a black market is likely to appear - consumers often try to build domestic stocks of the good in shortage, which may render the shortage worse

Price ceiling
Price

P* Excess demand Pmax D

Q1S

Q*

Q1D

Quantity

Price floors (minimum price allowed) are intended to protect the producers (an example was the agricultural price policy of the European Community in the past). The effects of a price floor (if it is higher than the equilibrium price) are: - supply becomes larger than at the equilibrium level, and demand smaller - there is an excess supply (Q2S-Q2D) - this would create an downward pressure on price - to enforce the price floor, the government has to withdraw from the market the excess supply at the floor price - the relevant cost (A-B-Q2S-Q2D) is born by the taxpayers - the withdrawn excess supply has to be disposed of
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Price floor
Price

Excess supply

Pmin P*

Q2D

Q*

Q2S

Quantity

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Long term trends in agricultural product prices


Comparative statics can be used to illustrate long term trends in agricultural product prices. - on the long run, demand is shifted to the right by the increase in population and in income - on the other side, also supply is shifted to the right by technological change - the final trend in prices depends on which shift is larger - if the shift of the supply curve is larger (i.e., the technological change is rapid, and/or the increase in population and in per capita income is slower), then there will be a downward trend in agricultural prices, as illustrated by the graph - nevertheless, if the growth in demand is larger than the growth in supply, an upward trend in agricultural prices will appear

Long-term trend in agricultural prices


Price

S1 S2 S3

Long-term trend

D3 D1 O D2 Quantity

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Dynamic adjustments of demand and supply


Comparative statics assumes instant adjustments of demand and supply to changing market conditions. In real life, adjustment takes time: and, when the market has moved away from equilibrium, it may be important to analyse the path it follows, and to assess whether it returns back to an equilibrium. An important model of dynamic behaviour of markets is the cobweb model. It assumes that: - there is a time lag between the moment supply decisions are made and the moment when the output is marketed - supply depends on the price at the moment the production is started (i.e., farmers decide how much to seed based on the price of that year) - demand depends on the price at the moment the supply is marketed (i.e., consumers decide how much to purchase based on the price the product has after the harvest, next year) - at the moment of harvest, supply is perfectly inelastic In this example, in year 1, the price is higher (P1) than the equilibrium price P*. The farmers decide their supply on this base (Q1). But when, in year 2, the product is marketed, there is excess supply (the supply is now perfectly inelastic at a quantity Q1). The price then falls to P2, the only price for which all Q1 can be sold. When the farmers have to make their production decisions in year 2, now they decide to produce Q2 (their supply for a price P2). When the output is marketed in year 3, the supply is perfectly inelastic at quantity Q2. There is excess demand (Q1-Q2), so that the price rises to P3. The process follows with price oscillations from one year to another. In this case, the oscillations around the equilibrium price are smaller and smaller, and the market tends to return to the equilibrium.
The cobweb model: damped oscillations

Price

P1 P3 P* P2 D

Q2 Q*

Q1

Quantity

Price

Years

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But it is possible another path: in the following example, the oscillations tend to be larger and larger, and the market does not tend to return to the equilibrium.

The cobweb model: explosive oscillations


Price

P3 P1 P* P2

Q2 Q* Q1

Quantity

Price

Years

The type of oscillations depends on the characteristics of the demand and supply curve. For linear curves: - if the absolute value of the elasticity of supply is lower than the absolute value of the elasticity of demand, the oscillations are dampened and the market tends to return to equilibrium; - if the absolute value of the elasticity of supply is larger than the absolute value of the elasticity of demand, the oscillations are explosive and the market does not tend to return to equilibrium; - if the absolute value of the elasticity of supply is the same as the absolute value of the elasticity of demand, the oscillations are constant and the market price oscillates every year above and below the equilibrium price. This is a very simple and unrealistic model, that assumes, among other things, that farmers never learn from the past experience; it nevertheless highlights the importance of time lags between production decisions and the time they are realised. 3.6 NON COMPETITIVE MARKETS The markets studied so far are competitive markets, where all operators are price-takers. M ore precisely, economics defines as a pure competition market a market where: 1. Firms try to maximise their profits independently (no agreements among producers) and consumers are also acting independently to maximise their utility 2. There are many operators both on the supply and on the demand side, so that none of them can influence the market, because each has a very small share of it. 3. The good is homogeneous, so that consumers have no preference for one producer or another 4. There are no barriers for firms to entry into or to exit from the market, because factors can circulate freely
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A market is defined as perfectly competitive if in addition: 5. All firms are identical in their technology, because the technology is known and can be reproduced by anyone All operators have full knowledge about the market conditions 6. The last two conditions are relevant for theoretical reason, but need not to apply for the real market to be competitive. The main point is that in a competitive market - producers are price-takers - their demand is perfectly elastic - their marginal revenue is the price - they produce a quantity such that the price is equal to their marginal cost There are many cases of non-competitive markets, and many markets that in the past were competitive became not fully competitive.

Factors explaining divergence from perfect competition


Economies of scale Economies of scale are relevant for the long-term, when all factors can be modified. By doubling all factors, one may reach a double output. This case is called constant return to scale. But it is also possible that doubling all the inputs one may obtain more than the double output. This case is called increasing returns to scale. This may be due to different reasons: - more division of labour is possible for a larger output - more specialised machines may be used - some efficient methods of organisation can be introduced when the output is larger It is also possible that increasing the scale of operation (i.e., increasing all inputs), the increase in output is less than proportional. This case is called decreasing returns to scale. Decreasing returns to scale are for instance possible when: - increasing the dimensions makes organisation costs too high - there are problems in purchasing the inputs (e.g., a food processing factory too big has to purchase agricultural products from far areas, which is costly)

Constant, increasing and decreasing returns to scale are reflected in long-term costs. By long-term costs we mean the costs that are possible when the scale of the operation can be freely chosen. For instance, before a factory is built, every factor can be chosen at its optimal quantity, to produce the chosen quantity at the lowest cost. After the factory has been built, some factors (the buildings, the machines, etc.) are fixed, so that the output can only be adjusted by changing the variable factors. If a larger output than the chosen one is produced, costs (short-term costs) are higher than what they would have been if the factory had been designed for this larger output. In the following graph, the curve ABCD shows the long-term average cost.
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Long-term and short-term average cost curves


Short-term AC curves A STAC1 STAC2 C2 C1 C3 B C STAC3 D

Price

Long-term AC curve

Q1

Q2

Quantity

If the entrepreneur, before building the factory, thought that the output would be Q1, then he would build the factory best fit to produce Q1, i.e., the lowest AC for producing Q1 is C1. But if, after building the factory, he decides to produce Q2, he can do it, but moving along the short-term AC curve STAC1, so that his AC is C2. If someone else has built a factory best fit to produce Q2, his AC would be C3, lower than C2. - the part AB of the long-term average cost curve shows increasing returns to scale: increasing the scale of operation, the AC decreases - the part BC of the long-term average cost curve shows constant returns to scale: increasing the scale of operation, the AC remain constant - the part CD of the long-term average cost curve shows decreasing returns to scale: increasing the scale of operation, the AC increases No firm will choose to operate with decreasing returns to scale: any competitor producing on a lesser scale would have lower costs. Different returns to scale may explain why some markets tend to become non-competitive. - if there are increasing returns to scale (part AB), no one can compete with the largest producer, who has lower costs than anybody else: this market will tend to monopoly (one producer): this is typical of utilities (irrigation, electricity, gas, water supply) with high fixed costs, that are on the average lowest the largest the number of consumers. - if there are constant returns to scale, no producer can take an advantage over competitors: if the output dimension at which returns to scale become constant is very small relative to the dimensions of the market, then there is room for many producers, and the market tends to be competitive. - but if the dimension at which returns to scale become constant is large relative to the dimension of the market, there is room for few producers, since each of them will exploit all of the increasing returns to scale. Few producers will remain, and the market is an oligopoly The technological change has a strong impact on the economies of scale: many innovations require larger scales to be profitably implemented. On the other hand, some innovations are also fit for small firms, and work in the opposite direction.
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Barriers to entry If for some reason (e.g., legal prohibition) no new competitor can enter into a market, then the existing producers gain a market power: what they do has an impact on the market, because nobody else can influence the output. As a consequence, they will not face a perfectly elastic demand, but a downward sloping demand curve. The case of increasing returns of scale is in fact a technological barrier to entry. But also financial constraints may be relevant, or institutional constraints.

Product differentiation If the product is different from one producer to another (both for an actually different quality, or for consumers opinion induced by advertising), then each producer has in a certain sense a market of his own: the products of the different producers are substitutable but not completely. In these markets, there are no barriers to entry, but products are not homogeneous: branded food products, branded clothes, etc. Again, what a single producer does has an impact on the market of his product (if he raises its price, some consumer will buy from the competitors), so that his demand curve is downward sloping.

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Monopoly
A special case of non-competitive market is when there is only one producer. This is called a monopoly. The case of monopoly can also illustrate other situations of non-competitive markets. A monopoly can exist if: - there are barriers to entry (legally enforced or for some other reason) - there are no close substitutes for the good the monopolist is the only seller of the product so, he faces all the demand curve as the only seller, he can set the price, but then consumers decide how much to buy in other cases, he puts a given quantity on the market, but the market sets the price any time he wants to increase the output, he has to lower the price the change in his total revenue depends on whether the increase in quantity is relatively stronger than the decrease in price: it therefore depends on the elasticity of demand - if the demand is elastic, a decrease in price will increase total revenue - if the demand is inelastic, a decrease in price will decrease total revenue

This is shown by the following example:

Elasticity of demand and total revenue Elastic demand Price Demand 300 300 285 330
8550 -4500 4050

Elasticity: -1.86

Change in TR
Increase in quantity * new price Price decrease*original quantity Change in TR

TR 90000 94050 4050

Elasticity: -0.29

Change in TR
Increase in quantity * new price Price decrease*original quantity Change in TR

Inelastic demand Price Demand TR 100 1000 100000 95 1015 96425 -3575 1425 -5000 -3575

Therefore, for the monopolist: - when increasing the output, the total revenue increases when the demand is elastic, and decreases when the demand is inelastic - the marginal revenue (the change in TR for a small change in output) is lower than the price (remind that for a price-taker firm, the marginal revenue is equal to the price)
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the marginal revenue is positive when the demand is elastic, and is negative when the demand is inelastic

The monopolist will therefore never produce a quantity for which the demand is inelastic: when the demand is inelastic, an increase in output decreases the Total Revenue, in addition to increasing costs.

Price

Elastic

|E|=1 MR Inelastic D O Quantity

Total revenue

TR

Quantity

Equilibrium for the monopolist: if the increase in revenue resulting from a unit increase in output (the M R) is larger than the increase in cost needed to produce it (the M C), it is profitable for the monopolist to increase the output for the monopolist it is therefore profitable to expand the output to the quantity for which M R=M C for that quantity (OA) profits are maximised the price at which the monopolist can sell OA is OP0: for that price, the demand is OA the TR for the monopolist is OACP0 the Total Cost is OABQ the profits are QBCP0

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Equilibrium for the monopolist


Price

P0 P1 Q

AC

B E D MR O A S

The equilibrium for the monopolist can be compared to the equilibrium in a competitive market, where the producer equates the M C to the price. In such a market, the quantity produced would be OS, and the price would be OP1. Therefore, in comparison with the equilibrium in a competitive market: - the quantity produced by the monopolist is less - the price is higher - the monopolist earns supernormal profits

It should be added that for this conclusion to be valid, it is not needed that the producer be strictly a monopolist, the only producer. Every producer having a market power and therefore facing a demand not perfectly elastic (i.e., facing a downward sloping demand curve) will equate his marginal cost to marginal revenue, not to price.

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Price discrimination
In some cases, the monopolist can further increase his profits charging different prices to consumers that operate in different markets. This is possible when it is possible to separate consumers in different market segments, that cannot trade among them. Assume there are no costs for differentiating the product between the market segments, so that there is only one M C curve. The optimal total amount of output is where the M C is equal to the M R (quantity OA); the price at which OA is totally sold is OP0. If the monopolist can sell separately the output, he can exploit the different willingness to pay of consumers. For instance, there are consumers prepared to pay a price as high as P1, and at that price the demand is OF. Setting for them the price at the level P1, the monopolist will have a revenue of OFGP1. If he sets the price for the other consumers at OP0, he will sell the quantity FA, with a revenue of FACH. The total output is OA, and the total cost is OABQ, as without price discrimination; but Total Revenue is now OACHGP1, as compared to OACP0. Total profits have grown by P0HGP1. It is now clear why for price discrimination to be effective, the segments must be separated: if consumers of the second group could sell to the first group what they purchased for price OP0, they would do so, because consumers of the first group would pay an higher price.

Price discrimination
Price

P1 P0

G H C AC

B E D MR O F A Quantity

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Monopsony
Another special market is monopsony: in this market, there is just one operator on the demand side. Examples of such markets might be the marketing boards existing in some countries for some agricultural products, that can only be purchased and sold by the marketing board; or, a wholesaler or a food processing company that in a particular area are the only ones who can buy a product. Another example is the labour market in areas where only one employer exists. We will illustrate the problem taking the example of a wholesaler, who is the only buyer in one area, and who has a market power in selling the product. He therefore has to decide in the same time the quantity to buy and to sell. In purchasing the product from the farmers, the monopsonist is facing the supply curve: if he wants more of the product, he has to offer to buy for a higher price; and, if he needs less of the product, he can buy at a lower price. He can set the price, and in this case producers decide the supply. Or, he can set the quantity he wishes to purchase, and the market will set the corresponding price. Suppose for simplicity that the only variable cost for the monopsonist is the cost for buying the product. His M arginal Factor Cost (the increase in cost he has to pay to have one more unit of the product) is larger than the product price. This is because, in order to have one more unit of the product, he has to: - pay for the additional unit, at the higher price - pay the higher price for all the units he would have purchased at the lower price This is an example of the additional cost for the monopsonist of buying 20 more units of the product: their M arginal Factor Cost is 510 SP/unit, as compared to the price of 310 SP/unit.

Total cost and marginal cost for the monopsonist Price 300 310 Supply 400 420 TC 120000 130200 10200

SP/unit SP/unit

Change in TC Increase in quantity*new price Price increase*original quantity Change in TC Marginal cost (S P/unit)

6200 4000 10200 510

This is illustrated by the following Graph, where the M FC curve lies above the supply curve. For a quantity Q1, the M FC is MFC1, and the price (which is the average cost for the purchased quantity) is P1.

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Marginal cost for the monopsonist


Price

MFC Supply

MFC1

P1

Q1

Quantity

The next graph shows the equilibrium for the monopsonist. When selling the product to retailers or to consumers, he faces a downward sloping demand curve, so that his M R is lower than the price. - if the increase in revenue resulting from a unit increase in quantity sold (the M R) is larger than the increase in cost needed to purchase it (the MFC), it is profitable to increase the quantity - it is therefore profitable to expand the quantity till M R=M FC - for that quantity (OA) profits are maximised - the price at which OA is sold is OPs since, for that price, the demand is OA - the price at which OA is bought is OPp since, for that price, the supply is also OA - the TR for the monopolist is OACPs - the Total Cost is OABPp - the profits are PpBCPs

This can be compared to the situation in a competitive market, where the equilibrium price would be at the intersection of supply and demand (point F): the equilibrium quantity in that case would be Q*, and the equilibrium price P*: - the quantity traded is less - the price paid by consumers is higher - the price to producers is lower

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Equilibrium for the monopsonist


Price

MFC Supply

Ps

P* E Pp B

Demand MR O A Q* Quantity

4. S TRUCTURE AND FUNCTIONS OF AGRICULTURAL MARKETS


Till now, markets for agricultural products were treated as one market, involving farmers on one side and consumers on the other side. In real life, the situation is quite different: several steps (or phases) are required to make the agricultural product available to the final consumer, i.e., along the marketing chain. We can analyse these steps in two ways: - in terms of the institutional operators that perform them - in terms of the functions that are performed at each step The institutional operators along the marketing chain can be: - producers - dealers - wholesalers - processors - retailers - consumers Not for all products the marketing chain includes all these operators. The number of operators in the various steps of the marketing chain is different:

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The marketing chain

Producers

Dealers

Wholesalers/Processors

Retailers

Consumers

Prices in the different segments of the marketing chain are different: producer price, wholesale price, retail price. Why are prices different along the marketing chain? Several functions are performed at different levels in the marketing chain: - assembly - transport - storage - grading - processing - distribution So, in the phases of the marketing chain, there is not simply a transfer of ownership of the product: value is added to the product and, in doing so, operators use inputs and incur costs. In each phase, therefore, there is an difference in price relative to the previous phases. The difference between the price received by an operator and the price paid by the same operator is called the marketing margin. The retail-farmgate margin is the difference between the retail price of a product and the producer price. The demand of consumers is not a demand for the raw product: it is a demand for the final product at the retailer level. It is a demand for a product that incorporates physical processing of the product, but also services: for instance, consumers wish graded, or sorted, or packaged products, so their demand is for a product incorporating these services. When income rises, consumers usually appreciate more and more services incorporated in the products; the retail-farmgate margin is likely to increase, since more services have to be added to the raw product. Therefore, the demand of consumers include two components: - a demand for the raw agricultural product - a demand for the services incorporated in the product the demand at the retail level is called primary demand the demand at the farm level is called derived demand the derived demand is the primary demand less the demand for services incorporated: in other words, consumers are willing to pay a higher price for the same quantity at the retail level, because it incorporates several services and transformations of the good

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Primary and derived functions


Price

Derived supply (retail) Primary supply (farm) Retail price Producer price Primary demand (retail) Derived demand (farm) Quantity

Q*

On the other hand, the primary supply concerns the agricultural raw product. The derived supply concerns the supply of the product at the retail level. It is higher than the primary supply because it incorporates the supply of all services included in the product in the shop. In other words, no retailer will be willing to supply a given quantity, unless the price at which he sells does not include the costs of the transformation of the raw product. The graph depicts a situation of equilibrium at the farm and retail level: the retail-farmgate margin is the difference between the retail price and the producer price. Any improvement in the transport and marketing system lowers the cost of the services, and shifts downwards the derived supply curve: the result is an increase in quantity and also an increase in the price at the farm level. In the following graph the effects of a change in marketing costs are presented: due, for instance, to some improvement in transportation, marketing costs are reduced, so that the Derived Supply curve shifts downwards from DS1 to DS2. As a result, the new equilibrium at the retail level is found at point E instead of E, at a lower retail price (Rp1 instead of Rp0) and at a larger quantity (Q1 instead of Q0). But also at the farm level the supply must increase, to match the larger demand, and to induce the increase in output the price grows from the producer price Pp0 to Pp1.

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Effects of reducing marketing costs


P ric e

Derive d sup ply (re ta il) DS 1 D S2

E Rp0 Rp1 P p1 P p0 F E' F'

P rima ry su pply (f arm )

P rima ry de ma nd ( re ta il)

Q 0 Q1

Q ua ntity

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Vertical and horizontal integration


Though marketing margins are to a large extent the result of costs connected with the marketing activity (transportation, storage, grading, etc.), they are often perceived as unfair, based on the argument that they are too large and that farmers get a low share of the retail price. In some cases, this may be true, if the operators between the farmers and the retailers have a market power (this is the case of monopsony analysed above). As a response to this problems, farmers can try: - to concentrate their supply, to gain a market power - to gain a share of the marketing margins, by providing some marketing and processing of the produce - to differentiate their product in consumers perception concentration of supply requires that farmers co-ordinate their production decisions, in order to control supply this is usually not possible without an institutional or legislative support, since the number of farmers is great, and there would be a high probability of free-riding (some farmers might be tempted to benefit from the higher prices, without limiting their output)

Examples of this are: - producers associations promoted by the European Union - M arketing Boards existing in some countries, that have the exclusive license to purchase from farmers and to sell the product - collective labels for typical products (wine, cheese, etc.) One main goal of these organisations is to control supply. Their effectiveness in fulfilling this task depends to a large extent on the legal enforcement. For instance, European producers associations have limited powers, and their action consists to a large extent to provide suggestions to farmers. A typical way for farmers to gain a share of the marketing margins is to establish co-operatives for storing, processing and marketing agricultural products. The goal of co-operatives is not to gain profits, but to increase the returns to the raw products provided by their members: in other words, the value added of the processing/marketing activities accrues to the farmers. A third action farmers can undertake is trying to differentiate their product. This is possible when the product has some specific quality that consumers can perceive, but also advertisement can help in this direction. M ost of the times, this implies imposing quality standards, and sometimes some control on supply. This is a promising direction specially for the markets in developed countries, where consumers are looking for more sophisticated consumption patterns. In this case too, some form of legal protection is needed: if the action is successful, there is the risk that other producers try to imitate the product, and to erode market shares. Examples in this field are: - the collective labels that are created by producers of typical products (wine, cheese). The European Union enforces a legal protection, through the VQPRDs labels for wines, and the Protected Denomination of Origin labels for other products. - the private labels of some producers associations, or by some co-operatives, to create a brand image among consumers

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Producers associations, marketing boards, collective labels, are examples of horizontal integration: it means collecting under one decision unit several operators of the same phase of the marketing chain. On the private firm side, a form of horizontal integration is the contractual integration: contracts are signed between the processing firm and the farmers who provide the raw agricultural products for processing. Private firms are interested in having a secure procurement, farmers are interested in having a secure outlet for their output, and possibly in reducing the price risk. Co-operatives in the field of processing/marketing are an example of vertical integration: it means a link between two or more different phases of the marketing chain under the control of one decision unit. Also private firms in the processing or marketing sector try to integrate vertically the agricultural production: examples are those multinational companies that own farms where they produce a part of the traded product.

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