AEA 207: Agricultural Price Analysis

Supply-Demand Price Relationship

By
Sanga, G.J.
2015
 Theoretical Basis of Supply Functions

• A static supply schedule shows how much of a given

commodity for sale per unit of time as its price varies
other factors held constant.
• In theory, a static supply function can be derived
from a knowledge of the underlying input-output
relationship.
– In a manner analogous to deriving a demand curve from
an individual utility function or an indifference map.
 Theoretical Basis of Supply Functions
cont…..
• Demand theory assumes the consumer wants to
maximize utility.
• But a theoretical supply curve is based on the
assumption that producers seek to maximize net
returns.
– They do so by equating marginal cost and marginal
revenue.
– Marginal costs are defined as the increment in total costs
associated with producing one more unit of output.
– Marginal revenue is the increment in total revenue
associated with selling an additional unit of output.
 Theoretical Basis of Supply Functions
cont……
• Because the individual firm is assumed to be a price
taker;
– Therefore, each firm’s marginal revenue is the prevailing
market price.
– As the market price change, so does the marginal revenue
confronting each firm.
• With an upward –sloping marginal cost curve, the
profit –maximization output of each firm rises as the
market price increases.
 Theoretical Basis of Supply Functions
cont……
• Cost curves and optimum output • The optimum output varies as the
at alternative prices price of the product rises or fall.
• At price P2profits are maximized
by producing Q2units.
At a price of P1the optimum level
Marginal
costs •
of output (dictated by the
Cost or revenue per unit

P2 intersection with the marginal cost

Q
Average total
costs curve) falls to . 1
Average variable
costs
• If the price does not cover average
P1
total costs, the firm will incur
losses.
• However, the cost will be
Q Q minimized and returns over
1 2
variable costs maximized by
Quantity per unit time
equating marginal cost and price.
 Theoretical Basis of Supply Functions
cont……
• The shape of the marginal cost curve is very
important because;
– it determines how output will change in response to
changes in product prices.
• The total and average cost curves are also important
because;
– They indicate the price at which a firm will cease
production.
• Note: Average total cost include fixed costs as well as
variable costs.
 Theoretical Basis of Supply Functions
cont……
• The distinction between fixed and variable costs
depends on the length of run or time period allowed
for adjustment.
• In the short run items such as fertilizer, feed, and
hired labour can be varied.
– It will not pay a firm to continue production if the price is
not sufficient to cover the variable costs.
• In the long run, equipment, buildings and even land
can be changed and consequently all costs become
variable.
 Theoretical Basis of Supply Functions
cont……
• Thus the cutoff point on the supply curve (i.e. the
price at which supply becomes zero) depends on the
length of the run one assumes.
– In the short run, the quantity supplied becomes zero at
any point below the low point on the average variable cost
function.
– This is the point at which the marginal cost curve intersect
the average variable cost curve.
– In the long run, the supply curve of an individual firm
becomes horizontal at the low point on the average total
cost curve.
 Theoretical Basis of Supply Functions
cont……
• The foregone analysis assumes that prices are known
(certain) when planning decisions are made that producer
have control over output.
• Neither assumption may be correct;
– In agricultural production, once the decision to produce has been
made, important time lags exists between planting or breeding
decisions and the realization of output.
• Two consequences follow:
– One is that the prevailing price at time the commodity is ready
for sale may differ from the price that was expected at the time
the decision to produce was made.
– Second the actual production may not equal planned production.
 Theoretical Basis of Supply Functions
cont……
• The first differences constitute to price risk, and;
• The latter may be caused by unfavorable weather
and outbreak of diseases, and;
– this constitute a yield risk.
• Price and yield risk can be viewed as factors that shift
the supply schedule.
• A theoretical supply curve normally assume risks are
held constant.
– But uncertainty regarding prices and yields must be taken
into account in making production decisions .
 Theoretical Basis of Supply Functions
cont……
• For this reason, the objective of the firm may not be
simple profit maximization;
– But rather maximization of expected utility, which is a
function of expected profitability and one’s aversion to risk.
• Also the foregone analysis of an individual firm’s
supply function ignores the impact of the alternative
uses of land, labour, buildings and equipments.
– It may be more profitable to devote those resources to
production of another commodity if the price of the
commodity on which the cost curves are based fall bellow
certain level.
 Theoretical Basis of Supply Functions
cont……
• In that case, the supply of commodity A may decline
to zero even if its price is above average variable
costs or even average total costs.
– Relative profitability must be considered in assessing the
impact of price on output.
– This can be done by incorporating opportunity costs in
constructing marginal and average cost curves.
• Note: opportunity costs vary from farm to farm.
– For example soil differences may make it possible for some
farmers to produce a wide range of crops, while for other
few alternative uses may exist.