Introduction to Agricultural Economics John B. Penson Oral T. Capps C. Parr Rosson Richard T. Woodward Fifth Edition

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1 Introduction to gricultural Economics John B. Penson Oral T. Capps C. Parr Rosson Richard T. Woodward Fifth Edition

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3 economics of input and product substitution b. Calculate the marginal rate of product transformation between points C and D. 6. In each of the following four graphs, please describe what caused the iso-revenue line to change in each box and the nature of the change on each line. Original iso-revenue line C B D B F E C D B F B REFERENCE Hall FF, EP LaVeen: Farm size and economic efficiency: the case of California, merican Journal of gricultural Economics 6(4): ,

4 Market Equilibrium and Product Price: Perfect Competition The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market and the demand of those who are willing to pay the natural price of the commodity. dam Smith ( ) Chapter Outline DERIVTION OF THE MRKET SUPPLY CURVE Firm Supply Curve Market Supply Curve Own-Price Elasticity of Supply Producer Surplus MRKET EQUILIBRIUM UNDER PERFECT COMPETITION Market Equilibrium Total Economic Surplus pplicability to Policy nalysis DJUSTMENTS TO MRKET EQUILIBRIUM Market Disequilibrium Length of djustment Period Cobweb djustment Cycle SUMMRY KEY TERMS TESTING YOUR ECONOMIC QUOTIENT We have discussed the derivation of the market demand curve, based on the demands of individual consumers, and its elasticity. This represented exactly one-half of the relationships needed to understand changing market conditions, including the market equilibrium price. The other part of the puzzle is the market supply curve. The purpose of this chapter is to explain how we can derive the market supply curve for a particular product under conditions of perfect competition and interpret what equilibrium means for consumers and producers. ttention will also be given to the forces that cause changes in the market equilibrium price, and to the nature of the adjustment to the new equilibrium. DERIVTION OF THE MRKET SUPPLY CURVE The market supply curve for a particular product is based on the decisions of what and how much to produce made by individual businesses in an industry. From Chapter 8 of Introduction to gricultural Economics, /e. John B. Penson, Jr. Oral Capps, Jr. C. Parr Rosson III. Richard T. Woodward. Copyright by Pearson Education. Published by Prentice Hall. ll rights reserved. 121

5 market equilibrium and product price: perfect competition FLP/lamy Holstein cows in a milking power on a dairy farm. The number of dairy farmers producing fluid milk is just one example of the type of enterprises in the farm sector that approximate the conditions of perfect competition. The firm s supply curve in the short run is that portion of its marginal cost curve that lies above its average variable cost curve. Firm Supply Curve The marginal cost curve and the average variable cost curve help determine the minimum price at which a business can justify operating from an economic perspective. For our hypothetical business TOP-G, whose costs of production were presented in Table 6 3, the minimum acceptable product price would be approximately $16, which is far below the $4 TOP-G is currently receiving for its product. If the price of TOP-G s product fell to $, should the business continue to operate? Would TOP-G be covering all of its costs of production at this product price? Would the business even be covering its variable costs of production? In the discussion to follow, we will see that the marginal cost curve lying above the minimum average variable cost represents the business s supply curve in the current period. Output O BE in Figure 1 represents the break-even level of production for TOP-G, or the point at which the marginal cost curve in Figure 6 4 intersects the average total cost curve. t this level of output, average revenue is just equal to average total cost. This means that at P BE, economic profits are equal to zero. Output O SD in Figure 1 is identical to the point in Figure 6 4 at which the marginal cost curve intersected the average variable cost curve. This means that if the price fell to P SD, average revenue would just equal average variable cost. The business could minimize its losses in the current period by continuing to produce if prices were below price P BE. If the product price corresponding to the segment of the marginal cost curve lies between prices P BE and P SD, the firm could cover all of its variable costs and some, though not all, of its fixed costs by continuing to produce. rational competitive firm will cease producing in the short run only when the product price falls below the average variable costs of production, which occurs at price P SD in Figure 1. Operating when price is below point P SD on the marginal cost curve will only add to the firm s losses because TOP-G is no longer covering all variable costs. Furthermore, the suppliers of variable inputs (such as fuel and hired labor) will likely cease supplying these services to the business when the checks start to bounce. This is why the level of output associated with price P SD on the marginal cost 122

6 market equilibrium and product price: perfect competition Dollars P BE P SD TOP-G's Firm-Level Supply Curve Figure 1 The portion of this business s marginal cost Marginal cost Marginal revenue curve that lies above the average variable cost curve represents a business s current supply curve under conditions of perfect competition O SD O BE O MX Output curve (output O SD ) is known as the shutdown point. This is also the reason why we present only the portion of TOP-G s marginal cost curve appearing above its average variable cost curve when illustrating this business s supply curve in Figure 1. Market Supply Curve Figure 4 6 illustrated the fact that the market demand curve represents the summation of the quantities desired by all consumers at specific market prices. The market demand curve for the two-consumer example depicted in that figure was found by horizontally summing the individual demands of both consumers. The market supply curve under conditions of perfect competition is determined in a similar manner. Figure 2 suggests that Gary Grower would be willing to supply 1 ton of fresh broccoli if the market price were $1.00 per pound, 2 tons if the price were $1.0 per pound, and so on. Figure 2B shows that Ima Gardner would decline to produce at a market price of $1 per pound, but would supply 1 ton of broccoli at a market price of $1.0 per pound, and so on. Figure 2C shows that if the market supply were limited to these two producers, the total supply of broccoli forthcoming at a market price of $1 per pound would be 1 ton, 3 tons at a market price of $1.0 per pound, and so on. Like the demand curve, we can also characterize the properties of the market supply curve by examining the elasticity of this curve. The market supply curve can be seen as a summation of all the firm supply curves, or the quantity each firm would be willing to supply for specific prices. Own-Price Elasticity of Supply The market supply curve for a particular product generally has a positive slope because the quantity supplied by businesses increases when the price it receives goes up. It is helpful to think of the behavioral response of producers in the context of their own-price elasticity of supply. This elasticity is expressed as own-price elasticity of supply = 1Q S - Q SB 2>31Q S + Q SB 2>24 1P - P B 2>31P + P B 2>24 (1) 123

7 market equilibrium and product price: perfect competition Producer and Market Supply Curves B C Gary Grower Ima Gardner Market supply (Gary & Ima) $3.00 $3.00 $3.00 Price of broccoli Price of broccoli = Price of broccoli Quantity of broccoli (tons) Quantity of broccoli (tons) Quantity of broccoli (tons) Figure 2 The market supply curve is found by horizontally summing the quantities supplied by all producers for given levels of market price. in which Q S is the quantity supply after the change in price from P B to P, and Q SB is the quantity before the change in price. n own-price elasticity of supply exceeding one indicates an elastic supply, and an own-price elasticity of less than one suggests an inelastic supply. For example, if the own-price elasticity of supply for a product is 1., a 1% increase in product price would cause businesses producing this product to increase their production by 1.%. Because the percentage change in revenue is equal to the percentage change in price plus the percentage change in the quantity supplied, the total revenue of producers would increase by 2.%. Finally, the more (less) elastic or flatter (steeper) the market s supply curve is, the greater (lower) the impact a price change will have on total revenue, all other things constant. 1 What would the impact of a 1% increase in product price be on quantity supplied if the market supply curve were perfectly inelastic? What would the change in total revenue be under these conditions? Producer surplus represents the profit realized by firms in the market for specific quantities supplied. Producer Surplus Economic rent, or producer surplus, is the economic return above the firm s variable cost of production. 2 When economic profit exists, surpluses are accruing to businesses. This surplus may be measured for an individual business by examining the business s returns above variable costs of production. business will supply the first unit of output at a price equal to the marginal cost of producing the first unit. If this marginal cost were $1 and the price of the product were $4, the business would receive a $3 surplus from producing and exchanging the commodity. If the marginal cost of producing the one-hundredth unit were $3, the surplus would be $1 for producing the unit. 1 If firms produce more than one product, and these products are independent of one another, the discussion presented earlier applies to each product considered separately. 2 If the rents disappear with entry or exit, they are a short-term phenomenon called quasi-rents. 124