Quantity Retail Price Marketing Cost Farm Price. Doz/cap/yr. $/doz. $/doz. $/doz. 17 $1.30 $0.50 $ $1.20 $0.50 $ $1.10 $0.50 $0.

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1 Derived Demand The basic idea of derived demand is that farmers don t experience retail demand, but instead they experience farm-level demand which is the demand for farm products by the marketing sector, who provide various services and then they serve retail demand. The simplest view may be seen in table 1. In this table,, the retail demand is shown in columns 1 and 2. As with all demand curves, it is downward sloping and in order to sell more eggs the retail price must be lower. For this problem we will assume that the marketing cost for eggs is $0.50/dozen. This $0.50 covers the cost of cleaning, candling, grading, packing, transporting, and retailing the eggs. In other words for $0.50, farm eggs are made available in dozen containers at a store near you. Table 1: Egg Demand Quantity Retail Price Marketing Cost Farm Price Doz/cap/yr. $/doz. $/doz. $/doz. 17 $1.30 $0.50 $ $1.20 $0.50 $ $1.10 $0.50 $ $1.00 $0.50 $ $0.90 $0.50 $ $0.80 $0.50 $ $0.70 $0.50 $ $0.60 $0.50 $ $0.50 $0.50 $0.00 If the retail customer pays $1.30 per dozen for eggs and the marketing cost is $0.50, then $0.80 is left for the farmer. For other prices the calculation is similar, but always with the retail price and farm price varying by the marketing cost, $0.50. The right hand column reflects this. These relationships may be graphed, as is seen in Figure 1. The retail (DR) and farm-level (DF) egg demand curves are parallel, separated by the marketing costs, (CM). If marketing costs should increase this would shift the farm-level demand curve down, while leaving the retail-level demand curve unchanged. This is simply because from any retail price after subtracting the new, higher marketing

2 Figure 1: Retail and Farm-level Egg Demand cost, there will be less left for the farmer. In order to complete the system we also need the farm-level supply of eggs. Table 2 has this information. This is a regular supply curve with a greater quantity supplied as the price increases. It may be added to the egg market graph, as in Figure 2. Table 2: Farm Egg Supply Quantity Price 17 $ $ $ $ $ $ $0.60

3 Figure 2: Egg Market At the point where the farm-level supply crosses the farm-level demand, the farm-level equilibrium will occur. This means that 21 dozen per capita will be supplied to the marketing sector at a price of $0.40/doz. These eggs will be delivered to the stores with the various marketing services having been provided and the consumers will buy them at a price of $0.90/doz. The market will be cleared at all levels and we have an equilibrium in the egg market. All eggs will be accounted for and the retail price will be the sum of the farm price and the marketing cost. PR = PF + MC In equation form, the two demand curves can be expressed as Q Q R F = 30 10P = 25 10P R F

4 You can see that they have the same slope but different intercepts, that is they are parallel lines, as is evident from the graphs as well. If the elasticities of demand are calculated at the equilibrium, the calculations are ε = b( P / Q ) 1 1 εr εf = b PR Q = = ( / ) 10( / 21) = b PF Q = = ( / ) 10( / 21) 019. A couple important points may be seen. First, the formulas are the same except for one uses the farm price and the other the retail price. This is because the system equilibrium requires that the same quantity be used at the farm and retail level. The implication of this is that the farm-level elasticity is always more inelastic than the retail elasticity. Since the retail demand for most food products is already inelastic, this means that the farm-level demand for most food products is very inelastic. This means, of course, that it is very difficult to get the farm market to take more product unless the price drops sharply. However, if the amount produced is a bit smaller the price can also rise sharply. If one looks at farm prices over time and their variability, this behavior is evident. Milk is a particularly vivid example. The figure below shows the wide price swings that accompany fairly small quantity changes on the supply side.

5 The concept of flexibility of demand is also important here. Flexibility is defined as the percent change in price in response to a 1 % change in quantity. This is the reverse of elasticity and actually in equation form it is the inverse of the own-price elasticity of demand. If P = c + dq then f = d( Q / P) = ( 1/ b)( Q / P) = 1 / ε When one solves the retail and farm demand equations for price, you get P R = $ Q P F = $ Q fr = d( Q / PR) = 01. ( 21 / 0. 90) = ff = d( Q / PF) = 01. ( 21/ 0. 40) = 525. As before these are parallel lines, in this case in price dependent form. Note the intercept is different by the $0.50 marketing costs. Calculating the flexibilities we get As with elasticity, the formulas are identical except for the prices and since the retail price is higher, the retail demand is less flexible than farm demand, which is another way of saying that the farm price will move farther for the same quantity change. The idea of flexibility is that often farm production is determined by decisions made earlier and the farmer cannot adjust the quantity supplied in the short run. This means that the market price is where all the adjustment must occur and for a larger quantity the farm price will drop proportionately more than the retail price. When conditions change, the whole market adjusts. For example, suppose the marketing costs rise form $0.50 to $0.60. As mentioned earlier, this will leave less for the farmer from the retail price at

6 any quantity. The result is seen in Figure 4. The new marketing costs MC, leads to a new farm-level demand curve, DF. The retail demand curve does not move. Figure 4: Marketing costs rise

7 When the farm level supply curve is added (Figure 5), the new equilibrium is established. At this new equilibrium, the quantity is lower, the marketing cost is higher, and the equilibrium prices at the farm level and retail level move in opposite directions. The retail price rises, while the farm price falls. Of course, farmers hate this. When the consumer is paying more and the farmer is getting less, farmers see a conspiracy. It need not be this, but rather some legitimate source of higher costs in the marketing sector. A few years ago the refrigeration requirements for eggs were made stricter to control salmonella. The farm and retail prices moved in opposite directions to accommodate this cost increase. Like many things in the food system, derived demand makes sense once one thinks about it. The key is understanding what you are looking at.