Three applications of supply demand and elasticity

Can good news for farming be bad news for farmers? Why did OPEC fail to keep the price of oil light? Does drug interdiction increase or decrease drug related crime? At first, these questions might seem to have little in common. Yet all three questions are about markets, and all markets are subject to the forces of supply and demand. Here are applying the versatile tools of supply demand and elasticity to answer these seemingly complex questions.

Can good news for farming be bad news for farmers?

What happens to wheat farmers and the market for wheat when university agronomics discover a new wheat hybrid that is more productive than existing varieties? First we examine whether the supply or demand curve shifts. Second, we consider which direction the curve shifts. Third, we use the supply and demand diagram to see how the market equilibrium changes.

In this case, the discovery of the new hybrid affects the supply curve. Because the hybrid increases the amount of wheat that can be produced in each acre of land farmers are now willing to supply more wheat at any given price. In other words, the supply curve shifts tot e right. The demand curve remains the same because consumers’ desire to buy wheat products at any given price are not affected by the introduction of anew hybrid. Figure shows an example of such a change. When the supply curve shifts from S1 to S2 the quantity of wheat sold increases from 100 to 110, and the price of wheat falls from $3 to $2.

Does this discovery make farmers better off? As a first cut to answering this question, consider what happens to the total revenue received by farmers. Farmers total revenue is P X Q the price of the wheat times the quantity sold. The discovery affects farmers n two conflicting ways. The hybrid allows farmers to produce more wheat (Q rises) but now each bushel of wheat sells for less (P falls).

Whether total revenue rises or falls depends on the elasticity of demand. In practice, the demand or basic foodstuffs such as wheat is usually inelastic because these items are relatively inexpensive and have few good substitutes. When the demand curve is inelastic as it in the figure, decrease in price cause total revenue to fall. You can see this in the figure. The price of wheat falls substantially whereas the quantity of wheat sold rises only slightly. Total revenue falls from $300 to $220. Thus, the discovery of the new hybrid lowers the total farmers receive for the sale of their crops.

If farmers are made worse off by the discovery of this new hybrid why do they adopt it? The answer tot his question goes to the heart of how competitive Markets work. Because each farmer is only a small part of the market for wheat he or she takes the price of wheat as given. For any given price of wheat it is better use the new hybrid to produce and sell more wheat. Yet when all farmers do this, the supply of wheat increases, the price falls and farmers are worse off.

Although this example may at first seem hypothetical it helps to explain a major change in the US economy over the past century. Two hundreds years ago, most Americans lived on farms. Knowledge about farm method was sufficiently primitive that most Americans had to be farmers to produce enough food to feed the nation’s population. Yet over time, advances in farm technology increased the amount of food that each farmer could produce. This increase in food supply, together with inelastic food demand, caused farm revenues to fall, which in turn encouraged people to leave farming.

A few numbers show the magnitude of this historic change. As recently as 1950, there were 10 million people working on farms in the US, representing 17 percent of the labor force. In 2004, fewer than 3 million people worked on farms, or 2 percent of the labor force. This change coincided with tremendous advances in farm productivity. Despite the 70 percent drop in the number of farmers US farms produced more than twice the output of crops and livestock in 2004 as they did in 1950.

This analysis of the market for farm products also helps to explain a seeming paradox of public policy. Certain farm programs try to help farmers by inducing them not to plant crops on all of their land. The purpose of these programs is to reduce the supply of farm products and thereby raise prices. When inelastic demand for their products, farmers as a group greater total revenue if they supply a smaller crop to the market. No single farmer would choose to leave his land fallow on his own because each takes the market price as given. But the farmers do so together each of them can be better off.

When analyzing the effects of farm technology or from policy it is important to keep in mind that what is good for farmers is not necessarily god for society as a whole. Improvement in farm technology can be bad for farmers because it makes farmers increasingly unnecessary but it is surely good for consumers pay less for food. Similarly a policy aimed at reducing the supply of farm products may raise the incomes of farmers but it does so at the expense of consumers.