Consumer Psychologist Facebook Forum

Lars Perner, Ph.D.
Assistant Professor of Clinical Marketing
Department of Marketing
Marshall School of Business
University of Southern California
Los Angeles, CA 90089-1424, USA
(213) 740-7127


Production Costs, Demand, and Competition

Influences on Prices. As the chart suggests, prices that farmers receive for their commodities and other products depend on supply and demand factors. The amount of output available from other farmers, from imports, or the extent to which other products represent good substitutes affect the supply side. Demand for the product can ultimately be traced back from the consumer through the value chain. Manufacturers will base their orders on expectations of demand. If demand is expected to be high, prices will tend to rise; if less demand is expected, prices are more likely to decrease.

Most retailers, with the exception of “giants” such as Wal-Mart, will tend to order through a wholesaler. The wholesaler must anticipate the demand from retailers and have stock on hand to meet this demand.

Bargaining Power of Farmers. Farmers, who sell commodities in relatively small quantities, ordinarily have very little bargaining power. Since the same commodity from different farmers is considered identical, the farmer can in theory sell all his or her product at the market price but cannot sell at a higher price. In practice, however, many of today’s commodities transactions take place electronically and/or through brokers. This means that there may not be reliable information about market prices available and that the buyer will have the upper hand in negotiations. The farmer could try to get bids from different buyers, but that will take a great deal of time away from the farmer’s work of actually producing crops.

Predictable and Less Predictable Market Changes. Farmers are very vulnerable to environmental change. Small changes in supply and/or demand can greatly affect the prices that are paid for commodities (where demand tends to be very inelastic) and for supplies needed. Some changes may be relatively predictable—e.g.,

Less predictable changes. Some market factors are more difficult to predict. Since most commodities prices respond very strongly to supply conditions, the size of the current harvest will greatly affect prices. The harvest crop yield usually cannot be accurately predicted at the time when sowing has to be planned. Exchange rates between currencies also fluctuate dramatically. If the dollar increases in value relative to other currencies, American crops will become more expensive for people in other countries to buy (they have to spend more of their own currency to buy the dollars that must be used to pay American farmers) and imports will become more attractive for Americans (because the dollar now buys more abroad).

Farm value. Farm value refers to the proportion of the total food costs paid by consumers that come back to the farmer. For some foods, such as bread, the farm value will be very low. Other ingredients are used in bread, too, but the farmer usually only gets about 5% of the retail bread price for the wheat supplied. The rest of the value is added through processing, manufacturing, distribution, and marketing. The farm value is higher for meat products.

The fact that parties other than the farmer are making money is not necessarily a bad thing. Other members of the value chain add steps that are valued by the consumer. In recent years, the farm value of many food products has decreased. Again, this is not necessarily unreasonable since consumers are demanding more services. The fact that consumers are willing to pay the supermarket more money for prepared foods, as opposed to the raw ingredients, does not mean that the farmer will be paid less. We can think of the trend toward consumers demanding more value added to the products as making the pie larger. The farmer will get a slice of fewer degrees, but because the pie is larger, the total area will remain unaffected. Other factors might, of course, influence farm value. When demand for a greater value added product is met, the demand for the farmer’s ingredients may go up, leading to higher prices and benefiting the farmer.

Several factors affect farm value. Some are:

Trends vs. fluctuations. It is normal that prices, demand, or other variables will fluctuate—that is, go up and down in a seemingly random manner—over time in response to a large number of factors. On the other hand, some changes over time tend to show a consistent trend—that is, even if prices seem to vary, they may tend to go up over time.

In the above chart, prices fluctuate, but if we graph a trend line (based on a regression analysis of price as a function of time), we see that average prices tend to increase over time. It is important to recognize that a trend that has been experienced in the past will not necessarily continue. For example, consumption of eggs had been declining for some time, due to concerns about cholesterol, until the trend reversed, in large part because of the growing popularity of high-protein diets.

Data with large fluctuations is described as “noisy.” That is, it is difficult to distinguish the genuine trend from the temporary fluctuations because these fluctuations are relatively large. Below, we see examples of relatively “clean” (as represented by the heavy line) and relatively “noisy” (as represented by the dotted line) data:

A number of characteristics influence the evolution of prices, costs, consumption rates, or other phenomena. Some possibilities can be see in this chart:

Some changes are linear, suggesting that the change happens at a relatively consistent rate over time. Changes can also be non-linear—that is, they can happen at increasing or decreasing rates. For example, immigration rates and the proportion of Americans over age 65 are growing at exponential levels. Some trends go until a point and then level off—thus, the early higher rates of growth are no longer predictive of future trends. A clear case of this is the maturity phase of the product life cycle where a product has now been adopted by most of the consumers who will, leaving little opportunity for growth. Some trends will reverse themselves. For example, in the late 1990s, a number of people invested in ostriches, driving up the price. Ostrich meat was touted as offering a taste similar to red meat but with much lower fat content. Owners bred the ostriches hoping for greater profits from selling ostriches to others. When the stocks were large enough that it was time to try to actually sell the meat, however, the “bottom fell out” of the market, resulting in a sharp decline in value. Much the same thing happened in the Internet stock market during the 1990s.

A special kind of trend involves seasonality. Turkey and cranberries are consumed disproportionately during November and December in the U.S. Prices of fresh peaches reach very high levels during the winter months, where much of the supply is imported, and drop dramatically during the summer months. It is possible to “partition” such seasonal effects from a long term trend:


When one adjusts for seasonal effects, this chart shows a consistent upward trend.

Lags in response to market conditions. A free market economy is based on the idea that the buyers and sellers will respond to changes in the market. When it is no longer profitable to produce and sell the current quantity, sellers will want to cut back on production. When prices rise due to high levels of demand, seller will want to increase capacity to produce a greater quantity. In practice, however, adjusting takes place. If the price of beef goes up, it will take time to raise more cattle to be slaughtered. In the short run, the farmer may actually produce less because cattle are held back for breeding rather than being sold off for meat. When prices go down, the farmer has already invested in facilities and/or the current crop. Thus, it will take time to adjust production. Ironically, the adjustment phase may take so long, and too many farmers may “jump on the bandwagon,” that by the time the adjustment has taken place, the trend may have reversed. For example, if farmers see an attractive market for almonds, they may grow more almond trees. By the time these trees are ready to yield, however, the price may have declined. Too many farmers may have grown too many trees, flooding the market. Many farmers may then rip up their trees and grow other commodities, forcing supply down and prices up, encouraging a new round of investments!

It takes time to recognize that prices are consistently going up or down (as opposed to just fluctuating). Implementing the capacity change then takes time, and it may be necessary to secure a loan or other capital before the investment can be begun. It may take some time for prices to be felt at the different ends of the value chain or channel. For example, if the wholesale supply price of peanut butter goes up, peanut farmers who contracted in advance to sell at a given price may not feel the price change until it becomes time to negotiate for next year’s contract.

“Real” vs. inflation-adjusted prices. Inflation is a reality. Over time, average prices tend to go up dramatically. Measures of inflation—such as the U.S. Consumer Price Index—are based on weighing the cost of a “basket” of goods. Different expenditures felt by a typical family—such as food, housing, medical care, and transportation—are each weighted in arriving at an estimate of overall price changes. Often, however, inflation rates vary dramatically between product categories. Some components of the economy—such as health care and real estate—have very high rates of inflation while the costs of many electronic products are actually declining. Changes in the prices of different agricultural products often vary considerably by category. To make price comparisons meaningful over time, we can adjust for inflation. If we set an arbitrary year to be our “index” year, we can more meaningfully compare economic data over time.