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Pork Economics 101

We’re going back to Econ 101 again this week. Figures 1 and 2 accompany the following discussion.

Higher demand is a great thing! It allows everyone to be happy. Consumers are happy because they are the ones who initiate higher demand. They decide how to spend their limited resources to maximize their utility or well-being. If they did not want to buy more product or pay higher prices, neither would happen.

Of course, that is not true of every consumer. Some may not want to pay more, but they are forced to do so by those that will. U.S. consumers may not like this summer’s higher prices, but robust export demand has set the course.

We have seen hog demand rise this summer, driven primarily by higher export demand for pork and pork variety meats. The increase in demand has caused prices to rise even though supplies have been significantly larger than one year ago. Figure 1 represents these changes by the shifts of demand from D to D’ and of supply from S to S’. The equilibrium quantity rises to Q’ and price rises to P’.

The position of the supply function in these P-Q diagrams is determined by a good’s variable costs of production. If they rise, then price must rise in order to cause producers to produce even the same amount of a good. The flip side is that fewer units will be produced at any given price level. That means that supply shifts up and to the left when costs rise – such as the shift from S to S’ in Figure 2.

So what happens if supply shifts up and to the left, but the quantity of output remains the same? In the short run, output remains Q and the price received remains P, but the cost of producing output Q is C=P* and per unit profit is P-C, which is obviously negative. Does that sound familiar?

There are only two ways to rectify this situation – increase demand or reduce output. A demand shift to D’ would push prices upward to P*=C and output could remain Q. Consumers would again be happy since they make the decisions that determine demand. Producers would again be happy since they are not losing money. In fact, at any point on their supply curve, producers earn a “normal” rate of return on invested capital since the opportunity cost of investing that capital elsewhere is built into a firm’s costs. I’ll ask you to just trust me on that one for now.

The more likely way to rectify this loss situation, though, is to reduce output from Q to Q’ in order to drive price to P’, a level which equilibrates the quantity demanded from demand D and the quantity supplies from supply S’. Consumers are once again happy and producers are once again earning normal rates of return on invested capital, but they are producing less and, quite likely, there are fewer producers. Not everyone is happy with that outcome.

Looking Ahead
It appears now that average hog production costs through the end of 2009 will be about $80-$83/cwt., carcass. The average for Chicago Mercantile Exchange (CME) Group Lean Hogs futures contracts over that same period as of Monday, Sept. 15 was $78.35, implying that average net cash hog prices will be $75-$77. At those levels, per head losses will average $6-$16 through the end of 2009.

So, can we wait for demand to catch up or must we cut back? Given the strength of demand this year, and the strengthening U.S. dollar, “demanding” our way out of this appears unlikely. And the reduction of the U.S. sow herd has been small thus far. U.S. sow slaughter of U.S. sows is 11% higher, year-to-date. U.S. beef cow slaughter is 13% higher. No data are available on the slaughter rate for broiler-type hens, but the size of that flock went below year-ago levels in June for the first time since February 2007 and stood 1.5% lower than last year as of July 30.

I still think output has to be significantly reduced if profits are to return to the pork industry. The average national net price for this year is going to be $66-$70/cwt., carcass. Reaching $82/cwt., carcass, would require a 20% increase in prices and using a price flexibility of 2:1 to 3:1 would mean production will have to fall by 7-10%. Since the least productive sows will be removed, the U.S.-Canadian sow herd must decline by a larger percentage than that. The U.S. isn’t there yet and will not get there in 2009, but given present cost prospects, that must still be the objective if profits are to return.

Click to view graphs.

Steve R. Meyer, Ph.D.
Paragon Economics, Inc.
e-mail: [email protected]