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A Supply-Demand Short Course

The entire concept of “demand” is foreign to many laymans economists. It is even foreign – or at least blurry – to some trained economists.

One of my missions since beginning my professional career with the National Pork Producers Council in 1993, has been to help people understand demand – what it is, what it is not, where it comes from, etc.

Live hog demand has been nearly unbelievable since mid-2007. While costs have not been covered since last September, it wasn’t the fault of hog prices! The remarkable performance of cash hog prices in the face of huge supplies has been well documented in these editions. The only way that can happen is for demand to be exceptionally good. But what is the source of that strength?

Figure 1 shows a conceptual model for the derivation of live hog demand and retail pork and pork by-product supply. My hope is that it will give you a mental model to see the relationships between the various parts, pieces, levels, etc.

Look first at red supply functions and the red arrows that indicate their influence on successive market level. For supply, everything starts at the farm level. The supply of market hogs is not the number of hogs available. It is the number of hogs that could be made available at various prices. The position of the supply function (the entire red line) in the P-Q space and its shape is based on the cost of producing pigs.

Successive supply functions are determined by the supply of hogs and the costs of transforming hogs into wholesale pork and pork by-products and, subsequently, retail pork and pork by-products. Thus, the wholesale and retail supply functions are “derived” from the farm level supply.

The green demand functions and green arrows work just the opposite. All demand relationships begin at the consumer level and work backward with upstream demands being “derived” from downstream demands and the costs of transforming hogs into pork and pork by-products. The demand for hogs is the last step in that process.

As with supply, demand is not the amount of product purchased. It is the amount of product that would be purchased at alternative prices. For example, the entire green line in each diagram, consumer tastes and preferences, income levels and the prices of complement and substitute goods determine the position of that green line in the P-Q space.

Note that export demand for both by-products and pork operated at the wholesale levels. The prices of these goods in export markets differ from those of domestic wholesale markets, due to differing specifications and transportation costs.

This model also provides a framework for “what-ifs” regarding changes in what we economists call “exogenous” variables. The only variables “endogenous” (or inside) these diagrams are quantity and price. Any other variable, such as fuel prices, packing materials prices, the prices of substitute or complement goods, and consumer tastes and preferences, are called exogenous. When any one of those changes, it will move one or more of the supply and demand functions within the P-Q spaces of these charts.

What if corn costs rise? The farm-level supply function would shift up and to the left. That shift would flow through the red arrows to other levels, driving all of the red-derived supply functions up and to the left. The quantity of hogs and all pork products would fall and the prices of hogs and all pork products would rise. I believe we are in the midst of such a change at present.

What if fuel costs rise? There would likely be a farm-level cost shift, such as is described above, but there are more complex impacts. The cost of transporting hogs and pork products would rise, thus changing the derivation of downstream supplies (i.e. the red arrows) from the basic hog supply. Downstream supplies would shift upward by a larger relative amount than would hog supply, causing the spreads between farm level price and wholesale price and retail price to grow.

The opposite would be true for wholesale and farm-level demand. The green derivation arrows would change due to higher energy costs and upstream demand functions would fall relative to retail and export demand due to higher transportation and processing costs.

What if export demand for pork rises? It would pull wholesale pork demand upward and, thus, pull hog demand upward. Domestic demand would not change, but domestic retail price would rise as more product flowed overseas, thus reducing the quantity of pork supplied to the domestic market at any price level.

And finally, what about export demand for pork by-products? The action would be the same as is described above for pork, but notice that the change in the by-product market would not impact the domestic retail pork market. Thus, the foundation for my long-held position that by-product exports are a win for almost everyone. Foreign customers get more product, wholesale by-product demand rises, thus increasing hog demand and prices, all while domestic pork prices are unaffected. There is, however, a loser even in this case – domestic buyers of pork by-products who must pay more.

Click to view graphs.

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