Shifts in Supply

Shifts in Supply

What other factors than price affect supplies? A supply curve for
any good or service shows the distinctive relationship between
just one variable, price and the quantity of supplies that each price
will call forth to the market. As before, if any exogenous variable
Fixed
supply
Price-inelastic
supply
Price Price-elastic supply
Quantities
(a) (b) (c)
Figure 2.11 Changes in price-elasticity of supply over time. (a) Spot market,
(b) the short term and (c) the long term.
© 2004 Tony Cleaver
outside of this relationship changes then the original supply curve
will shift in its entirety – showing that at whatever price that existed
before, now at that same price a new supply relationship exists.
Any sudden change in production costs, say due to a technological
breakthrough or breakdown, an increase in wages, any transport and
distribution hold-up, will all effect a shift in supply (Figure 2.12).
Government tax and regulation can also affect supplies of certain
goods and services.
If a local brewery was prepared to supply quantity Q1 of beer to
town at a price of P1 and then the government raises the beer tax
by £x per pint sold then this will shift the supply curve as shown.
That is, the brewery will only be prepared to sell the same quantity
as before at a price of P1 £x. Equally, if they had to pay the tax at
the old price P1 then the brewery would only be prepared to supply
the much-reduced quantity Q2.
PRICE DETERMINATION: A CASE STUDY
We now have all the analytical components in place to complete our
theory of price. To recap, price changes signal how resources in the
economy must automatically re-allocate so as to match consumer
demand to potential supplies. How does this work? How are sudden
changes in market preferences or in production conditions accommodated
in an economy and what are the implications for the
people involved?
Consider again the world market for coffee, which is the most
important agricultural commodity that is traded internationally and
Price of beer Supply after tax
(per pint) Supply curve of beer
0 Quantity
P1+£x
P1
Q2 Q1
£x
Figure 2.12 A shift in supply.
© 2004 Tony Cleaver
is currently exported from fifty-two countries. Since the mid-1990s,
world production of coffee has dramatically increased, mainly due to
continued expansion in Brazil and the recent entry of Vietnam as a
major producer with its new plantations now bearing fruit. (Coffee
production in Vietnam has increased 1400 per cent between 1990
and 2000!) Other big producers of coffee, such as Colombia, have
maintained stable or slightly falling supplies over the same period.
Global demand for coffee has not shown an increase on the same
scale as supply over the last few years. There is a change in consumer
tastes within the coffee market – in favour of more organic, environmentally
friendly products – but overall consumption has increased
hardly at all, relative to supply.
We can illustrate this in Figure 2.13 as follows. World demand
for coffee is stable and relatively price-inelastic as illustrated by the
demand curve shown.World supply is also relatively price-inelastic
and is illustrated by supply curve S1. Supply, however, is unstable
in that Vietnam’s drive to increase exports and incomes at home has
meant increased efforts to plant and produce coffee. The supply
curve therefore shifts to S2, there being no reduction in supplies
elsewhere in the world.
At the old price P1, the world demand for coffee is represented by
the distance P1A.World supply is now greater and equals P1B.With
an excess supply of AB in world markets, the price will be under
pressure to fall. As it does so this induces some extension in demand
(an increase in quantity illustrated by movement along the demand
curve from A to C) and simultaneously some contraction in supply
(movement from B to C). In time, a new market equilibrium will
Quantity
Demand
Price
S2
S1
A B
C
0
P1
P2
Figure 2.13 Prices in the world coffee market.
© 2004 Tony Cleaver
evolve at C at a lower price P2 and a small increase in the quantity
of coffee traded, equal to P2C.
Note that so long as the demand curve is stable and priceinelastic
(relatively steep) then relatively small shifts in supply (due
to sudden increases or decreases in coffee harvests) will cause relatively
large changes in price, as shown earlier. The irony is that for
small producers who are anxious to increase outputs and increase
their incomes, if they are collectively successful then the result of
their efforts is to drive coffee prices down a long way – thus significantly
reducing their incomes! Individual farmers may not increase
production so much themselves, but they are dependent on world
markets and as prices fall, they and their family will face increased
hardship, if not actual poverty.
In this example, the chain of events has been as follows: a change
in the factors affecting production (sudden entry of a new, large
producer) has caused excess supplies, which has pushed down the
world market price and this has called forth just enough increased
demand to buy up the excess.
The truth is that almost all agricultural markets are vulnerable
to sudden fluctuation brought about by exogenous shocks. Good
harvests can produce bumper crops one year, which push prices
down, or another year natural disasters can decimate production,
causing prices to soar. Farmers have uncertain incomes, therefore,
and the ill fortune which visits one family and destroys their crop
may push up prices and reward another lucky enough to escape and
bring their supplies to market (see Box 2.7).
Sudden shocks in supply conditions are common in agriculture.
In contrast, movements in consumer demand tend to be less
frequent and more long-drawn-out since peoples’ consumption
habits are typically slow to change. The final example for this
chapter looks at the effects of one such development in demand – the
environmental movement.
Although it has been mentioned that aggregate world demand
for coffee has been stable over recent years, there has nonetheless
been a swing within the market towards purchasing the product of
more sustainable agricultural practices. The World Bank estimates
that demand for certified organic coffee is currently increasing
at around 15–18 per cent per year. Such a demand is delivering
a considerable price premium to the farmers involved.
© 2004 Tony Cleaver
Consider the supply conditions for traditional, smallholder
coffee, grown on mountain slopes at the interface between primary
tropical rainforest and cleared agricultural land. Such coffee naturally
grows in the shade of a forest canopy that supports a rich flora
and fauna and is not uncommon for many small farms in Central
America. Some investment will be required to have this traditional
practice certified as ‘organic’ or ‘shade-grown’ but the benefit for
the smallholder of such certification can be illustrated as seen in
Figure 2.14.
Box 2.7 Coffee prices: part 2
In reality, all sorts of factors change all the time so that prices
are constantly on the move. In 1997 a severe drought in Brazil
destroyed a large fraction of the coffee harvest which caused a
sudden peak in world prices (see Figure 2.9). Since then
however supplies have steadily increased and prices fallen to an
all-time low, as already explained. The International Coffee
Organisation report that world production in the crop year
2001/02 totalled 109.8 million bags, rising to 120 million bags in
2002/03. This data compares to a relatively stable demand, estimated
at 108.3 million bags in 2002. No wonder that prices
slumped!
Predictions for the future, however, indicate cutbacks in
production. This is so particularly in Brazil for the following
reasons: First, there is a biennial production cycle which means
that very good harvests are normally followed by poor ones.
Second, recent low prices, earnings and profits in the plantations
have meant maintenance difficulties which inevitably
depletes future production potential. Last, there has been a
recurrence of drought. Add to this contractions in production
predicted for other countries where agricultural costs have also
risen whilst coffee revenues have fallen and the outlook for world
prices looks uppish. The forward shifts in supply illustrated
earlier which have caused prices to fall should be followed by
shifts back in supply to return the market to close to where it
was before. Farmers are hoping for higher earnings.
© 2004 Tony Cleaver
Assume the supply of smallholder coffee increases with price as
indicated by the standard supply curve shown. Demand in the
market place is given at first by the demand curve D1 but, over
time, there is an increasing growth in consumer preferences for this
traditional, environmentally friendly product such that demand
shifts to D2.
If the old market price, P1, were to persist, supply would equal
the distance P1M but demand would now exceed this, at P1N. The
excess demand MN would force the price up in the market to a new
premium price P2. Such a price induces more smallholders to enter
the market, to certify their product and increase the supply of this
sustainable coffee, corresponding to a movement along the curve,
MR. Meanwhile, the price rise from P1 to P2 has reduced the
demand somewhat, illustrated by the move NR. The new equilibrium
quantity of coffee now traded has grown overall to the amount
represented by the distance P2R (Box 2.8).
Thus we see the effect of changing consumer demand, transmitted
by higher prices, signalling to producers that increased earnings and
profits can be had by switching agricultural practices to more environmentally
friendly techniques. By such market mechanics, induced
by the ‘invisible hand’ of the price system, both the wishes of
consumers and the needs of the planet are efficiently met.
These are the workings of the price mechanism – an automatic
device that operates to balance supplies and demand for all goods
and services marketed. There is no national or international government
or bureaucracy involved, no official targets set and orders
Supply
D1 D2
R
M N
Quantity
Price
P1
P2
Figure 2.14 Demand, supply and price for sustainable coffee.
© 2004 Tony Cleaver
Box 2.8 Sustainable coffee
The World Bank Rural Development Department identifies
different standards of sustainability: organic coffee, which is
grown without synthetic fertilisers and pesticides; shade-grown
coffee, farmed under a forest canopy which provides different
species habitat; and fair trade coffee which guarantees minimum
prices and a living wage for poor farmers when world market
prices are low.
To qualify for certification in any of these categories, farmers or
small producer co-operatives must establish appropriate monitoring
and documentation of their agricultural practices for a
number of years. This can be an expensive process. Investment
in these procedures is essential however both for convincing
buyers that their product is genuinely complying with sustainability
criteria and to ensure a high quality taste. Gaining access
to high value markets is the key to success. This is critical if
producers are to reap the rewards for the costly and timeconsuming
expenditures necessary to certify their product. A
substantial reduction in yields (down by 66 per cent!) can be
expected at first if farmers switch from high chemical inputs to
organic or shade-grown methods. Studies show that it may take
up to five years for yields to recover. The longer-term pay back will
be high since environmentally beneficial practices do not exhaust
the soil, but in the meantime punishing costs must be endured.
Provided marketing links can be established, long term contracts
with coffee buyers in niche European and North American
markets can ensure access to significant price premiums that can
generate high farm incomes, even if yields are lower. There are
external benefits too. Higher farm incomes mean that the exodus
of young people to city slums in poor countries is reduced, as is
the temptation to farm illegal crops. Additionally, the process of
certification and the requirements of village level organisation
together promote entrepreneurial practices that have a direct
educational and developmental benefit that may impact on a wide
range of rural activities. Environmentally sustainable farming thus
may produce a sustainable rural economy.
© 2004 Tony Cleaver
given – other than private contracts signed to purchase supplies and
promise payments. The prices paid and earnings gained are not
designated by some central authority and any changes that take
place are not necessarily planned or co-ordinated – they are
solely the outcome of privately agreed deals between buyer and
seller. But the result is that due to the combined efforts of dealers
all pursuing their own interests we can buy a decent drink at an
affordable price in a local coffee shop.
The free market may, as we have seen, reward people sometimes
arbitrarily and, according to its critics, unfairly (we will return to
this theme in a later chapter) but the system works and adjusts efficiently
to exogenous shocks that are part and parcel of the world we
live in. It signals where people can work for profit, which production
techniques are best employed and what goods and services
serve society’s needs most. Quite some mechanism!