Market Preview: Costs Still Drive Supply, Demand

by 5m Editor
21 January 2010, at 6:41am

US - Weekly US Market Preview provided by Steve R. Meyer, Ph.D., Paragon Economics, Inc.

The economics of a cost increase are not terribly complicated. We all need to appreciate what higher costs are doing to all livestock and meat sectors.

Costs are the basis of supply. More specifically, a firm’s marginal cost (the additional cost of each additional unit of output) forms the firm’s supply function. Any rational manager will increase output to the point that the cost of adding one more unit of output is larger than the price that will be received for that unit. This assumes that marginal costs rise with output, a realistic assumption for most farms, I think, where crowding or strapped labor or some factor would cause efficiencies to fall and costs to rise at some point, and to keep rising if the manager tries to push more and more output through a given system.

But time is a big factor as well. In the short-run, hog farms can’t do much about output. We economists say the short run supply function is inelastic, meaning that output cannot be changed much in response to a different price. Dashed lines SSR and S’SR in Figure 1 are short-run supply functions. They indicate, for instance, that the industry’s total slaughter for next week (or even the next 26 weeks since the pigs are already on the ground or 40 weeks since the sows are already bred) cannot be changed by much in response to a price change.

Given time, however, producers can increase or decrease output. A few more sows can be bred to fill in for those that recycle. A few more can be bred and pigs cross fostered to maximize litter size in each crate. Additional labor can be added to raise pigs that otherwise might not make it to market weight. These kinds of changes would move the firm along one of the solid lines SLR and S’LR in Figure 1. Since time allows for changes to be made, the output change for a given price offer can be much larger. The long-run supply function is more elastic.

But none of these actions change supply. They are what economists call a “change of quantity supplied” or a move along an existing supply function.

A change of supply is when the whole line moves. Short-run supply can change even without a shift of long-run supply. The primary example of such a shift is when the price of an input changes. Nothing else would change in the short run. The producer would still use the same technology, would be locked into the same number of head, and would still employ roughly the same level of inputs, such as labor, feed milling, transportation and even feed ingredients. The only difference would be that the dollar cost would rise due to the higher-cost input.

Does that sound familiar? This is the precise situation we saw when corn prices took off and moved our short-run supply functions from SSR and S’SR in Figure 1.

The trouble is, output QE had been set before the price/cost increase. The new cost level (determined by the intersection of QE and S’SR) is much higher than the price (PE) determined by the intersection of QE and SLR and firms lose money big time!

But moving the long-run supply curve is much more difficult since its position depends on the size of the production plant. In this market-wide diagram, that means that QE and SLR depends on the total number of sows and, indirectly, the breeding, gestation and farrowing facilities in the United States. To move the long-run supply curve to the left to S’LR where any level of output will only occur if a higher price is paid or, conversely, higher prices will be paid for any level of output, sows and sow farms must be taken out of production. Such action will align S’LR with S’SR, drive output downward to Q’ and price up to P’, where price again equals marginal cost.

Using weekly data for 52 weeks ended on 2 January 2010, the year-on-year changes in output level for the four major species in 2009 were as follows:

Pork -1.0 per cent
Beef -1.8 per cent
Chicken -3.3 per cent
Turkey -6.8 per cent

It is clear that this downward supply adjustment is underway for all four commodities. Turkey and chicken may have done enough, but they could respond much more quickly. The pork decline would have been roughly twice as large without last summer’s temperature-induced high market weights. The December Hogs and Pigs report suggests that, if market weights are more normal this year, the reduction will about double the 2009 level. The beef cutbacks may not get larger, but they will certainly go on longer due to the long generation interval of cattle.

Hold ’em or Fold ’em?

The futures markets are now suggesting that the pork industry may have already made a large enough shift in its long-run supply curve. Using 14 January-closing futures prices and the production parameters in the Iowa State University cost and returns estimates, the average profit for Iowa farrow-to-finish units would be $7.34/head in 2010.

But it appears to me that the futures markets are, more importantly, assuming that the demand curve for pork and hogs is going to rise dramatically – meaning that the leftward shift of supply doesn’t have to be as large as it would be if demand was constant.

Hedging the profits being offered now versus waiting to see if cash markets are higher is simply a bet on where pork and hog demand will go in 2010. You can fold ’em or hold ’em. The nice part is that if you fold ’em right now (i.e. hedging), you’ll be paid a profit!