Results & Evaluation: Text Assignment Showcases:
Producer Theory
Wheat (more showcases)
- Portrait
- Industry Structure
- Profitability
- Cost Structure
- Entry/Shutdown/Exit
- Changes in Underlying Market Conditions
- Government Regulations
Analysis
- Industry Structure
- Profitability
- Cost Structure
- Entry/Shutdown/Exit
- Changes in Underlying Market Conditions
- Government Regulations
- Policy
- Bibliography
- Some useful suggestions from the professor
Imagine yourself walking through a beautiful field of wheat that you recently inherited from your Uncle Sam. Being the entrepreneurial farmer that you are, you realize that the possibility of entering into the wheat industry could be a challenging experience given its state of relative perfect competition.
The wheat industry is experiencing perfect competition due to the fact that there are many firms producing identical products for which there are virtually perfect substitutes and many buyers. For example, the wheat industry tends to classify different types of wheat geographically, such as Chicago wheat and Kansas City wheat. Although the wheat is grown all over the country, there is little if any difference in the use of each type; thus, wheat from each geographic region is virtually a perfect substitute for another. Furthermore, the wheat industry experiences perfect competition, because any farmer with basic farming equipment may enter the industry without having to face a disadvantage relative to other farmers who are presently in the industry. Finally, farmers and buyers are completely informed about the prices of the wheat given the ample amount of statistics and data available.
Since all farmers in the wheat industry are operating under conditions of perfect competition, they are each able to achieve, under standard conditions, merely normal profit, and not positive economic profit. "I am constantly having to dip into my budget to replenish my organic fertilizers. I am barely keeping up." Although in the short run, some farmers are achieving economic profit due to newly acquired technology (explained later), in the long run, farmers are at best able to make their entrepreneurial normal profit.
As for technology, only recently have there been technological improvements to farming that will serve to reduce costs in the long run. For example, the new Global Positioning Satellite (GPS) farming system now allows farmers to control costs and boost crop yields.
Due to increased government regulations, there has been virtually no entry into the wheat industry. In fact, because of these government regulations, wheat firms are exiting the industry at a much higher rate than in the past. For example, the U.S. government has ended government storage payments to farmers, leading to a decline in farmer owned wheat reserves.
Changes in Underlying Market
Conditions
Only recently have the underlying market conditions been changing. As mentioned earlier, the new GPS technology is offering precision farming to farmers in the wheat industry. This allows them to analyze more precisely why some land is less productive, and to manage their wheat fields on a less costly basis. As for regulations, it is known that the United States has included a policy to increase the quality of U.S. grain to its farmers. It is the aim of this policy to provide monetary incentives to the wheat farmers for the production of high quality wheat. In terms of of demand, there has been a recent price slide, which may have stimulated buying by some of the world's top wheat importers, says Jerry Gidel, grain analyst for Dean Witter in Chicago. The USDA supply and demand report projects wheat exports of 1.025 billion in 1997-98, which is up from the May projection of 1 billion, and the actual wheat exports of 995 million in 1996-97.
First and foremost, an important government policy dealing with U.S. wheat farmers for 1998 was to reduce farm program spending by 79%. This would jeopardize domestic jobs and productivity growth and handicap U.S. farmers in the competitive world market. The government has also made it a policy to offer no assistance in the event of a natural disaster destroying the crops. The farmers are now responsible for purchasing their own crop insurance to protect them if such a situation may arise.
Analysis
As described earlier, a firm in the wheat industry, which would be producing a mere fraction of the total output, faces perfect competition, and therefore is a price taker. As a price taker, the individual firm is unable to influence price, and is faced with perfectly elastic demand due to the abundance of virtually perfect substitutes. In such a situation, the best a firm can hope to achieve is normal profit in the long term. Although economic profit may be achieved in the short term because of breakthroughs in technology, a wheat industry firm can only achieve normal profit in the long term, and therefore has very little incentive to expand, as expansion would mean an increase in costs.
When examining profitability, there are two possible outcomes for the firms of the wheat industry in the short term. First, a wheat farmer will achieve only normal profit, and will be working at the break even point, that is, where the Marginal Cost curve intersects the Average Total cost curve at a minimum. At that point price will equal marginal revenue, which will equal marginal cost. Second, the wheat farmer is operating with the use of new technology, such as the GPS system, which allows him to achieve an economic profit in the short run. The new technology allows the farmer to produce the same amount of wheat at a lower cost, thus moving him to a lower Average Total Cost curve. Because of this, the intersection of marginal cost with Short Term Average Total Cost curve is below price, and so the farmer is able to achieve an economic profit. In the long term, however, each and every firm still competing in the industry will have the benefit of this new technology, and so economic profit will be competed away.
The wheat industry is experiencing neither economies of scale, where costs would decrease as production increases, nor diseconomies of scale, where costs would increase as production increases. As a result, there is little to no incentive for any of them to change plant size, because it would mean accruing many unnecessary costs. When looking at the merger mentioned in the above portrait, the two firms, Harvest States and Continental Grain, joined up, thus increasing their operations and plant size. In the short run, this merger would help reduce operation costs and provide the newly formed organization with accounting profits. However, in time, all profits in the industry are competed away resulting in economic profit for the merged companies.
As mentioned above, firms are exiting the wheat industry due to somewhat harsh government policies. The exit of these firms will result in a temporary price increase as the total quantity decreases in the short run due to the lessened supply of wheat. The remaining firms will then increase their output and ultimately compensate for the reduced number of firms in the long run. This will allow the industry to return to its long run equilibrium. The price increase in this case will cover the increased costs incurred by the remaining firms that are finding themselves producing more wheat than in the past.
Changes in Underlying Market
Conditions
The U.S. policies regarding increased wheat quality should put the wheat firms in a favourable position to compete in global market because of their new public image. The increase in demand internationally that has recently been stimulated, according to USDA projections, should allow several firms in the industry to achieve a short term economic profit. These firms will continue to accrue these profits until such a time when high quality wheat will be produced by all firms, thus economic profits will once again be competed away.
Because the government has significantly reduced subsidies to the wheat farmers in the United States, many firms are exiting the industry due to their inability to cover costs. Their Average Variable Cost curve is above their marginal revenue curve, causing short term shutdown of the firm. Furthermore, since their Average Variable Cost curve remains above the firm's marginal revenue curve, the firm must exit in the long term because of the lack of a remedy to the situation. In terms of the new regulations concerning crop insurance, this is increasing the Total Fixed Costs and Average Total Costs for each of the firms, which is potentially causing them economic loss. If, however, a firm opts not to purchase crop insurance to reduce their costs, it is putting itself at significant risk of exit from the industry should a natural disaster occur.
There is a limited role for government in the wheat industry. The most effective area for its intervention would be in setting quality standards. By introducing these industry standards, the reputation of American wheat would improve because it would be of a higher quality than in previous years. This would allow wheat firms to compete even more effectively globally, and their export market is a significant part of the industry. The government will be required to continue subsidizing the farmers to a certain extent to ensure that they are able to meet the quality standards without a significant increase in costs.
The government should not be setting any price standards, because in this situation where the firms are already price takers, it would cause significant problems. As it is now, the prices remain reasonably constant, and it would be difficult to operate in a situation where that was disrupted. For example, if the government was to set a price ceiling that was too low, then several of the firms may not be able to cover their costs, and this would result in mass exit from the industry. In trying to compensate, the remaining firms would be pushed to their limit. (Prof. comment: this is a vague, meaningless sentence.) On the other hand, if the government set a price floor which was too high, there would be a large amount of entry into the industry, which would cause a producer surplus. Neither of these situations is desirable, and so the government should continue to allow the wheat industry to regulate its own prices.
Some useful suggestions
from the professor
This assignment is made easier for you, as the basic structure has been provided. You are given a checklist of the various aspects of market structure. As I said in the generic instructions, it is not always necessary to write elaborate commentary on all of the aspects of market structure. Your article probably will not contain relevant information on such and such a point. For industry structure, you should indicate whether the market is better characterized as fairly competitive or fairly non-competitive. For profitability, try to find some clue as to whether economic profit is being made. If firms are entering, that is a sign of economic profitability. If firms are exiting, that is a sign of economic losses. For the cost structure point, try to find some indication of whether costs are high relative to the industry norm, and how costs vary with the output level. For instance, are the average costs mostly fixed costs or mostly variable costs? Are variable costs pretty low for a feasible range of output? For the entry/shutdown/exit point, look for evidence for barriers to entry, or firms exiting the industry. For changes in the underlying market conditions, look for changes in production costs, technological innovations, changes in consumer tastes, or other factors which are likely to influence supply and demand conditions. Finally, for government regulation, you may find that it does not apply to your particular case. Is there some intervention that the government is carrying out? If so, is this policy warranted?
The industry structure paragraph is well-done. The economic analysis is very sound.
This group zeroes in on the structure of the market without giving irrelevant points. The
paragraph concerning profitability is also pretty lucid. The name of the game is to apply
the models of firm behavior that we have studied, with their assumptions, their variables,
and their results (i.e. the posited relationships with variables) to the economic events
described in the article. Usually, this does not require many sentences. In this case,
they do a good job of avoiding irrelevant (and possibly incorrect) discussion. The
discussion of the cost structure seems a bit contradictory, as they start by saying that
constant returns to scale apply, and end up implying that increasing returns to scale
apply because two merging firms will realize lower per-unit costs. The discussion of
entry/shutdown/ exit is good, and that is not an easy point to deal with. For the
paragraph on changes in underlying market conditions, the economic analysis is correct,
but the writing is awkward. As far as government regulations are concerned, again I find
the writing style awkward. The points need to be explained more clearly. The economic
analysis is good. Finally, for the policy section of the assignment, I am quite pleased
and in agreement with their ideas. This group really gave the question some thought, and
they back up their recommendations with pretty precise arguments. In most cases in which
markets are fairly competitive, like agriculture, the proper role for the government is to
promote competition, not to restrict it.
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