Editor’s Note: You may have heard that price theory needs a revival. We agree. The economic way of thinking has of late been subsumed by mathematical analysis absent intuition. Fortunately, Professor Bryan Cutsinger is here to help. We are happy to present this first in what will [for now] be a monthly series in which Cutsinger presents price theory questions for your consideration.
Professor Cutsinger will be present for two weeks for feedback in the Comments section, helping you to “solve” each problem. We can’t wait to see your responses!
Question 1:
In his book, Basic Economics, Thomas Sowell (2015) writes, “the price which one producer is willing to pay for any given ingredient becomes the price that other producers are forced to pay for that same ingredient” (p. 20). With that quote in mind, consider the following scenario:
The demand to drink milk rises while the demand for milk in the form of cheese, ice cream, and yogurt remains the same. Assume that the supply of milk is perfectly inelastic. Explain why the elasticities of demand for milk in these other uses determine how much milk will be reallocated from these uses for direct consumption.
READER COMMENTS
David Henderson
Sep 18 2024 at 2:27pm
Quick friendly suggestion re use of the word “intuition.” When I grew up, we used the word “intuition” to refer to some gut feel that came to you absent any reasoning. It was only when I got into economics that I heard the word “intuition” used the way you use it, Bryan. But it’s not intuition. It’s understanding.
Robert EV
Sep 18 2024 at 2:33pm
Barring theft, demand in a market economy is equal to the dollars put forward to that purposes.
Dollars to drink milk = DM
Dollars for cheese = DC
Dollars for ice cream = IC
Dollars for yogurt = DY
Supply of milk = 1 (constant)
DM + DC + IC + DY = 1
If DM increases, and DC + IC + DY stays the same, then DC + IC + DY must be a smaller proportion of the supply of milk. Since we already know that the demand (aka dollars) for milk for the other uses stays the same, I don’t understand how elasticity factors in here? The elasticity is imposed by the increasing demand for milk to drink, and unwillingness of people to pay more for the other products. This “elasticity” will be directly proportionate with cheese, ice cream, and yogurt each decreasing by an equal fraction of supply, unless suppliers alter the allocation based on profit margin.
E.g. let’s say we have 5000 milk units of drinkable milk (D), 200 milk units of cheese (C), 1000 milk units of ice cream (I), and 600 milk units of yogurt (Y). If demand for drinkable milk increases by 500 units, then allocation for C+I+Y goes from 1800 units to 1300 units. So C = 200 * (1300/1800) = 144.4 units, I = 1000 * (1300/1800) = 722.2 units, and Y = 600 * (1300/1800) = 433.3 units of milk.
I don’t want to do the dollar calculations.
Robert EV
Sep 18 2024 at 2:49pm
I think I get it now. Prices are going to rise for all milk products. People have shown they’ll pay more for drinkable milk, but they haven’t shown how much more they will pay each for cheese, ice cream, and yogurt. There will be a period of trial and error as producers reduce the amount of cheese, ice cream, and milk on the market, raise prices on all milk products, and consumers show which they are willing to buy at what prices. For things like aged cheeses with long lead times, the price increase may be delayed, but will ultimately rise, extending the trial and error time for up to a year or so.
This trial and error will result in some shortages when the less available cheese, ice cream, and yogurt are priced too low. It will also result in some wastage when the reverse happens. Eventually prices and availability will settle down with a varying amount of drinkable milk, cheese, ice cream, and yogurt available. These proportions will likely not be the same as before demand for milk increased, as some customers will stop eating ice cream entirely and instead spend their remaining milk money on cheese and yogurt, and et cetera.
Don Geddis
Sep 18 2024 at 8:06pm
Yes, “demand for drinkable milk” should be in units of “dollars”, not in units of milk. You already knew that (you said “the demand (aka dollars) for milk”), but then later you also tried to measure milk demand in milk units (“If demand for drinkable milk increases by 500 units”). That’s the core mistake.
Also, of course, the price that cheese, yogurt, and ice cream makes pay for their milk ingredient will change, and similarly the price they charge for cheese, yogurt, and ice cream can also change. What is stable is the demand CURVE for cheese, yogurt, and ice cream (which means: the quantity demanded at any given price). But the price will change, and then (based on elasticity) the quantity transacted will then change as well.
Just to take an extreme case: it isn’t at all clear that more quantities of milk will be drunk! Just because there is more demand (dollars) for milk, does NOT mean there will be greater quantities. With perfectly inelastic demand (for cheese, yogurt, and ice cream), you might wind up with the exact same quantities, but simply at higher price points. (This of course isn’t realistic, not the least because cheese, yogurt and ice cream sellers would not have settled at the former “stable” equilibrium if demand for their products actually was perfectly inelastic.)
Robert EV
Sep 19 2024 at 12:27am
I was trying to do calculations and wasn’t up to doing the more complex algebra required to equivalate an increase in dollars for the various milk products versus the actual unit reallocation of those products, so simplified by discounting dollars and going straight to the unit allocations.
The demand curve for a particular product can’t be stable as it’s affected by the price changes of other products. I thought this was particularly apt here as most people who buy dairy buy a variety of milk products. Unless they have the personal wherewithal to absorb the price increases, they will need to cut back what they were previously willing to spend on some categories.
Your extreme case is interesting. Yes, I guess it’s possible for the milk producers to not allocate more milk to the better profit center. This would definitely happen if there’s a long enough lead time to convert or build processing facilities. Since this was a demand question I purposefully ignored supply-side considerations to the extent possible. Your case seems to come back to a unit-based demand situation instead of a dollar-based demand situation, though.
Dale Courtney
Sep 18 2024 at 5:16pm
When the demand for drinking milk rises while the total supply of milk remains unchanged (perfectly inelastic), the available milk must be redistributed from other uses—such as cheese, ice cream, and yogurt—to meet this increased demand. This reallocation happens through price changes in the market and is influenced by how sensitive producers are to changes in milk prices, known as the elasticity of demand for milk in these other uses.
Knut P. Heen
Sep 19 2024 at 8:26am
If the demand for the other uses does not depend on price, no milk will be reallocated.
If the demand for the other uses does depend on price, some milk will be reallocated.
Phil H
Sep 19 2024 at 9:29am
My 13 year old is doing economics at school, and I can’t deal with his homework any more than I can deal with this. I need more explanation of why the particular simplified model in use here is a reasonable way for me to start learning. Because everything in this question just seems untrue – which is not uncommon for very simplified beginner work, but needs some measure of justification or trust. And they’re both lacking right now.
“the price which one producer is willing to pay for any given ingredient becomes the price that other producers are forced to pay for that same ingredient” – not if there’s any elasticity in the market. And seeing as in the question, we’re explicitly told to think about elasticity, I can’t see how this generalisation helps us. One producer might pay more for some ingredient because of some variation in transaction costs, internal strategic considerations, willingness to sacrifice profit, etc. This does not mean that they will have the capacity to immediately buy up all of the supply. It does not mean that all other producers will immediately start paying that amount.
“the elasticities of demand for milk in these other uses determine how much milk will be reallocated from these uses for direct consumption” – actually, it would be the combination of elasticity in the consumption demand and the elasticity in demand for other uses.
I wouldn’t mind learning this stuff. But I will need an introduction explaining why you’re presenting it this way, whatever this way is. I’d accept the unrealistic simplifications if you explained how it would lead to greater insight.