Question

When a farmer uses raw milk to produce skim milk, he also produces cream which is used to make butter. a. Explain how a rise in the price of cream influences the supply of skim milk. b. Explain how a rise in the price of cream influences the supply of butter.

Short answer

A rise in the price of cream decreases the supply of skim milk but increases the supply of butter.

Step-by-step solution

Understanding the Relationship Between Products

When raw milk is processed, it produces both skim milk and cream. The cream can further be used to produce butter. Therefore, there is an interconnection between the supply of these products.

Analyze the Effect on Skim Milk Supply

If the price of cream rises, farmers have more incentive to produce and sell cream because it is now more profitable. This may lead them to allocate more raw milk to cream production rather than skim milk. As a result, the supply of skim milk might decrease because less raw milk is being used to produce it.

Analyze the Effect on Butter Supply

A rise in the price of cream also affects the production of butter. Since cream is a necessary ingredient for making butter, an increase in the price of cream may lead to higher production of cream, followed by higher production of butter. Therefore, the supply of butter would likely increase as more cream becomes available for its production.

Key concepts

price elasticity

Price elasticity measures how much the quantity supplied or demanded of a good responds to a change in its price. In the case of our example, if the price of cream rises, it might cause significant changes in supply behaviors.
For farmers, if the price of cream increases, the supply of cream becomes more attractive. This usually means the quantity supplied of cream will rise.
However, the supply of skim milk might decrease as a result. This is because raw milk has to be allocated between producing cream and skim milk. With the higher price for cream, the incentive to produce skim milk is reduced.
Understanding price elasticity helps predict how much the quantities of goods will change when prices fluctuate. Keep in mind that elasticity varies; some goods' quantities change a lot with little price change, while others are less responsive.
In summary, rising cream prices lead to more cream production and less skim milk production, reflecting their price elasticities.

interconnected markets

Interconnected markets explain how different goods and their markets are related. In our example, the markets for raw milk, skim milk, cream, and butter are all interconnected.
When raw milk is processed, it produces both skim milk and cream. The cream, in turn, is a key input for butter production. Hence, changes in one market can significantly affect others.
For instance, if the price of cream rises, it not only boosts cream production but also impacts the supply of skim milk and butter. Here's why:

• More raw milk will be diverted to cream production, leading to less skim milk.
• With more cream available, the production of butter can also increase.

These interconnections show how a change in one market trickles down to related markets. Understanding these links helps predict the cascading effects across different markets.

production incentives

Production incentives are factors that encourage producers to alter the amount of goods they produce. These are often governed by profitability.
For our farmer, an increase in the price of cream provides a strong incentive to produce more of it. This is because the higher price means more income can be earned from selling cream.
This shift in focus happens because farmers allocate their resources based on potential earnings. In this case, more raw milk will be directed toward producing cream rather than skim milk.
These incentives are crucial in understanding supply changes. If a product suddenly becomes more profitable, producers will dedicate more resources to it, affecting the supply of other interconnected goods.
In our example, the production incentive shifts towards cream and away from skim milk, reshaping the supply dynamics of both products.

derived demand

Derived demand occurs when the demand for one product creates demand for another related product. In our case, the demand for butter increases the demand for the cream needed to make it.
Here's how it works:

• If the demand for butter goes up, producers need more cream.
• To meet this demand, more raw milk is processed to produce cream.
• This increases the overall demand for raw milk.

Therefore, a rise in butter demand can drive changes up the supply chain.
This concept helps to understand ripple effects in interconnected markets. For example, if the price of cream increases, stimulating more production, it directly influences the supply of both butter and the raw materials used.
Understanding derived demand is essential for predicting how shifts in one market affect others, especially in a production chain as interconnected as the dairy industry.