Question

Dairies make low-fat milk from full-cream milk, and in the process they produce cream, which is made into ice cream. The following events occur one at a time: (i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With a drought forecasted, dairies raise their expected price of low-fat milk next year. (v) $$ New technology lowers the cost of producing ice cream. Explain the effect of each event on the supply of low-fat milk.

Short answer

Event (i) decreases, (ii) increases, (iii) increases, (iv) decreases, (v) increases the supply of low-fat milk.

Step-by-step solution

Identify the factors affecting supply

Understand that supply is influenced by costs of production, price expectations, and technological changes. Each event listed will affect supply differently.

Analyze event (i): Wage rate of dairy workers rises

Higher wage rates increase production costs for dairies. Increased costs typically reduce supply because dairies may produce less to maintain profitability. Hence, the supply of low-fat milk decreases.

Analyze event (ii): Price of cream rises

Cream is a byproduct of low-fat milk production. A higher price for cream makes creating low-fat milk more profitable. Therefore, dairies are incentivized to produce more low-fat milk, increasing its supply.

Analyze event (iii): Price of low-fat milk rises

An increase in the price of a product usually encourages producers to supply more of it to capitalize on higher revenues. Consequently, dairies will increase the supply of low-fat milk.

Analyze event (iv): Forecasted drought raises expected price of low-fat milk next year

If dairies expect higher prices for low-fat milk in the future, they might reduce current supply to store more milk for future higher-priced sales. Thus, the current supply of low-fat milk decreases.

Analyze event (v): New technology lowers cost of producing ice cream

Cheaper ice cream production means cream is even more profitable, incentivizing dairies to produce more low-fat milk to get more cream. The supply of low-fat milk increases.

Key concepts

Production Costs

Production costs are vital in determining the supply of a product. When costs increase, such as the wage rate of dairy workers rising, it becomes more expensive for dairies to produce low-fat milk. Higher production costs can lead to a decrease in supply because dairies aim to maintain profitability. For example, if it costs more to pay workers, dairies might produce less low-fat milk to control expenses, reducing the available supply for consumers.

Price Expectations

Price expectations influence supply decisions significantly. If dairies anticipate that the price of low-fat milk will rise due to future events, they may alter their current production strategy. For instance, a forecasted drought might lead dairies to expect higher prices for low-fat milk next year. In such a scenario, dairies might reduce the current supply to stock up on milk for future sales at higher prices. This strategic move can lead to a decrease in the present supply of low-fat milk, driven by the expectation of profiting more later.

Technology in Production

Technological advancements can drastically lower production costs and increase efficiency. For dairies, the introduction of new technology in producing ice cream can make the process more cost-effective. When producing cream, a byproduct of low-fat milk, becomes cheaper due to better technology, it becomes more profitable. This encourages dairies to produce more low-fat milk to obtain more cream, effectively increasing the supply of low-fat milk.

Byproduct Profitability

Byproducts can significantly influence the production decisions. Cream is a lucrative byproduct of low-fat milk production. If the price of cream rises, dairies find it more profitable to produce low-fat milk to obtain cream. This increased profitability from cream can boost the supply of low-fat milk, as dairies are motivated to produce more to capitalize on the higher cream prices. Essentially, higher byproduct profitability translates into an increased supply of the primary product, in this case, low-fat milk.

Incentive Structures

Incentives play a crucial role in shaping production and supply. Dairies are constantly evaluating their profitability and making decisions that maximize their returns. For example, if the price of low-fat milk itself rises, dairies have a strong incentive to produce more low-fat milk to increase revenues. Similarly, if new technology lowers production costs or if there are higher profits from byproducts like cream, dairies are motivated to increase supply. Understanding these incentives helps explain why supply might increase or decrease in response to various market changes.