Wednesday, 9 April 2014

Fancy a margarita? Why it'll cost you more

I ran a special workshop for high school students in Tauranga on Friday. One of the students, very perceptively, asked why a firm would reduce supply now if they believed that prices would be higher in the future (or alternatively, why they would increase supply now if they believes that prices would be lower in the future). The textbook answer is that, by delaying supply (or bringing supply forward), they make higher profits. They student asked whether there were real-world examples of this.

And it turns out there are many, including this one in the New York Times last week (see also here in the NY Daily News). The story is about the market for limes in the U.S., which is dominated by Mexican suppliers. This bit in particular answers the student's query well:
Farmers have already been stripping their trees to cash in on sky-high prices, said David Krause, president of Paramount Citrus, which grows Persian limes in Tabasco State for the United States market. Such premature harvesting exacerbates the shortage because the fruit never grows to normal size and is 20 to 40 percent lower in volume, he added.
So, the farmers are supplying now in order to profit from the high prices, knowing the prices will be lower later. This is more than just an increase in the quantity supplied, because they are 'harvesting prematurely', i.e. shifting some of their future supply to now instead.

While we're thinking about this market, let's go through all of the effects. First, let's assume there are two markets here for substitutes - Key limes (the small, seeded, highly aromatic type preferred in Mexico) and Persian limes (the large, seedless type exported to the United States). The two markets are described in the diagrams below.

First, note that supply is relatively inelastic. This is because you can't easily jump into the lime market, or easily increase production - it takes time for new trees to mature. Second, the bacterial disease HLB has been killing Key lime trees, and Mexican drug cartels have been hijacking lime trucks. Both of these effects reduce supply in the Key lime market, raising the price from P0 to P1. Since Key limes and Persian limes are substitutes, at least some of the demand for limes shifts to the Persian lime market (Persian limes are now relatively cheaper), raising demand there and increasing the price from Pa to Pb. Some Persian lime farmers shift their supply forward (because they anticipate lower prices in the future and want to take advantage of the high price now), so supply increases. However, because yields are lower if you pick the fruit early, the increase in supply isn't large enough to fully offset the price increase. The resulting price is Pc (higher than Pa, but a bit less than Pb).

What does that mean for margaritas? Well, since limes are a key ingredient in margaritas and they now cost more, the cost of producing a margarita has increased which will almost certainly increase the cost for consumers (or lower quality, by substituting lemon juice in place of lime juice). Maybe time to switch to a substitute (not likely these though!).

[HT: Marginal Revolution]

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