Thursday, 24 December 2020

The economics of Christmas trees and the cobweb model of supply and demand

Zachary Crockett at The Hustle has an excellent article on the economics of Christmas trees. It's somewhat specific to the U.S., but there is a lot that will probably be of wider interest. I recommend you read it all, but I want to focus my post on this bit:

...even if all goes well, Christmas tree farmers still have to forecast what the market is going to look like 10 years out: Planting too many trees could flood the market; planting too few could cause a shortage.

History has shown that the industry is a case study in supply and demand:

- In the 1990s, farmers planted too many Christmas trees. The glut resulted in rock-bottom prices throughout the early 2000s and put many farms out of business.

- During the recession in 2008, ailing farmers planted too few trees. As a result, prices have been much higher since 2016.

That reminded me of the cobweb model of supply and demand, which we cover in my ECONS101 class. A key feature of a market that can be characterised by the cobweb model is that there is a production lag -  suppliers make a decision about how much to supply today (based on expectations about the price, which might naively be the observed price today), but the actual price that they receive is not determined until sometime later. In the case of Christmas trees, this is much later (emphasis theirs):

What makes a Christmas tree an unusual crop is its extremely long production cycle: one tree takes 8-10 years to mature to 6 feet.

So, a Christmas tree farmer has to make a decision about how much demand for Christmas trees there will be in 8-10 years' time, and plant today to try to satisfy that demand. Now, let's start with an assumption that Christmas tree farmers are naive - they assume that the price in the future will be the same as the price today, and that's the equilibrium price shown in the diagram below, P*, where the initial demand curve (D0) and supply curve (S0) intersect. Then, the Global Financial Crisis (GFC) strikes. Consumers' incomes fall, and the demand for Christmas trees falls to D1. However, the GFC recession is temporary (as all recessions are), and demand soon returns to normal (D2, which is the same as the original demand curve D0).

Now consider what happens to prices and quantities in this market. During the GFC recession, the price falls to P1 (where the demand curve D1 intersects the supply curve S1). Christmas tree farmers are deciding how much to plant for the future, and they observe the low price P1, which because they are naive, they assume will persist into the future. They decide to plant Q2 trees (this is the quantity supplied on the supply curve S2, when the price is P1). By the time those trees are harvested though, demand has returned to D2, so the price the farmers receive when they harvest the trees will increase to P2 (this is the price where the quantity demanded, from the demand curve D2, is exactly equal to Q2). Now, the farmers are deciding how much to plant for the future again, and they observe the high price P2. They assume the high price will persist into the future, so they decide to plant Q3 trees (this is the quantity supplied on the supply curve S3, when the price is P2). By the time those trees are harvested, the farmers will accept a low price P3 in order to sell them all (this is the price where the quantity demanded, from the demand curve D3, is exactly equal to Q3). Now the farmers will plant less because the price is low and they assume the low price will persist... and so on. Essentially, the market follows the red line (which makes it look like a cobweb - hence the name of the model), and eventually the market gets back to long-run equilibrium (price P*, quantity Q*).

However, in the meantime, there is a cycle of high prices when the number of trees planted was too low, and low prices when the number of trees planted was too high. And that appears to be what has happened in the market for Christmas trees described in the quote from the article above.

A savvy Christmas tree farmer could have anticipated this cycle, and used a strategy of going against the flow. Essentially, that involves taking some counter-intuitive actions - planting more trees when the price is low, and planting fewer trees when the price is high. As I discuss in my ECONS101 class though, there are three conditions that you have to be pretty confident about before the strategy of going against the flow should be adopted:

  1. That this is a market with a production lag (which is pretty clear for Christmas trees);
  2. That the change in market conditions (that kicks the cobweb off) is temporary (you would hope a recession is temporary, and that consumers aren't going to permanently switch to fake trees); and
  3. That other firms have not already realised the profit opportunities in this market (in this case, you should look at what other Christmas tree farmers are doing - if they are planting less during the recession, you should probably be planting more).
If one or more of those conditions don't hold, then going against the flow is not likely to be a good idea. However, if they do hold, the profit opportunities are likely to be high. It seems that there are a lot of Christmas tree farmers in the U.S. who could do with a better understanding of business economics.

Merry Christmas everyone!

[HT: Marginal Revolution]

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