Economics in Order to Understand the Ways

Economics

In order to understand the ways that different changes in the external environment will affect the demand for milk, some assumptions need to be made with respect to the milk market. We know that demand for milk will increase as wealth increases, which is the result of milk being something of a luxury item (Arnold, 2007). This means that there is some degree of correlation between wealth and milk consumption, and that implies that if wealth declines, milk consumption will also decline.

We also know that demand for milk is somewhat price inelastic. When prices rise, people still pay them (Dohery, 2007). This is the result of two factors. The first is that there is a baseline demand for milk that is not going to be affected by price. The second is that the demand for milk is affected more by the wealth of the purchaser than the cost of the milk. We will also assume that there are substitutes and complements for milk. There are many alternative milk products, like soy milk or rice milk. These are not perfect substitutes, however. Many milk buyers will not see these as viable substitutes, just as many vegetarians and vegans will not see them as perfect substitutes for milk, as they would not normally drink milk anyway. As well, there are complementary products, one of which would be cookies. In considering the affect of complementary products on the demand for milk, both the relationship between the demand for the complementary product and the cross-price elasticity of demand with milk need to be taken into consideration.

If more people start drinking soy milk, some of these people will be people who would otherwise have consumed milk. This should have the affect of reducing demand for milk, as fewer consumers are consuming milk, and some who remain milk consumers are drinking less of it. This is because soy milk is a substitute (albeit an imperfect one). Consumers of soy milk are often going to be directly substituting soy milk consumption for milk consumption, so it is reasonable to expect that an increase in soy milk consumption is going to result in a decrease in demand for milk. In this case, the supply of milk is not likely to change. The response by milk producers is more likely to reduce the cost of milk so it is better value compared to the cost of soy milk. They may also seek foreign markets although those are usually protected with respect to dairy.

A mad cow epidemic is likely to have two different affects on the milk market. The first is that consumers are likely to reduce milk consumption. So demand for milk will fall. Milk producers, however, may not actually be affected by the mad cow epidemic. In that case, supply would remain the same and producers would be forced to reduce the price of milk in order to better align it with the new demand. Foreign markets would not be an option in the event of mad cow crisis. Another possibility is that producers would be forced to liquidate their herds if those herds were subject to the epidemic. Under such a scenario, the supply of milk would decline, possibly even more than the demand for milk. That would mean that milk would become scarce and might actually rise in price, even with shrinking demand.

If the price of milk increases, demand for milk will fall. As we have seen above, the demand for milk has a low price elasticity of demand. Thus, demand will not fall much, so it is expected that supply will remain the same. However, demand will fall a little bit as some consumers will reduce their purchases of milk. Additionally, milk substitutes like soy milk will become a more viable option for some consumers.

If the government imposes a price ceiling on milk (many governments do this by way of subsidies for farmers), then the demand for milk is going to be high. The price of milk will remain artificially low, and may in fact decline from current levels depending on where the price ceiling is set. Higher demand would result. However, if the price ceiling is not supported by subsidies, it can be expected that the supply of milk would decline. With a price ceiling, many producers may not be able to sell their milk above their total cost of production, meaning that they would lose money. Selling above marginal cost of production is required in order to cover fixed costs, and a price ceiling would also threaten that. Thus, a price ceiling that is not supported with subsidies for farmers would see supply decrease and demand increase, taking the milk market out of equilibrium.

2. Broadly speaking, there are five determinants of elasticity of demand. Whether the good is a necessity or a luxury is important -- milk has a baseline of necessity demand, but there is some luxury demand as well. The availability of close substitutes is a factor as well. Soy milk and other milk alternatives are substitutes that can have an affect on the demand for milk. The definition of the market is another factor. Some consumers see milk as a narrow market with no real substitutes and other consumers see a broad market with many potential substitutes. The time horizon also affects the elasticity of demand. Milk is used immediately after purchase and very shortly after production. Consumers can respond more quickly to changes in the milk market than can producers. The relative size of the purchase is also a factor. One of the reasons that the market for milk has relatively low price elasticity of demand is because it is such as small part of the average consumer's budget (No author, 2011).

3. Demand for milk is inelastic. If the price of milk increases, the demand for milk will fall but not to the same degree, making it inelastic. Inelastic demand holds that the demand will change less than the price. So for milk, which might have elasticity of 0.3 for example, the demand would be characterized as inelastic. Elastic demand would be if the demand changes more than the price changes. If elasticity is zero, then this would imply that the demand and the price are not related. Anything under 0.1 or 0.05 could be considered more or less zero elasticity.