Chap 8 - Price Discovery

1. Chap 8 - Price Discovery Meaning of Price Discovery Classifying Price Discovery Mechanisms Different Price Discovery Mechanisms

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3. Price Discovery Process -Mechanism - Institution arrange acceptable terms of trade for transfers of ownership true willingness to pay/accept payment • Diversity - systems used • across commodities: house, food, power • Across locations • Over time Costs & Benefits Every transfer involves costs – cost of price discovery Different mechanisms => different investments of time & resources

4. Factors Affecting Number of Changes in Ownership More marketing services => + changes in ownership Economies of scale Greater control – quality, quantity & timeliness Cost of arranging transfers of ownership (TC’s) Consequence: Less trade through spot (terminal) markets Alternative mechanisms • Agricultural industrialization • more contracting • continuing ownership of products through successive stages of marketing

5. March 12, 2001 – Headline - Feedstuffs due to declining volumes,the cash (spot) market for hogs in the US will be non-existent within 5 years what mechanisms will be used to establish (discover) the price of hogs? prices in cash market are signals to market participants efficiency = f(extent to which prices give correct signals) System of price discovery must be robust to: mis-representation of preferences, small or unequal numbers of buyers and sellers, and coalitions of buyers and sellers

6. Price Discovery Mechanisms Individual Agreements – peer to peer, private Group Actions – public arena – groups of agents Government Influences - interventions

7. Individual AgreementsDistinguishing Different Types of Transactions 1 - When does exchange of ownership occur? Immediate or in the future? Forward contracts (marketing/production contracts) vertical co-ordination reduce price risk faced by buyer and seller assurance of quality characteristics for buyer (quality risk) Alternative to contracting - vertical integration replaces transfers with an alternative set of contracts within the firm Common in chicken, eggs, turkey

8. US Hog Production and Slaughter Hogs on farms with more than 2,000 head 38 % in 1994 79 % in 2004 C4 hog slaughter - increased 20% over 10 years, to 64% in 2004 C4 cattle slaughter - 70% (2004) Marketing Contracts: 1993 87% of hogs sold on spot market 2006 70% of hogs sold using contracts 20% owned and slaughtered by the packer 10% sold via “negotiated purchase” (spot market) Source: Martinez, Steve. The U.S. Food Marketing System: Recent Developments, 1997-2006. ERS, Economic Research Report, Number 42: Washington, May 2007

9. Source: MacDonald, J.M. and Penni Korb. Agricultural Contracting Update: Contracts in 2008. ERS-USDA, Bulletin Number 72, February 2011

10. Source: MacDonald, J.M. and Penni Korb. Agricultural Contracting Update: Contracts in 2008. ERS-USDA, Bulletin Number 72, February 2011

11. Source: MacDonald, J.M. and Penni Korb. Agricultural Contracting Update: Contracts in 2008. ERS-USDA, Bulletin Number 72, February 2011

12. Contract Broiler Production High level of vertical co-ordination – “integrator” & farmers Integrator: Breeding flocks, hatcheries, feed mills, processing plants Provides chicks, feed, medications, technical advise, managerial oversight Responsible for processing & marketing Increased efficiency, uniform birds Reduced land & capital requirement vs full integration Farmer: housing (25,000 sqft per house; 50,000 birds), litter, labour Reduced capital & expertise required Reduced marketing risk Low return to labour in early years Price – “negotiated” – with premium + discounts Few integrators

13. Individual AgreementsDistinguishing Different Types of Transactions 2 - How is price negotiated ? Pricing Arrangements Explicit (Posted) Price OR Negotiated Price? When it is worthwhile for agents to bargain/negotiate ? potential gain through good negotiating skills value of the sale is relatively large ability to price discriminate Benefit > transaction cost

14. Individual AgreementsDistinguishing Different Types of Transactions Price for future delivery: Deferred pricing according to a formula? Predetermined price - Price & quality risk • feel cheated - • - potential for default – transaction cost Alternative – Predetermined mechanism for price Link price to some “anchor price” – e.g. Basis Contract Premiums/discounts - quality variations Price determined outside public markets – information loss

15. Group Actions Auctions competitive - revelation of valuation (livestock, EBay) more or less public location - electronic auctions and efficiency single or multiple items simultaneously Vernon Smith (2002) auctions and economic experiments Auction structures – strategies + price (valuation WTP) English (open outcry) Dutch First price Second price (Vickrey) Double auctions (CBOT) WTP ≥ English = Second price > First > Dutch

17. Group Bargaining Multiple agents cooperate countervailing power (marketing boards/co-ops) willingness to finance costs requires group solidarity – no “free riding” CWB – “public goods” Government Intervention Enabling legislation Physical facilities Information (USDA/Agr-Can) Direct Intervention minimum or maximum prices regulated industry groups

18. Price discovery – many alternative institutions Choice – Benefits/Costs (Transactions costs) Dynamic