MARKETING PIH-51
PURDUE UNIVERSITY. COOPERATIVE EXTENSION SERVICE.
WEST LAFAYETTE, INDIANA
How and Where is Price Established?
Authors
Steve R. Meyer, University of Missouri
Ronald L. Plain, University of Missouri
Glenn Grimes, University of Missouri
Reviewers
William T. Ahlschwede, University of Nebraska
Harold F. Breimyer, University of Missouri
Gene A. Futrell, Iowa State University
Richard L. Trimble, University of Kentucky
The question ``How and Where is Hog Price Established?'' is
a seemingly simple one. The pricing mechanism for hogs, however,
is complex. Prices for hogs, as for other commodities traded in
competitive markets, result from the interaction of supply and
demand. But a long list of factors affects supply and another
long list affects demand. In addition, the precise state of each
of the factors and the exact influence on supply and demand are
often not fully known at any given time.
Demand
``Demand'' for a product is not consumption. If true, demand
for pork and hogs would be nearly synonymous with production
since, after making adjustments for imports, exports and carry-
over stocks, the pork produced in any given year is consumed. The
important question is: At what price? Demand must therefore be
defined in terms of both price and quantity. Demand is the rela-
tionship between alternative prices and the quantities of a com-
modity which buyers will purchase at those alternative prices.
Lines D1 and D2 in Figure 1 represent two such relationships.
To understand the demand for pork, one must have a clear
idea of two concepts: change in quantity demanded and change in
demand.
A ``change in quantity demanded'' occurs when only the price
of pork changes and consumers respond by altering the quantity
they are willing to buy. This is illustrated in Figure 1 by the
move from point A to point B in response to an increase in supply
from S1 to S2. Quantity demanded changes from Q1 to Q2. This
adjustment is merely a move along D1, the existing relationship
between quantities which buyers will purchase and the alternative
prices at which the product may be purchased. D1 is a demand
schedule.
A ``change in demand'' involves a shift of the entire demand
schedule. This is represented by the shift of D1 to D2 in Figure
1. With supply constant at S1, price changes from P1 to P3 solely
because of the change in demand. Demand shifters for pork include
1) consumer preferences, 2) consumer income, 3) prices of beef,
broilers and other competitive products, 4) prices of complemen-
tary products and 5) season of the year. Note that advertising,
promotion, race, religion and culture are not listed as demand
shifters. These factors are manifested in the demand structure
through consumer preferences.
For many years, the demand for pork was about constant-a
given quantity placed on the market brought about the same price
as before. During the '60s and '70s, though, the demand for beef
increased thus putting pork in a disadvantageous position. In the
early '80s, however, demand for both beef and pork declined
markedly. It appears that the demand for pork has shifted upward
somewhat since 1986, while the demand for beef declined through
1987. Beef demand appears to have improved in 1988, but declined
again in 1989. The exact cause of these shifts is not known. But
a combination of factors such as declining poultry prices, health
concerns over cholesterol and changing lifestyles probably all
played a part.
Finally, the nature of a given demand schedule, as well as
the factors which shift it, are vitally important. Demand for
pork is ``inelastic.'' This means that a given percentage change
in the quantity of pork placed on the market will cause a larger
percentage change in retail prices. And of course, the larger
percentage change in retail prices will be in the opposite direc-
tion of the change in supply. This is why a relatively small
increase (decrease) in pork supply often causes a surprisingly
large decrease (increase) in prices. The relative size of these
changes when demand is inelastic causes total revenue to fall
when quantities increase, and to rise when quantities decrease.
Supply
``Supply'' is not simply the quantity placed on the market.
It is the relationship between alternative prices and the quanti-
ties producers are willing to place on the market at those alter-
native prices. As was discussed for demand, changes in the quan-
tity offered for sale can be caused by either of two distinct
happenings: change in quantity supplied in response to a change
in price and a change in the supply schedule itself.
A change in quantity supplied is simply a response to a dif-
ferent price. If the price goes up while production costs remain
constant, a producer is willing to produce and sell more; if it
goes down, a producer is willing to produce and sell less. These
reactions illustrate movement along a supply schedule. Such a
change is shown by the move from point A to point B on supply
schedule S1 in Figure 2. Note that an increase in demand from D1
to D2 caused price to increase from P1 to P2 and quantity sup-
plied to increase from Q1 to Q2, yet did not change supply
schedule S1.
A change in supply involves a shift of the entire supply
schedule. This is illustrated by the move from S1 to S2 in Figure
2. Supply shifters for hogs include 1) input prices (feeder pigs,
corn, soybean meal, other feed ingredients, labor, interest
rates, etc.), 2) opportunities for income from alternative farm
enterprises such as beef cattle or crops, 3) expectations of fac-
tors 1 and 2, and 4) time.
Time is a factor because of the biological nature of hog
production. Production responses to higher or lower prices will
be greater over longer periods of time than they will be over a
few days or weeks. In Figure 2, the short-run production
response to the price increase P1 to P2 is a change from Q1 to Q2
(i.e. move along supply schedule S1). However, the long-run
increase (where ``long-run'' is a time period sufficient to allow
for increased gilt retention and, possibly, construction of new
facilities) is from Q1 to Q3 where supply schedule S2 intersects
demand schedule D2. Supply increases from S1 to S2 because of the
increased production capacity of a larger sow herd. The fact that
time allows for more production response can be seen from Q3
being larger than Q2. Schedules S1 and S2 are short-run supply
schedules, and schedule LRS is the long-run supply schedule.
Supply and Demand: Retail vs. Farm
The demand for market hogs is derived from the demand for
pork. Having an idea of the demand schedule for pork, retailers
deduct an amount sufficient to cover their costs and provide a
profit and thus define a wholesale demand schedule for pork. Like
retailers, packer-processors then deduct an amount sufficient to
cover costs and provide a profit and thereby define the demand
for market hogs. So, the demand for market hogs is derived down-
ward from the demand for pork.
The supply of retail pork is derived from the supply of
market hogs. This is accomplished by all levels of the marketing
system adding their costs and desired profits to the cost of the
purchased item (be that wholesale cuts or hogs). So, the supply
of pork is derived upward from the supply of market hogs.
Marketing margins (the difference between retail price and
farm price for equivalent units of product) are most accurately
characterized as being the residual of retail price over the cost
of market hogs. Marketing costs (i.e. costs of processing, pack-
aging and transportation) exert a major influence on the size of
the marketing margin. The relative bargaining power of the par-
ties involved, however, is also an important factor.
Hog slaughtering capacity is limited and tends to be scaled
toward an average crop of market hogs. As hog production drops
below historical averages, the bargaining power of producers
improves. Packers need hogs to keep plants operating as effi-
ciently as possible. Toward this end, they compete actively with
one another for the available hogs, thereby driving live-hog
prices up relative to wholesale and retail prices. Packer profits
are reduced by both narrowing gross margins and higher per-unit
slaughtering and processing costs which result from less-than-
optimal plant utilization.
As hog production rises above historical averages, producer
bargaining power drops drastically. Packer slaughtering capacity
is sufficiently utilized, and packers are not forced to bid as
actively or aggressively as when hog numbers are short. Farm-
level prices fall relative to wholesale and retail prices and
packer-processor profit margins increase.
The latter of these results is often observed by producers
as inequitable. When producer prices are lowest (with production
up) packer-processor margins and profits are greatest. But
remember, when producer prices (and usually profits) are highest,
packer-processor margins and profits are smallest. Therefore,
the matter of what is equitable with regard to marketing margins
is very much in the eye of the beholder. In any event, though,
the situation is marked by sharp fluctuations-or instability.
Price ``Determination and Discovery''
On the question of who or what determines prices, it is use-
ful to distinguish between price discovery and price determina-
tion. It is often easiest to discover prices at assembly points
such as terminal markets and auctions, because it is here that
more than one buyer and seller will be present. From the above
discussion, it should be obvious that this does not mean that
prices are determined at these points.
Prices are determined by buyers and sellers acting upon
their knowledge of supply-demand information at a given point in
time. This information travels both horizontally through the sys-
tem (among farmers or producers) and vertically from consumers to
farmers and back again. Studies have shown that prices are simul-
taneously determined by everyone operating in the market and at
all levels of the system.
There is some concern that the declining proportion of hogs
which moves through terminal markets and auctions has impeded the
price discovery process. Whether this impediment has been offset
by improvements in price and market information reporting systems
is, as yet, an unanswered question.
Types of Price Changes
There are four basic types of price changes in the hog
industry. They are 1) trends, 2) cycles, 3) seasonal variations
and 4) day-to-day changes.
Trends
Long-term trends in U.S. hog prices are related mainly to
four factors: inflation, production efficiency, changes in con-
sumer preferences and marketing-distribution service. Inflation
affects hog prices simply by changing the value of the dollars in
which prices of hogs and production inputs are established. Pro-
duction efficiency affects hog prices by shifting the supply of
market hogs and, consequently, pork. Supply increases (shifts to
the right in Figure 2) when producers become more efficient and
thereby reduce production costs. Conversely, supply decreases
when production efficiency falls. Consumer preferences influence
hog prices through their effect on retail (and thus farm-level)
demand.
Marketing-distribution services can affect prices through
their influence on the size of the marketing margin. If marketing
and distribution can be performed at less cost, the marketing
margin may decrease without affecting packer-wholesaler-retailer
profits. This will allow either of two things (or a combination
of them) to happen. First, farm demand may increase relative to
retail demand, simply because the cost of marketing and distribu-
tion activities declines. This would allow producers to get
higher prices for the same amount of live hogs without any
increase in retail prices. Second, retail supply may increase
relative to farm supply. Such a shift would cause the retail
price to fall thereby increasing the quantity demanded at retail
(and at the farm) without driving farm prices downward. Either of
these scenarios results in higher revenues at the farm level and
demonstrates that producers have a definite stake in an efficient
marketing and distribution system.
In addition, improved marketing-distribution services may
not reduce the size of the marketing margin and still help pork
producers. This happens when the marketing-distribution sector
(frequently in cooperation with producer groups) develops better
products, more accurately identifies consumers' desires or more
effectively influences consumers' preferences through advertising
and promotion. All of these result in increased retail demand for
pork. That is, the demand curve has been moved to the right. If
marketing margins remain constant in this process, the entire
amount of the increase in demand is passed along to the farm
level. Even if marketing margins increase, some portion of the
increase in retail demand may be passed through to the farm
level. In this way, more effective marketing-distribution leads
to value-added products from which producers may benefit even if
marketing margins increase.
Trends emerge from the interplay of these factors. If
improvement in production efficiency causes supply to increase by
a larger amount than changes in consumer preferences cause demand
to increase, the price trend is downward. This situation is
illustrated in Figure 3. On the other hand, if, say, improved
marketing-distribution services cause demand to increase by a
larger amount than supply increases, the price trend is upward as
in Figure 4. Other situations can be easily visualized from
these diagrams.
Cycles
Hog cycles are the single most important source of wide
variations in hog prices. The time necessary for producers to
respond to changes in profitability is one reason for cycles.
This factor, however, accounts mainly for cycles' lengths, not
their existence. For many years it has been assumed that the rea-
son for the existence of price cycles is that producers make pro-
duction decisions on the assumption that selling prices (or pro-
fitability) will remain about constant at existing levels. While
recent and expected profits may influence producers, it is hard
to imagine that producers who have seen cycles for many years are
naive or not able to learn from painful experiences.
There is a more plausible explanation. Up markets bring with
them many reasons for expansion even if producers do not believe
the favorable market will continue. These include the increased
availability of capital, more positive outlooks of individuals
involved in management decisions (i.e. bankers, spouses, consul-
tants, etc.) and potentially high-tax liabilities which may make
equipment and breeding stock purchases (and depreciation on these
assets) attractive.
Conversely, down markets are accompanied by the opposite of
these situations; cash flow is tight or negative, attitudes are
negative and tax liabilities are of little concern. Such condi-
tions may result in liquidation even though producers believe
profitability will increase.
There are two principal phases of the hog cycle: the expan-
sion phase and the liquidation phase. Each has distinctive
characteristics. During the expansion phase, hog prices are rela-
tively high. This encourages producers to increase the quantity
supplied in the long run. The culling rate on sows is reduced,
sow slaughter drops and more gilts are retained in herds for
breeding purposes. These actions tend to reduce marketings (i.e.
the quantity supplied) in the short run and drive market prices
even higher. However, the increased number of breeding animals
which results from increased sow and gilt retention eventually
causes supply to increase. Because of the inelastic demand for
pork, the price declines, which result from the increase in sup-
ply, are often abrupt.
The liquidation phase develops when prices turn lower. Pro-
ducers keep fewer gilts for breeding and cull more sows. These
added marketings put further downward pressure on prices in the
short run and may result in large quantities of pork and pork
products in the marketing channel and storage. Reductions in the
breeding herd will eventually cause supply to decrease which, in
turn, will cause prices to increase and start the entire cycle
again.
Seasonality
Seasonal variations in prices are associated with seasonal
changes in both supply and demand. Seasonal variation in hog pro-
duction and consequent changes in hog slaughter and pork supply
cause the majority of these variations. Pork demand does have
some seasonal variations which can be important at certain times.
Examples are the historical increase in the demand for spareribs
and bacon in summer months and in the demand for ham and sausage
in the winter months.
Hog prices have two fairly distinct seasonal peaks and two
valleys (Figure 5). A major upturn in prices often occurs in May
or June due to reduced farrowings and litter sizes in the winter
months. Prices usually peak in July or August. A significant
price downturn usually runs from late August through October due
to the increased number of sows which farrow in the spring and
early summer months. A secondary price peak is common in January
and early February. The fall pig crop, normally smaller than the
spring crop, reaches market weight in March or April, depressing
prices again during this season. These lower prices may extend
into May or early June, depending upon winter weather and its
effect upon litter sizes and rates of gain.
There is evidence that year-round farrowing has reduced sea-
sonal variations somewhat in recent years. As the proportion of
hogs produced in pasture farrowing and rearing systems continues
to decrease, seasonal variations may diminish even further. It is
not anticipated that they will disappear because the seasonal
demand factors will still be present.
Cold storage of pork products also tends to reduce seasonal
price fluctuations. Packers build stocks in periods of high-hog
numbers and reduce stocks when numbers are less. While exces-
sively large cold-storage stocks of pork can be negative factors
on hog prices in the short run, the process of building stocks
may well reduce price declines at some times of the year.
Short-term Factors
The major short-term factor affecting hog prices is the
number of hogs marketed (and thus slaughtered) on a given day or
in a given week. Figure 6 shows average weekly slaughter for
1980-89. Excluding dramatic declines in May, July, September,
November and December, which are attributable to holidays, there
still is substantial variability in weekly slaughter volume.
These fluctuations can have a major impact on live prices because
orders for wholesale and retail cuts are taken by packers in
advance, and there is limited storage capacity for carcasses and
wholesale cuts.
Backlogs of hogs on farms can also cause short-term price
changes. Hogs are sometimes held on farms when 1) prices are low
and/or are trending downward, 2) producers are preoccupied with
farming activities or adverse weather, 3) substantially higher
prices are expected and 4) hog prices are high in relation to
feed prices. In all cases, withholding hogs may have positive
impacts on prices in the very short-term, but may cause prices to
decline sharply when the animals are finally sold at heavier
weights. In addition, these heavy hogs may have some long-term
negative impacts on demand because of the increased fat content
of heavy carcasses and the negative consumer perceptions which
fatty cuts may cause.
Finally, short-term fluctuations in consumer demand for pork
may contribute to short-term price changes for market hogs. These
changes are most easily seen in the marketplace in wholesale
prices. Stocks of wholesale cuts available on any given day are
largely fixed so day-to-day variation in the prices of these
items is mostly a function of variations in consumer demand.
Pricing Systems
The final source of variation in hog prices is the pricing
system. The systems used are live weight and visual appraisal,
reputation and carcass merit. Great variation exists from packer
to packer in the system used and even the characteristics of sys-
tems.
The oldest method of pricing hogs is live weight and visual
appraisal. This method is most commonly used at terminal markets,
country markets and auctions. Some weight range is specified for
top hogs by packer buyers. Discounts are applied to hogs that do
not fall into this weight range while both premiums and discounts
may be used for hogs that deviate from some norm in terms of fat-
ness and muscling. Degree of fatness and muscling are determined
visually by the packer buyer. Price premiums and discounts for
leanness and muscling are usually small in this system and there-
fore penalize high-cutability hogs while favoring those with low
cutability.
Carcass merit pricing systems were based on USDA grades and
carcass weight until the advent of the National Pork Producers'
Council (NPPC) Lean Value Buying Guide in 1981. Since then,
backfat thickness and, in the original NPPC system, degree of
muscling have replaced USDA grades in most packer carcass merit
pricing programs. Today, the terms ``grade and yield'', ``car-
cass merit'' and ``lean value'' are, for all intents, synonymous.
However, individual packers have developed their own versions of
the system which have 1) base carcass weights and
premium/discount structures which differ from the NPPC guide and
2) usually omit premiums and discounts for degree of muscling.
In all carcass merit pricing systems, prices are paid for
carcasses, not live animals. A base carcass price is applied to
carcasses which meet certain standards for weight and backfat
thickness. Premiums are paid for leaner carcasses of a given
weight or heavier carcasses with a given backfat thickness. How-
ever, carcass weights must fall within a prespecified range to be
eligible for premiums. Packer employees do all of the carcass
measuring in today's systems. Only after carcass prices have been
determined is dressing percentage applied to convert prices to a
liveweight basis.
The proportion of hogs sold on a grade and weight system has
fallen since 1985 after twenty years of growth. In 1965, only
3.6% of all hogs were sold on a grade and weight system. This
percentage grew steadily through 1985 when it reached 23.4%. The
percentage fell to 19.5% and 15.7% in 1986 and 1987, respec-
tively. The most plausible explanation for this decline is the
emergence of new packers that employ a reputation pricing system
in which premiums and discounts are based upon the historical
quality of animals sold by the individual producer, not neces-
sarily the quality of the lot of hogs being sold.
Summary
Hog prices are established by the interplay of many forces
ranging from long-run changes in consumer tastes and preferences
to short-run factors such as the fat content of the particular
hog being sold. Prices are frequently discovered at concentration
points in the swine-pork industry because it is at these points
that information is most easily disseminated and received.
Cycles play an important part in the variation of hog prices
over time. The biological lag of actual production to production
decisions explains the length of hog cycles. Recent and expected
profitability, the availability of resources and attitudes of
influential parties are the reasons for the cycles' existence.
Cycles have recognizable expansion and liquidation phases of
which knowledge is important if producers are to make sound
financial, production and marketing decisions.
Season affects hog prices for two reasons; variation in pro-
duction and variation in demand, with the former being the more
important. Hog prices usually peak in July and August and reach
lows in October and November. A secondary peak usually occurs in
January and February while another seasonal low occurs in March
and April.
Short-term moves in hog prices are a function of the number
of hogs marketed (and thus slaughtered), retail movement of pork
and the resulting changes in prices of pork carcasses and primal
cuts. Short-term fluctuations in demand are usually less signi-
ficant than those on the supply side. The cut-out value of pork
carcasses and the particular cost structures of pork processors
are balanced by packer buyers in determining daily bids for
market hogs.
Related Publications
The following PIH factsheets contain additional information
related to swine production.
PIH-6 Producing and Marketing Hogs Under Contract
PIH-12 Choosing a Slaughter Hog Market
PIH-19 Using Futures Markets for Hedging
PIH-24 Optimal Weight to Market Slaughter Hogs
PIH-109 Commodity Options as Price Insurance for Pork Producers
PIH-119 Understanding Hog Production and Price Cycles
PIH-123 Marketing Cull Sows
REV 5/90 (5M)
Figure 1. Change in demand and change in quantity demanded.
Figure 2. Change in supply, change in quantity supplied and
long-run supply.
Figure 3. Downward trend.
Figure 4. Upward trend.
Figure 5. Average weekly barrow & gilt prices 1980-89 of seven
markets.
Figure 6. U.S. average weekly federally inspected hog slaughter,
1980-89.
% Figures are available in hard copy.
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