Answer to Question #129867 in Microeconomics for Chelsea

Question

when rice farmers are faced with a bumper harvest due to good weather, their total revenue actually falls, and these farmers will burn their crops rather than sell them away. Assume the price elasticity of demand for rice is -0.45. Explain, with the help of an appropriate demand and supply diagram, why a phenomenon like this occurs.

Answer 1

Assuming that the price elasticity of demand for rice is -0.45 means that rice is inelastic in demand. This will be mainly due to the fact that rice is a basic good. The price elasticity of supply of rice is also inelastic due to the difficulty by rice farmers to quickly respond to market conditions as rice has a long growing season. Thus, in this case, both demand and supply are inelastic.

A bumper harvest increases market supply and hence a fall in market price. Now, because demand is inelastic, a more than proportionate decrease in price is required to clear the resulting excess supplies. This results in a huge fall in revenue. The condition is best described by the graph below.

As shown on the graph above, the initial equilibrium point is e1 where demand curve DD and the initial supply curve S0 interact. The initial equilibrium price is Pe1 and the initial equilibrium quantity is Qe1. Because of a bumper harvest, supply curve shifts rightwards and upwards from S0 to S1 showing an increase in supply.

The new equilibrium point is established at e2 with the new equilibrium price Pe2 and equilibrium quantity Qe2. The graph shows that a small increase in equilibrium quantity, Qe1 to Qe2, induced by an increase in supply results in a huge decline in price, Pe1 to Pe2. Thus, the fall in revenue is drastic.

These market conditions on their own would imply that farmers will be making losses from their sales. There seem to be no reason to proceed with harvesting and taking rice to the market when the market is already unprofitable. There is no logic for the farmers to incur additional costs in harvesting, processing, grading, packing, transporting, and selling which will increase the loses that had already occurred. There is also no point in deciding to store the produce for rice do not mature, and given also that warehousing costs are also huge. This means that the only option to reduce more costs and the amount of loss is to burn the crops rather than selling them away.