Factors Affecting Cocoa Production

Following of the above factors had affected the cocoa production

Changes in input prices: Inputs are known as goods and services required for producing another goods or service. There is a possibility as stated by ICCA in the case that due to competition for land, water and labor with the mining industry there would be a shortfall in production.

Changes in technology: Technologydoesn’t necessarily mean high technology, it means methods used for converting inputs into goods and services. In cocoa producing countries like Ghana,

Supply

Supply is based on the producer’s evaluation of the amount of goods to be produced and the various factors which would affect the production of these goods. Supply is the function of the quantity of material that the producers are able to supply and the price of that product or service. From the case study we understand that the prices of Cocoa beans were rapidly rising due to various factors which affected Ghana a major cocoa producing nation which led to cocoa prices to rise by 2% thus affecting the costs of the chocolate to rise by 10 percent over the years.

There are various non price factors which affected the prices of Cocoa beans. Economists are believed to state that there are majorly five factors which affect the supply curve of goods or service

 Changes in input prices

 Changes in the prices of related goods and service

 Changes in the technology

 Change in expectation

 Changes in the number of producers

Nigeria and Cameron farmers were using farming methods which were outdated and had not replaced trees which were past their peak productivity. Hence lack of usage of updated methods had affected the production of Cocoa.

Change in expectation & number of producers: Due to Harmattan winds, late application of fertilizers, curtailment of Ghanaian governments mass spraying program, the forecasts affirmed cut in production of cocoa output, leading to expectation for production shortage in Ghana. In this circumstance other Cocoa exporting countries expected a supply shortage. Thus when the numbers of suppliers have reduced in the market, there would be an effect on the price of goods. Lack of supply would increase the prices of the product.

Price

Quantity

The Above graph demonstrates decrease in the supply of the goods due to above stated factors.

Demand elasticity

Price elasticity of a demand is known as the percentage change in quantity demanded relative to percentage change in price. It is known that price and quantity demanded have an inverse relationship. The demand curve is elastic when a small increase in price reduces the quantity demanded a lot. It is inelastic when with increase in price there is not much effect on quantity demanded.

Price elasticity depends on consumer’s willingness to pay a higher price for a similar quantity. Price elasticity depends on:-

 Availability of close substitutes

 Necessities versus luxuries

 Definition of the market

 Narrow markets face more elastic demand

 Proportion of income devoted to the product

 Time horizon

In case of cocoa beans price elasticity of demand is inelastic as with the increase in prices of cocoa quantity demanded is not affected as it is the primary ingredient for chocolate manufacturing. However since the market for chocolate is highly price sensitive, it has an elastic demand curve. The case illustrates that with increase in prices, demand for chocolate decreases as it is not a primary input for the consumers as shown in Fig1. Unfortunately changes in price are not the only factor affecting quantity demanded. Other factors affecting demand of chocolates are change in taste, availability of substitutes which shift the demand curve. For instance Nestle business model was challenged by changing taste of consumers and also chocolate is considered as a luxury product as consumers were moving away from the processed foods to healthier alternatives due to health concerns regarding sugar present in most chocolates.

Price

0.795 A

0.66 B

Quantity

6.36 11.87

Fig1

Equilibrium

Since a shortage in the market has been created due to shortage in supply of cocoa beans, the prices of beans would increase which would fetch a new equilibrium point. Due to shortage of cocoa beans the market cost of cocoa goes up hence firms have to procure at a higher price. This results in increase of Marginal cost and average total cost of the firms.

Price S2

P1 Cost

Qs Q1 Quantity

Market structure

An industry with few sellers is known as oligopoly and a firm in such an industry is called oligopolistic firm. Those firms which compete in the market but also have market power to affect the pries are known to demonstrate imperfect competition. There are two kinds on imperfect competition that is monopolistic competition and oligopoly. Although nestle chocolates is a multibillion company however it has very few competitors of its size and market power.

If we try and understand why oligopoly is prevailing, it can be understood as pertaining to same factors that sometimes lead to monopoly but in a faint form. However the most probable reason why oligopoly is prevalent is because certain large producers have cost advantage over smaller producers due to economies of scale.

For understanding the market structure better some firms use the HHI Index also known as Herfindahl – Hirchman Index or HHI. The HHI can be calculated by square of market share of each firm summed over the firms in industry. By calculating HHI we can yield a larger number when a large share of industry output is dominated by a small number of firms. Thus calculating HHI for chocolate industry as given in the graph in case study

HHI – 14.4²+ 13.7²+ 10.2²+ 9.5²+ 7.2²+ 5.1²+ 40² = 2261.47

This figure demonstrates how concentrated the industry for chocolate is. HHI is utilized by US Justice department and federal trade commission’s to implement antitrust policies which ensure adequate competition in the industry and helps break monopoly. HHI figure above 2250 indicates an oligopoly market. Thus from the above calculation we derive that nestle was operating in an oligopolistic market as its HHI index is 2261.47.

In the non premium chocolate segment of Nestle according to the graph provided in the back of case study the major competitors are Mars and Mondelez.

There are two kinds of oligopolistic models followed by managers. In the non cooperative oligopolistic models the managers would anticipate the strategy of their rivals and make strategies that would impose maximum damage to the competing firms. Managers then have to make decisions in response to the competitor’s strategies. The inference is that the firms would benefit more through cooperating. In cooperative oligopoly models there is an interdependence of firms on each other. In such a case the firms will cooperate to raise their profits. Although cooperation would benefit the firms however in certain circumstances firms have an incentive for cheating on their cooperative behavior.

Cartel is known to be a strong form in collusion where for instance if we consider nestle, Mondelez and Mars, each firm would decide on quantity they would produce and fix prices for chocolates.

Assuming -we consider two firms for understanding collusion and competition in oligopoly. Suppose Nestle and Mars were to form a cartel and this coordination decided to act as if it were monopolist by maximizing industry profits.

Price of chocolate( per carton)

Quantity of chocolate demanded(carton boxes)

Total revenue

$110

$200

$270

$320

$350

$360

$350

320

270

100

200

110

120

Reefing to above table, This cartel should set 60 boxes of carton which would sell at a $6 price thus leading to the maximum revenue of $360, which means each firm has to produce 30 boxes of chocolate. Even if the two firms settled on this price they might have incentive of breaking this deal. In the past the leading chocolate firms nestle, mars and craft foods have been accused of price fixing by raising the prices of the chocolates. Let’s assume that Nestle ignored this cartel and reduced its price from $6 to $5 per cartoon, this would lead to increase in the quantity of chocolate demanded to 70 boxes out of which quantity demanded for Nestle would increase to 40 Boxes but for Mars quantity demanded would be 30 boxes thus bringing down the total revenue of firms to $350. Nestle might perceive initial revenue rise from $180(6 *30 boxes) to $200 (5*40 boxes), However the revenue for mars would fall from $180 to $ 150( 5*30 boxes), as quantity demanded for Mars would fall with decrease in price for Nestle chocolates.

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The reason why one firm would find an incentive to decrease the price is because of its desire to increase the total revenue and thus increasing the firm’s profit. But if manager of Mars decides to work in a similar manner then each firms profit would fall as with increase in prices quantity of the goods demanded decreases. Chocolates having elastic curve have an inverse relation between quantity demanded and price.

Nestle

Priced at $6 per carton Priced at $5 per carton

Nestle makes $180 in revenue

Mars makes $180 in revenue

Nestle Makes $200 in revenue

Mars Makes $150 in revenue

Nestle Makes $150 in revenue rerevenue

Mars Makes $200 in revenue

Nestle makes $160 in revenue

Mars makes $160 in revenue revenue

Priced at $6 per carton

Mars

Priced at $5 per carton

To understand further how oligopolies behave economists developed the game theory which states that considering two players interdependence can be represented by payoff matrix. Hence when the prices are set at $6 both the firms ie nestle and Mars can maximize their profits. However if one of the firms for instance Nestle decides to break the collision due to decrease in price, quantity demanded would increase thus affecting the overall revenue. However on a short term Nestle would make higher revenue of $200.

When Mars tries to make the same calculation by decreasing the prices to $5 Per carton due to decrease in price the quantity demanded would then increase to 80, thereby affecting the per unit prices to come down. In such a case each firm would make a $160 in revenue.

However breaking collusion might be an option for a firm if they are planning to establish themselves for a short period of time and then move out of business. However for firms planning to stay in business for a longer tenure usually such understanding is not broken. For instance if nestle decides to cheat it might be able to make some short term profits. However on a long run it might provoke Mars to cheat as well.

Non cooperative Oligopoly Model

In case where Nestle decides to follow the Non cooperative model for monopoly, then by using the Kinked demand curve we consider that there are two scenarios. One which reflects the demand If the rivals follow the firms price changes (D1) and one which reflects demand if the rivals do not follow the firms price changes.

For instance in case of Nestle if it decides to increase the price of its chocolate and other firms also decide to follow the firm then there would be very little impact on the quantity demanded for Nestle (D1). However if other firms do not follow Nestle then quantity demanded for Nestle chocolates would reduce drastically as represented by D2 in figure. Similarly if Nestle reduces its prices and other firm’s do not follow then there would be an increase in demand for Nestle chocolates.

MR2

D2- Rivals don’t follow

D1- Rivals follow

MR1

0 Q1 Q

Market Power

This is the ability of the firm to raise its prices above competitive level or the marginal cost. Elastic product will have constrained market power. In an oligopoly we have a small number of firms; there are certain barriers to entry and interdependence of firms on each other by reacting to one another in terms of pricing. The barriers of entry which would help Nestle maintain its oligopoly structure by keeping competition away are brand loyality of customers, Economies of scale, technology and legal barriers. Market power can be evaluated by {(P- MC)/P}, this is the markup of price over market power.

Costs and input

Total cost is the sum of two elements – fixed cost and the variable cost.

Fixed costs are costs which do not change with change in the quantity. Variable costs are costs which change with change in quantity. Represented by the below equation-

TC = FC + VC

FC- fixed costs

VC- Variable costs

Marginal cost- It is the total cost incurred by producing one extra unit of output.

Marginal cost = Change in total cost / change in quantity of output. The marginal cost curve slopes upward. This is because as the output increases, more and more variable input is used for producing this output. Since each variable input incurs cost the cost of each additional unit also rises.

Average total cost: This is the total cost divided by the quantity.

Average total cost is the sum of average fixed cost and average variable cost. The average total cost curve has a U shaped graph because the average total cost first falls and then rises. This happens because with increase in quantity of input the average fixed cost decreases, however the average variable cost rises hence resulting in the U shaped curved a.

Average fixed cost (AFC)= Fixed cost / Quantity of output

Average Variable cost (AVC) = Variable cost/ quantity of output

Long run costs:-

For the long run a firms fixed cost also becomes variable thus it can choosetovary the fixed cost component of the firm. In case of Nestle since the taste of consumers was changing as they were becoming more health conscious Nestle had found a process which could reduce the sugar content by as much as 40% and they were in the process of patenting this technology. Since integrating any technology into the existing infrastructure is a tedious and a lengthy process hence technology implementation can be considered as a long run cost. With introduction of technology the total fixed cost of the firm would increase. But with increase in the output with introduction of technology, Nestle would experience increasing returns to scale where the overall cost reduces because of more production over output level 0- Q where the curve is declining. In contrast the decreasing returns to scale occur after that in which the total cost increases when the output increases. In the curve this occurs after point Q. This could occur because Nestle would have to indulge into technology transfer after a certain time period as bounded by the patent laws.

Behavioural economics:

We assume that humans would always be rational in their decision making, a rational decision maker chooses from the best available options which lead to a good outcome. However Behavioral economics states that humans are not always rational. Humans have to choose from multiple options and the option they choose by forgoing the other available options forms the opportunity cost. Firms use behavioural economics to influence consumers. For instance nestle found an effective way of increasing its process by introducing sharing bags or bags with small sized chocolates. To the consumers it looked like a good deal, where the consumers assumed the quantity to be more within the price, but in fact these were more expensive than the standard chocolate bars. There was a 25% difference in rates.

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Prospect theory states that comparison is made relative to a reference point, anything above the reference point would increase satisfaction. This theory could also be compared with premium chocolate market where a premium chocolate demands a price almost 50% over the regular market. In this segment consumers differentiate the product of being high quality as compared to mainstream chocolate and hence are prepared for paying the higher prices.

Dynamic analysis

Price

1.17

1.06 ATC

0.79

0.66

3.36 4.67 6.36 11.87 Quantity

In the Demand equation based on current macroeconomic conditions we obtain that to maximize the revenue the company must produce a quantity of 6.36, the market elasticity for this condition is given as -2.43 which means that If the price goes up the quantity demanded would fall by 2.43. When a quantitative easing occurs the central bank would purchase bonds from the market to reduce the interest rate and increase the money supply into the market. Due to lower interest rate there would be more money in the market thus increasing the purchasing power of the consumers leading to increase in production by firms. Thus at this market condition we obtain new increased quantity as 11.87. This states that to maximize revenue in current circumstances firms must produce a quantity of 11.87, profit maximization would occur at 4.67.

Price

1.17

1.06 ATC

0.79

0.66

3.36 4.67 6.36 11.87 Quantity

Figure 2

Appendix

P = -0.1250Q + 1.59

TR= P x Q

TR= 0.125Q² + 1.59Q

d/dQ (TR) = 0.25Q +1.59