Impact of a Rise in Butter Prices on Total Revenue in Related Markets

Question

Butter is a key input in the production of many types of pastries. The main input to the production of butter is milk and dairy. Over recent years, due to a fall in number of butter producers, the prices of butter have increased.

(b) Discuss the likely impact of the rise in price of butter on the total revenue earned by producers and those who produce related products. [15]

Answer

Total revenue (TR) earned by a producer is price multiplied by quantity exchanged, $TR = P \times Q$. The question asks how a rise in the price of butter — driven by a fall in the number of butter producers, and so a fall in supply — affects the revenue of butter producers themselves and of producers in three related markets: a substitute (margarine), a good in competitive supply (cheese), and a good for which butter is a factor input (pastries). The thesis is that the outcome is not uniform: butter producers are likely to gain while pastry producers are likely to lose, because the sign of each revenue change turns on the price elasticity of demand (or, for margarine, the cross elasticity of demand) in that market.

Butter producers. The fall in the number of producers shifts the supply of butter leftward, raising price and lowering quantity exchanged along the demand curve. A leftward supply shift moves price and quantity in opposite directions, so the effect on revenue is indeterminate until PED is known, as set out in applying PED. If butter’s demand is price inelastic, the proportionate fall in quantity is smaller than the proportionate rise in price, the price effect dominates, and total revenue rises. If its demand is price elastic, the quantity effect dominates and total revenue falls.

Margarine producers (a substitute). Margarine and butter are substitutes — they satisfy the same want — so their cross elasticity of demand is positive, as explained in applying XED. A rise in the price of butter therefore raises the demand for margarine, shifting the margarine demand curve rightward. Both price and quantity of margarine rise, so margarine producers’ total revenue increases unambiguously: the elasticity of margarine demand does not need to be invoked, because a demand shift raises $P$ and $Q$ together.

Cheese producers (competitive supply). Cheese and butter are in competitive supply because both draw on the same factor input, milk. As butter becomes more profitable, producers divert milk away from cheese towards butter, reducing the supply of cheese and shifting it leftward. This raises the price of cheese and lowers its quantity — the same opposite-direction movement as in the butter market, so the revenue outcome again depends on the PED of cheese. If cheese has inelastic demand, cheese producers’ revenue rises; if elastic, it falls.

Pastry producers (butter as a factor input). Butter is an input to pastries, so a higher butter price raises the cost of producing pastries and reduces their supply, shifting it leftward. Price of pastries rises and quantity falls, and as before the revenue effect turns on the PED of pastries: inelastic demand means revenue rises, elastic demand means revenue falls.

Evaluation and judgement. The sign of the revenue change in each market is decided by the relevant elasticity, so a reasoned verdict must judge which elasticity values are realistic. Butter absorbs only a small proportion of a household’s income and has no perfectly close substitute — margarine differs in taste and texture — so its demand is likely price inelastic, and butter producers most probably enjoy rising revenue. Pastries are different: many substitutes exist (other baked goods, vegan options using non-butter inputs), so pastry demand is likely price elastic, and pastry producers most probably suffer falling revenue. This judgement is, however, conditioned by the time period. In the short run consumers lack time to find substitutes, so demand for both goods is more inelastic and both sets of producers tend to gain. In the long run consumers locate substitutes that fit their tastes, demand becomes more elastic, and the revenue gains erode — so butter producers’ revenue may itself fall over a longer horizon. On balance, the rise in butter prices most likely raises total revenue for butter and margarine producers and lowers it for pastry producers, with the durability of any gain hinging on how quickly demand becomes elastic as substitutes emerge.