Observations on the recent crisis in world milk markets…. Or…. Why economists get it so wrong so often…

Introduction

Believe it. Milk prices at the farm level are among the most volatile in the world; more volatile than pork or beef; more volatile than coffee or cocao; more volatile than rice or soybeans and the level of price volatility associated with milk prices is increasing. This is not really a new phenomena because milk prices were very volatile before governments started to intervene in dairy markets. This is why governments developed price support and market intervention policies in the first place. And despite what you may believe these policies worked to stabilize and enhance the incomes of milk producers for a number of years. With the abandonment of support prices in the US in the early 90’s and the signing of trade agreements that restrict government’s ability to act effective intervene in milk markets, milk price volatility has returned with a vengeance.

Figure 1

Source: IFCN – Fluctuating Milk and Feed Prices – Torsten Hemme IDF World Dairy Summit 090921

Costs of current price volatility

The world dairy industry continues to suffer through a significant crisis that has seen milk prices at the farm level, and this is an important distinction, drop by 50% from a high of about $US 47 / 100 kg of

milk to as low as $US 20. At $US20, IFCN1 has estimated that only about 2% of world milk production covers its cost of production .2 This means that the value of world milk production3 increased by about $US 135.8 billion and then declined by up to $US 183.4 billion over a period of just 2 years. These are staggering value changes. To put this in context milk exports from New Zealand total around $NZ 10 billion (year end Mar 2008) on about 16 million tonnes.or Canadian production of about 8 million tonnes which sold for about $Cdn 5 billion.

It should be noted that these adjustment costs do not include crisis adjustment costs to governments. These have been substantive and are likely on the order of billions.

These numbers reflect the fact that there is a lot of pain involved in getting to equilibrium using price especially when compared to the values that would have been associated with supply adjustments to meet demand (assuming this option would have been available). As can be seen in figure 2 the unmet changes in supply and demand balance that were cause of these extreme price moves were relatively modest.

Figure 2

At about $US 25 /100kg of milk the value of milk required to be produced to meet changes in demand over 2004, 2005 and 2006, but which was not, amounted to about 6.4 Million tonnes. During 2008 the amount of milk that was produced that was not required was on the order of 4.0 Million tonnes. If farmers had been persuaded not to produce that 4 million tonnes; price levels could have presumably maintained at those higher levels. The value of that adjustment at $US 25 would have been only $US 1 billion and even at $US 47amount to less than $US 2 billion.

1 IFCN – International Farm Comparison Network; Source: Torsten Hemme Presentation to IDF World Dairy Summit, Berlin September 21, 20092 Note price level in 2006 was around $US 27. 3 This calculation is based on milk volumes delivered to processors when the market was more or less in balance in 2007 at 679.2 million tonnes. This volume is less than total world cow milk production which is estimated to be on the order of 880 million tonnes.

Why does milk production not respond more quickly to price changes… who produces this stuff anyway? (The discussion here focuses on the work of IFCN)

The currently accepted economic theory postulates that farmers are totally rationale economic agents focused on maximizing profit. If price falls below their marginal costs they immediately shut down operations until the price recovers or they can reduce costs…. and this poses no long term difficulty because farmers can move out of and into milk production quickly. The problem is that this is not how things work.

The International Farm Comparison Network for example (in a simple approach but which is not so simplistic as the economic theory’s assumption) seeks to understand observed farmer behavior (i.e. how farmers actually behave as opposed to how they are supposed to behave in theory) by considering three basic dairy farm types: household farms (75% of all farms producing 30-40% of the milk; small farms of 1-3 cows, dairy is only one income source; 50% of the milk produced is consumed and 50% sold); family farms ( 24% of the farms and 40-50% of the milk produced; mainly family labour. Size ranges from 10 to 300 cows (in developed countries)); business farms (0.4% of all farms producing 10-20% of the milk. Labour is provided by employees. Size in developed countries is greater than 300 cows). Economics assumes each type of farmer acts as a profit maximizing business but these farmers are driven by more subtle motivations. The key driver for the household farmer is to obtain cash to meet basic survival needs. The family farmer seeks to generate an income stream and pass on the farm to the next generation. The business farmer seeks to generate target returns to investment and labour etc.; objectives more in line with economic theory. The first two farm types tend to ignore opportunity costs and are driven more by cash flow requirements than their cost profile.

Figure 3

The recognition of these differing motivations helps to explain low or negative price elasticities of supply in the short run. In the short run household and family farmers are likely to try and maintain cash flow by

delivering MORE milk to compensate for reduced prices. It is anticipated that the business farmer will stop or reduce milk production more quickly than the household or family farmer but it is not clear whether it is the farmer or the banker that pulls the plug. Canadian experience supports the view that the price signal required for a quick supply response at the margin is low; in fact below marginal costs; below the theoretical shut down price anticipated in neo-classical economic theory of the firm; or even zero.

So milk production can be expected to increase when producers first see dropping prices and this exacerbates the supply problem and increases the amplitude of the price swing required to get to equilibrium.

The world has about 145 million dairy farms and between 0.7 and 1 billion people living on those dairy farms. They deserve a more supportive policy and market environment.

Why don’t consumers gobble up bargain milk… Because they don’t get to see the bargain! The reality of asymetric Pricing…

It is often astounding to hear economists talk in enraptured tones about competition and the market. There is competition to be sure but it is not the “perfect” competition envisioned in the economic theory that informs most policy discussions. Venerable international institutions like the OECD and proponents of free trade measure the level of consumer transfers to producers and always imply that de-regulation in dairy will lead to lower consumer prices. The observed facts, however, do not support this view. De-regulation and lower producer prices have never led to a comparable reduction of consumer prices in the longer run. In the UK; in Australia;, in the EU; de-regulation finds lower producer prices that are not reflected at retail. Recent data for the EU is presented below as an example of the relationship between consumer and producer price movements in a de-regulated setting.

Figure 4

This is not just a short term phenomena; a recent IDF study found that with a decade of de-regulation under their belts, both Australia and New Zealand have seen price rises for dairy products at the consumer level in excess of those in “regulated” Canada.

Figure 5

Source: IDF Survey – Price Fluctuations and Inflation Trends in the World Food and Dairy Markets – Gilles Froment Presentation to IDF World Dairy Summit Berlin 090921

The growing disconnect between producer and consumer prices has been news in the dairy community for some time and is known to most economists as “asymmetric pricing”. Asymmetric pricing describes the observed behavior that prices at retail rise quickly when producer prices rise but respond only sluggishly to drops in producer price. Economists have postulated a number of rationales for this behavior but the “elephant in the room” is that it seems to be a consequence of the exercise of market power. The big surprise is that economists are surprised by this. One only needs to consider the structure of dairy markets in most markets to get an idea of the potential for market power to be exercised. The structure of the Swiss market illustrated below is not atypical; many producers selling to few processors selling to even fewer retailers selling to many consumers.

Figure 6Market Structure in Switzerland 2005

After:

- Presentation to IDF World Dairy Summit Berlin 090921

After years of righteous indignation over alleged consumer transfers to producers, professional neo-classical apologists are left to mutter about competition policy as a solution to this market incongruity. Anyone who knows the glacial pace at which competition policy solutions work; knows that it is a non-solution and a hopeful copout for those that are paid to believe that markets are perfectly competitive.

A consequence of asymmetric price behavior is that stable prices at the producer level are of significant benefit to consumers. Less ups (even those followed by significant downs at the producer level) mean fewer opportunities to jack up prices at retail.

The Recent Milk Price Volatility Was An Aberration… Right?...... WRONG!

In this case a picture says a thousand words. At the recent IDF Dairy Summit held in Berlin, Dr. Novokavic observed that U.S. support prices at one time acted as the de facto world support price. This situation changed in the early 90’s when U.S. policy makers decided to move away from price support and leave producer milk prices to the vagaries of the market place. Since then the U.S. and the world have seen increasingly volatile milk prices and a scramble to come up with policies to support producer incomes during periods of low prices. The ability to forward contract it seems was not enough to manage producer exposure to the way unmanaged dairy markets behave.

Figure 7

Price volatility is not going away either. Dr. Novokavic et al have analyzed this price behavior and found that a number of cycles seem to underlie the observed volatility. Prior to the reduction of support prices in the early 90’s there was really only one cycle that influenced milk pricing and that was the seasonal production cycle. Since that time, however, a number of other cycles have been introduced into the dairy pricing equation. While these cycles can be identified there cause has not been fully understood.

Figure 8

The take away from the cycle discussion is that some of those cycles are increasing in amplitude through time (observe cycle 388 and 288). We are not heading towards more stable milk markets; we are heading towards greater price volatility. The cycles identified by Dr. Novakovic can be used to predict future prices and DFC staff have completed an initial estimate of the future of the U.S. All Milk price.

Figure 9

1-1970 9-1972 5-1975 1-1978 9-1980 5-1983 1-1986 9-1988 5-1991 1-1994 9-1996 5-1999 1-2002 9-2004 5-2007 1-2010 9-2012 5-20150

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All Milk Price ($/cwt)

DFC Forecast

As predicted by the cycle analysis, the U.S. All Milk price will experience higher highs and lower lows in future.

The US all milk price is used in this context as an indicator of general price signals. One might expect that the appropriate long term price signal for producers to use in determining their production plans would be the underlying price trend. This signal is, however, masked by the extreme volatility observed. It could be reasonably argued that US producers are not receiving appropriate price signals.

When are extreme price adjustments appropriate?

In systems that adjust to equilibrium using primarily quantitative adjustment price is still an important element. While the general price level received for most of the milk production reflects the current average industry costs the expansion price reflects the expected return for additional milk production. In these systems, production limits (either base or quota) are not absolute. Production is self-limited because producers receive a very low return for “expansion” milk produced at the margin. If producers with a quota system wish to expand “within-quota” then quota price offers the analogous signal.

This concept of lower pricing for “expansion” milk is incorporated into the Holstein Association USA Inc. Dairy Price Stabilization Program. Here producers wishing to expand, beyond historical shipments, incur a de facto price cut at the margin when they wish to increase production. This is accomplished by way of a “market access fee” of $US 6.00 to $US 9.00 per hundredweight. Monies collected are re-distributed to those who choose to supply only their historical volumes. The introduction of these types of policies means that only low cost producers can afford to expand. In deference to economists why not set the “market access fee” at a level equal to the marginal cost of the lowest cost producers?

Market management and quantity adjustment to equilibrium vs price adjustment to equilibrium….

In the chart below, the era of effective government intervention in dairy markets is plainly visible.

Figure 10

There was a reason for government intervention and that reason was rooted in the excessive market and price volatility that characterized dairy markets before that era. What we have seen since the early 90’s is a return, with a vengeance, to the market failure that characterized the pre-government era. IFCN has estimated that at $US 20 per hundred kg. only about 2% of the world’s milk supply can cover its costs of production. With increased price volatility these low prices levels can be expected to be seen far too often. Governments will scramble to inject billions into the industry. They will have no choice. A billion people depend on it.

The alternative is to figure out how to manage supply to better meet demand without using the least effective tool for doing so…. general price signals. In Canada, this is supply management with all the trappings and extremely tight management of supply with significant price reductions for delivery of milk at the margin. I would postulate, however, that whatever policies can be put in place to better manage supply responses would be of benefit. The U.S. Holstein proposal for supply managing U.S. milk production would be one example of a partial supply solution and it contains provision for reduced price for beyond base (marginal) milk. Fonterra’s (or other cooperatives) requirement to buy shares in order to ship milk could be another if made more responsive. It is not really an either or. These approaches would likely not end price volatility but they might significantly reduce it and minimize its destructive potential.

Economist can do better than simply applying neo-classical theory to develop policies that have no place in markets as they are structured in reality. Markets do not ascribe to theory but their behaviors can be observed. It is perhaps time for economists to stop trying to explain away the fact that the “free trade” and “free market” policies pursued for dairy markets since the early 90’s have failed to deliver for producers and for consumers. Increasing price volatility is not the answer. Dairy markets need policies that better manage supply.