Rethinking The Demand,
                                             And Supply, Effects Of
                                             Milk Prices

                                             Dick Groves, Publisher, Editor, Cheese Reporter

                                             May 18, 2001

                                             Farm milk prices are on the rise, which
                                             means that retail milk prices are also going
                                             to increase and sales are going to go in the
                                             tank. That’s just simple dairy economics at
                                             work.
                                             Or is it? Recent evidence indicates that at
                                             least part of that equation doesn’t always
                                             work as expected. And that evidence, in
                                             turn, could have some effect on future
                                             dairy policy discussions.
                                             One piece of that recent evidence is the
                                             University of Connecticut’s study of the
                                             Northeast Interstate Dairy Compact. As
                                             reported a couple of weeks ago, that study
                                             concluded that retail prices did in fact go
                                             up when compact over-order prices went
                                             into effect, but they actually increased
                                             considerably more than did farm milk
                                             prices. Retailers and processors basically
                                             used the compact price to boost their profit
                                             margins, the study found. Prior to compact
                                             implementation, the study said, when farm
                                             prices dramatically increased or decreased,
                                             retail prices “hardly budged.”
                                             Another piece of that evidence was
                                             submitted on Monday of this week, at a
                                             hearing in Philadelphia, when (as reported
                                             on our front page) Robert Robinson of the
                                             US General Accounting Office told a US
                                             Senate subcommittee that while farm milk
                                             prices have some influence on retail prices,
                                             other factors may ultimately have a greater
                                             influence on retail milk prices. As Robinson
                                             pointed out, because farm milk prices
                                             account for only about 40 percent of the
                                             retail price, there is “adequate opportunity”
                                             for other factors, such as wholesale
                                             processing costs and retail pricing
                                             strategies, to “significantly influence” the
                                             other 60 percent of the retail price.
                                             A couple of thoughts spring to mind here.
                                             First, and frankly foremost, are those “retail
                                             pricing strategies” Robinson referred to.
                                             The Connecticut study of dairy compacts,
                                             as well as previous studies of slotting
                                             allowances by various federal agencies and
                                             entities, leave us a bit leery of having milk
                                             sales determined in part by “retail pricing
                                             strategies.”
                                             After all, recent evidence has also found
                                             that fluid milk demand is more price-elastic
                                             than previously believed. That is, increases
                                             in prices lead to decreases in demand. So if
                                             retailers decide, strategically, to boost milk
                                             prices, demand will decline accordingly.
                                             Why might retailers make such a decision?
                                             First of all, because milk is a profitable item
                                             already, one of the most profitable in the
                                             entire store, as shown by previous dairy
                                             industry-conducted studies. Second,
                                             because they can, at least in some markets,
                                             because according to the Connecticut
                                             study they have quite a bit of market
                                             power.
                                             Another point concerning retail and farm
                                             price movements concerns dairy policy
                                             discussions. Historically, one of the main
                                             arguments against legislatively boosting
                                             farm milk prices is because it would end up
                                             killing demand.
                                             That is, if farm milk prices are artificially
                                             increased, retail prices will also move
                                             higher, and demand will suffer.
                                             The GAO’s Robinson would seem to at
                                             least partially disagree with that argument.
                                             His point that other factors may have a
                                             greater influence on retail prices than do
                                             farm prices would seem to mean that
                                             policy-makers should pay more attention to
                                             those “other factors” than they do to farm
                                             prices if ensuring reasonable prices to
                                             consumers is their main goal. Put another
                                             way, arguments that legislated attempts to
                                             boost farm prices will end up costing
                                             consumers maybe shouldn’t carry as much
                                             sway as they once did.
                                             Or maybe they should be viewed in
                                             conjunction with those “other factors.” In
                                             the dairy industry, for example, fluid milk
                                             and cheese are sold through different
                                             channels, with retail being far more
                                             important for fluid milk than for cheese.
                                             And things are changing rapidly within the
                                             retail sector. While retail consolidation is
                                             certainly a concern, we seem to recall
                                             seeing recent studies that indicate
                                             supermarkets are becoming less important
                                             as far as retail milk sales are concerned.
                                             More and more milk is being sold through
                                             retail channels that include wholesale clubs,
                                             convenience stores and mass
                                             merchandisers.
                                             And of course the array of milk moving
                                             through those channels is changing as well.
                                             What’s sold in the supermarket is different
                                             than what’s sold at convenience stores.
                                             And competitive pressures to sell those
                                             products varies.
                                             Thus far, we’ve looked at the price issue
                                             from a demand standpoint. But that ignores
                                             the all-important supply side of the
                                             equation, of which there is also recent
                                             evidence of a more practical, as opposed
                                             to academic or theoretical, nature.
                                             That is, while farm price increases may not
                                             make it all the way through the supply chain
                                             to consumers and therefore may have
                                             minimal effect on demand, they do appear
                                             to have a fairly large impact on supply. And
                                             that’s something policy-makers always
                                             need to keep in mind.
                                             The latter part of the 1990s illustrated the
                                             effects of high prices on milk supplies. In
                                             1998 and 1999 we saw some of the
                                             strongest milk prices in history. The result
                                             was a two-year expansion (1999 and 2000)
                                             in milk production unlike any other in
                                             history. That expansion, of course, then led
                                             to a collapse in prices that lasted from late
                                             1999 until early this year — and persisted
                                             despite some of the strongest demand
                                             increases in memory.
                                             The collapsed farm prices in turn led to
                                             legislative efforts to prop up milk prices
                                             beyond what the market dictated. While
                                             this is a politically tempting idea, it creates
                                             at least some potential problems.
                                             Yes, apparently it doesn’t necessary hurt
                                             dairy demand, since farm price increases
                                             don’t necessarily show up in retail prices.
                                             But it does, potentially, lead to oversupply,
                                             because producers expand when milk
                                             prices are high (“high” being a relative
                                             term).
                                             Our conclusion to all of this is that
                                             legislatively propping up milk prices may
                                             not harm demand as much as once thought,
                                             but should still be viewed cautiously
                                             because of what can happen to supply. •