The US milk market is characterized by five links. Farmers, who produce the milk and sell it through cooperatives to huge dairy processors, who transform it into the different products, like packed fluid milk, cheese or yogurt. Then retailers sell those products to consumers.
In this market we can find a combination of government policies and economic conditions that shape a complex structure. The important characteristics for this work are:
Inelastic price elasticity of demand: small changes in quantity demanded give large price effects. This is due to the fact that households still purchase milk products even though the price has increased. Thus, a small decrease in production makes consumers compete for it and price will go up. On the other hand, an increase in production makes milk used to make other products with lower values –like powder- and the price decreases.
Inelastic price elasticity of supply: Dairy farms cannot vary the quantity they produce easily. This is because cows and pastures take time to become productive. Also, once they are producing, they remain for several years, thus increase or decrease these factors of production is not done in a fast way. Also there are several specific production factors, like, milking machines and infrastructure needed for feeding the cows, which are not easily used in another production. Farmers have high fixed costs that make them stay in the activity even when prices make their profits negative but above the short-run variable cost. This makes the price elasticity of supply inelastic, because a change in price does not impact the quantity produced in a big way.
Federal regulation: there are two important regulations in dairy markets. The first one is the Capper-Volstead from 1922 that exempts US farm co-operatives from most of antitrust laws, allowing farms to coordinate milk marketing and input purchases. The Agricultural Marketing Agreement Act from 1937 that established milk marketing orders that a minimum price for milk be set. Both laws had the intention of improve the prices received by dairy farmers.
Daily farmers are grouped into cooperatives: farmers alone are in an extremely weak negotiating position. Because there are many small producers against big dairy processors. That is why, having the federal regulation described above, the farmers joined in cooperatives, improving their power and giving them a relative bargaining strength as a group generating an income transfer from processors to cooperatives (Prasertsri and Kilmer, 2008).
Controlling the Quantity Supply
The mentioned characteristics make the US dairy market very singular compared with other commodities (like corn, soybean or beef) and prepare the field for the strategy taken by the cooperatives and described by the Bloomberg´s article titled “Killing Off American Cows to Keep Milk Prices High” (Shanker D., 2016). According to this text, a group of farmer cooperatives have created in 2003 a program called “Cooperatives Working Together (CWT)” with the goal of increase the price of milk. That is why the CWT generated the “herd retirement program” that worked with the balance of supply and demand, decreasing the quantity supplied by promoting firms to retire production. To do this, the program induces milk producers of organization to give 10 cents for every hundred pounds of their milk sold. This pool of funds was used to compensate farmers retiring entire herds from production.
First of all, we will need to understand why farmers end up producing milk in a quantity bigger than what is apparently more profitable. The article says that American dairy consumption has gone from 539 pounds per person in 1975 to 627 pounds in 2015. Another article, from Mulvany, 2015 also published in Bloomberg, mentions that domestic output is the highest ever for a fifth straight year. “Farmers are still making money as prices tumble because of cheaper and more abundant feed for their herds”. This means that actual price (P*), even lower than in the past, is above the average cost (AC), and that is the explanation about why farmers have increased their quantity supplied (Qs). Of course, in farming, AC varies from year-to-year since it depends on the weather that affects the feed produced by pastures and by the price of inputs like corn, that are highly volatile. But, we can assume that for a combination of good weather and improvements in technology of production, AC is most of the time bellow P and that makes that farmers earn profits (π) and increase their production over time.
Second and more interesting, we are going to see how cooperatives manage to increase profits by reducing quantity produced. For this approach we will notice that the “herd retirement program” gives incentives to farmers that retire their farm by selling their entire dairy herd for slaughter and agreeing not to produce milk for the duration of five years to receive the compensation (McCay, 2011).
In a classic monopoly, with a single company, the firm will adjust Qs in order to maximizes profits, following the rule of MR=MC, and, for making that, the monopoly has the power of closing factories to reduce production to that level that maximizes profits. In the milk market, a single farmer is a price taker, thus it will produce under rule of P=MC. But, in this case, the association in the CWT program gives the possibility to merge all the supply in a “Cartel” where the producers follow the rule of MR=MC and transform a competitive market with price taker firms into another that behaves as a monopoly. They do this modifying the number of firms (n), or in other words “closing factories,” like a monopoly would do. This way they produce a restriction in Qs. Since Qd is inelastic (a small change in quantity produce huge change in price) the new price (P**) is much higher than the previous (P*) and remaining farmers make extra- profits. Of course, since they are modifying n, to get everybody to agree with this strategy, they share the extra profits generated by the remaining farmers with the ones that are getting out of business (that would be the 10 cents per 100 pounds of milk sold by farmers that is used to compensate farmers retiring herds).
But, why would some of the farmers agree to stop producing even when they were making money? Retiring farmers accept to do that because they also increase their profits. They prefer to sell their cows, accept the compensation, and use their lands to produce something else. It is highly probable that farmers who decide to retire are those that are less cost efficient. An efficient farmer is making profits before the supply shift, and the compensation is not enough to make them prefer to retire. That would make a double effect on the profits of the farmers as a group: one effect is due to the higher price and the other is due to a gain in cost efficiency (among the firms that stay the AC will be lower than before the program).
To sum up, it is important to highlight that CWT was run by dairy farmers with the goal to benefit all dairy farmers of the United States. No one is obligated to participate in it, neither to give money to the fund, nor to get compensation and close a firm. The existence of cooperatives with a Federal Law that exempts the United States from most of antitrust laws makes possible the transformation of a competitive market into an imperfect market and that change in Qs is what we are experiencing under the “herd retirement program.” The interesting fact is that they manage to do that changing n, not just qi, and sharing the extra-profits with the retiring farmers in order to make a win-win strategy. Another discussion question would be to ask, “Who loses with this increase in price: the processors, the retailers, or the final consumers.”
McCay C. J. 2011. Purdue University. Effect of Cooperatives Working Together Herd Retirements on the U.S. Dairy Herd Size. http://www.bloomberg.com/news/articles/2015-07-01/milk-spilled-into-manure-pits-as-supplies-overwhelm-u-s-dairies
Mulvany L. 2015. Bloomberg News. The U.S. Is Producing a Record Amount of Milk and Dumping the Leftovers. http://www.bloomberg.com/news/articles/2015-07-01/milk-spilled-into-manure-pits-as-supplies-overwhelm-u-s-dairies
Cakir M. and Balagtas J. 2011. Purdue University. Estimating Market Power of U.S. Dairy Cooperatives in the Fluid Milk Market. http://www.agecon.purdue.edu/staff/balagtas/Coop_Paper_noauthors_Final_20111021.pdf
Prasertsri P. and Kilmer R.L. 2008. The Bargaining Strength of a Milk Marketing Coopera-tive. Agricultural and Resource Economics Review 37: 211-226.
Shanker D. 2016. Bloomberg News. Killing Off American Cows to Keep Milk Prices High. http://www.bloomberg.com/news/articles/2016-09-08/cow-killing-and-price-fixing-in-your-supermarket-dairy-aisle