Is the Northeast Interstate Dairy Compact milking the consumer?
A New Regional Milk Cartel – Northeast Interstate Dairy Compact
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Is the Northeast Interstate Dairy Compact milking the consumer?A New Regional Milk Cartel – Northeast Interstate Dairy Compact |
from NewsLink, Volume 2, Number 3, Spring 1998
By Aniko Laszlo*
In February 1998, dairy farmers, processors, distributors and consumer advocates gathered at the State House in Boston to debate the merits of setting the price for milk. On one side, consumer advocates argued that the extra 10-20 cents the price maintenance program adds to each gallon of milk would hurt all consumers - especially low-income families with children. According to estimates prepared by Public Voice for Food and Health Policy, a Washington-based consumer advocacy group, consumers in New England will pay an extra $55 million on an annual basis for the milk-price maintenance program, $25 million of which is expected to be paid by Massachusetts consumers [1].
Proponents, the dairy farmers argued that the price support for milk helps preserve open space, keeps jobs on the farmland, helps struggling farmers earn a meager living. They argued that a price floor is necessary to supply fresh milk to millions of local consumers. The truism of economics, i.e. “there is not such thing as a free lunch” can readily be extended to the dairy industry. If there is no free glass of milk who then pays for the price maintenance of milk? One answer is the consumer.
Federal regulation of the milk industry is a good example of a very complex bureaucracy that has been continuously growing in size and complexity since 1933. As many federal programs of the New Deal, intervention in the dairy industry was designed to protect dairy farmers against demand and supply fluctuations in the 1930s. Historically, the federal government's interference with milk pricing came in two main systems; dairy product price support and milk marketing orders. The latter program operates as a price floor that interferes with the price system's most basic function, voluntary contracting between buyers and sellers.
What are the economic consequences of a price floor?
A price floor (Pf) is a legal minimum price below, which a good may not be sold. The established price is higher than market clearing level (P*), therefore consumers adhering to the law of demand will demand less of the good (Qd) for a higher unit price. On the other hand, dairy farmers are willing to bring more to market (Qs) if prices are higher, all other things being the same. The resulting gap between quantity demanded and supplied is overproduction or surplus of milk.
How to produce a milk surplus
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The federal government as a consumer of last resort
Since milk is an input to produce other dairy products, a higher than market-clearing price for milk, on one hand, boosts an overproduction of various dairy products such as powdered milk, butter, and cheese. According to reports, milk production increased faster in New England than in the 20 largest milk producing states in the last quarter of 1997 [2]. On the other hand, price maintenance increases the price of milk for consumers who as a result will demand less than without price intervention. What to do with the surplus? It turns out that the federal government had become the nation's customer of last resort for dairy products buying up billions of dollars worth of dairy products every year [3], [4]. To mitigate the overproduction crisis, Congress, in the Farm Bill of 1996, called for a phase-out of the price support system by 2000. Yet, the final version of the bill contains a provision creating a regional milk cartel, the Northeast Interstate Dairy Compact to protect high-cost milk producers in six New England states, including Massachusetts.
The Milk Industry Foundation, a trade association of milk processors and distributors challenged the constitutionality of the Northeast Interstate Dairy Compact. The association argued that milk crossed state lines, therefore only Congress had authority to regulate its flow in interstate commerce. On January 20, 1998, judges on the U.S. Court of Appeals rejected the challenge and ruled that the Department of Agriculture was justified to approve the compact because there was a “compelling public interest” in New England for the arrangement. The compact requires wholesalers to pay $16.94 per hundred pounds of fluid milk, or about $1.46 a gallon. Without the compact distributors paid $14.99, or $1.29 per gallon last year [5].
Dairy farmers are the sole beneficiaries
Beyond the shadow of a doubt dairy farmers in New England are the only beneficiaries of the continued price maintenance. With established prices they do not have to face the uncertainties of market competition. Dairy farming without legislatively created entry barriers is a very competitive business. There are numerous dairy farmers selling a relatively homogeneous product in any given geographic region. Dairy farmers do not possess market power individually. Farms, however, do differ in their respective cost structures attributable, among other things, to the size of their business, opportunities to exploit economies of scale, price of factor inputs, etc. If the market price is such that average revenue from sales just covers average current expense of the business, the farm breaks even. Competition brings out the lowest market price for milk produced by the most efficient farmer.
The following graph indicates three producers with different short-run average cost functions (SAC). On the graph the farm with the lowest average total cost curve is the large-size farm that could invest in new technology thereby increasing its productivity and reducing unit price. The other two SAC curves represent successively higher cost producers. If we assume that in the absence of price maintenance the market clearing price and quantities are P*, Q*, respectively, the marginal farm with a short-run average cost curve, SAC1 just breaks even. At that point processors get the lowest price for their marginal valuation of milk. However, if the price rises from P* to $16.94 more dairy farmers are in the market. It is because those who at market clearing price would go bankrupt are now able to turn a profit. On the graph it is farm 2 with a short-run average cost curve of SAC2 that becomes profitable at $16.94 per hundred pounds of fluid milk. Between SAC1 and SAC3 there can be numerous other producers that turn a profit.
Processors profits get squeezed
The level of profit to processors and distributors who sell milk to final customers through grocery retailers depends in large part on the degree to which they can shift the higher cost of milk to consumers. The phenomenon measuring the responsiveness of customers to a price change is called price elasticity. It measures the percentage change in quantity demanded as a response to a percentage change in price. For example, the consumer is called price inelastic if a 1-% increase in the price of milk prompts him to cut his purchases by less than one percent. The less responsive consumers are to milk price increase, the larger share of the price increase will be born by consumers and the smaller the share distributors and processors have to pay. No doubt, milk is healthy food, a great source of calcium and other minerals for which there is no good substitute available. Despite a more health-conscious lifestyle it seems that consumers are not entirely unresponsive to price changes. What would that mean for distributors and processors? They cannot shift the price increase of milk entirely to the consumer, thus their profit is smaller than it would be if consumers were entirely unresponsive to price change, or if they could obtain milk from dairy farmers at true market price.
The purchasing power of low-income people is diminished the most
Let us consider two examples: a family of four with two school children that lives below poverty level, on $12,000 annual income, and a family of four with median income in the Boston metropolitan area of $60,000 [6]. Assume further that both families consume 4 gallons of milk each week, i.e. 208 gallons per year and the price for a gallon on milk is $2.00 without the NIDC's price maintenance program. Both families spend $416 on milk per year. The family living below poverty level spends 3.5% of its annual income (excluding taxes, subsidies and other transfers) for milk while the median-income family spends only 0.7% or 5 times as much as the median family. As with most interventions designed to help one group, another group – in this case low-income families – loses. To see why, add another 20 cents to the price of a gallon of milk. Both families now spend $458 per year. The fraction of the poor family's budget that goes to buy milk has risen by 10%. The same fraction for the median income family has risen by 8.5%. The burden of the higher price is greater for the poor family than for the richer family.
In a letter to the Northeast Dairy Compact Commission [7], Attorney General Scott Harshbarger called for exempting nutrition programs aiding children, seniors and low income families from compact prices by arguing that the purchasing power of these groups are diminished more relative to that of other people. The compact rejected his request [8].
Out of state dairy farmers pay a “compensatory fee” if they want to sell milk within the territory of the compact
Any dairy farmer located outside the compact area who wants to sell milk to processors in New England has to pay an “entrance fee” or a tariff not paid by compact members. This phenomenon does not just increase the price of milk; it has a potential to set a dangerous precedent for future regional trade barriers. The precedent of the Northeast Interstate Dairy Compact already found followers. In 1997, in the Southeast, another high-cost producer area, the Southern Interstate Dairy Compact was established. It has been approved in North Carolina, Georgia, Florida and signing in 12 other states is expected soon.
Most ordinary citizens have no idea that delivering dairy products to breakfast tables is not simply a matter of milking cows, processing fluid milk and shipping it off to grocery outlets in the form of cheese, yogurt and the like. The federal dairy program has been a tangled web of numerous pricing schemes that turned economics on its head more than sixty years ago. The price maintenance program has undermined the most basic free market concept, voluntary contracting between buyers and sellers. Even though the federal government will phase out operating the dairy price maintenance program in 2000, market conditions will not be allowed to govern dairy prices. The role of the federal government will be taken over by a regional cartel, the Northeast Interstate Dairy Compact, which will keep hiding the well-organized special interest of dairy farmers. State policy makers should think twice before allowing the Compact to keep milking consumers.
Footnotes
[1] Patriot Ledger staff: “Paying a higher price for milk”, Patriot Legder, Oct 18, 1997.
[2] AP: “Production on the rise among dairy farmers”, Boston Herald, April 22, 1998;Bruce Mohl: ”Milk-rich region may get soaked by surplus”, Boston Globe, May 20, 1998
[3] In 1994, the US government held 80.18 million lbs. of butter, 437.25 million lbs. of cheese, 47 million lbs. of canned mild and 9.2 million lbs. of dry milk on stock.
[4] Agricultural Statistics, 1995, United States Department of Agriculture, http://wwwaix.fsa.gov/agstats
[5] Northeast dairy compact upheld by appeals court panel, Associated Press, 01/21/1998, http:/www.boston.com/dailynews/wirehtml/021-lr/Northease_dairy_upheld_by_a.htm
[6] FannieMae, Median Income Statistics, 1997, http://www.fanniemae.com/cgi-bin/hud/hud.cgi
[7] Letter to Jay Healy, Commissioner, Northeast Dairy Compact from Attorney General Scott Harshbarger, February 2, 1998.
[8] Letter to Attorney General Scott Harshbarger from Daniel Smith, Executive Director, Northeast Dairy Compact Commission, March 4, 1998.
*Author is an Economic Research Associate at the Beacon Hill Institute
posted 6/10/98
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