Thoughts on milk

There is talk about the Commerce Commission investigating milk prices in New Zealand.

An interesting passage from this piece states:

At the moment, we basically have a monopoly supplier of milk and two supermarkets selling it,” she said. “I think an inquiry could be a really good thing for consumers.

I think this is a bit over the top, and plays on how poorly the idea of a monopoly is understood in general parlance.  There is a general impression that the existence of a “monopoly” along some attribute indicates that we need government intervention – when the case is actually a lot more complicated then that. We need to ask why the market has a monopoly, what the characteristics of the market mean, and whether there a policies that can then genuinely improve outcomes – in many cases there are not.

Now note that I don’t necessarily disagree there might be issues – but we can’t just scream monopoly to ask for intervention.  So lets do a primary run down ourselves shall we 😉

So lets start just with Fonterra as the monopoly supplier of milk for retailers.

Lets ask if  there is effective competition?  What do I mean here?  Well the question has to be are there potential entrants into the milk provision market, and does this potential for entry in turn hold down milk prices?

This determines whether the world market for milk determines the price in NZ – if there are significant barriers to entry, Fonterra will be able to charge a premium on milk sold within the country.  This alone doesn’t justify intervention – but if such barriers exist it creates a reason why the Commerce Commission can look into the issue.

People often talk about the cost of milk being set by the “global market” and this is true – the global price sets a “floor” on what NZ producers will sell it at.  However, if Fonterra could sell it at a higher price without entry into NZ this is a possibility …

Then lets move down the chain to the supermarkets.  We have two supermarket chains selling relatively homogeneous products and competing in close proximity.  Do we really think there is a competitive issue here?  Sure with two firms we may have tacit collusion, we have have firms limiting their own capacity in order to extract rents, we may even have explicit collusion between firms (which would be against the law).  The reason the commerce commission will likely be willing to look into supermarkets again is because there is still some uncertainty regarding whether the industry is competitive following Woolworths merging into Progressive Enterprises.

However, to be fair – Warehouse Extra found it couldn’t make sufficient margins to stay alive in the industry (*,*,*), doesn’t that sort of suggest that there is a strong competitive element?

Conclusion

I don’t have one.  I’m looking forward to reading their preliminary results – and hope that they quickly discover that the industry is working spectacularly. If they do find issues, expect me to discuss them in very little detail on the blog 😉

  • And all the dairies that explicitly compete on milk prices, combined with zero restrictions on anybody setting up town milk supply and selling to those dairies to compete on price….

  • @Eric Crampton

    Dairies have far to limited capacity to compete on price, and if they wanted to expand they would become … another supermarket. Coming from a small town, I can tell you that even the largest dairy will sell at a premium 😉

    Regarding town milk supply it is an issue of barriers to entry IMO – a mix of legislation and the fact that supermarkets are the main players and they will be unwilling to deviate in supply for a single franchise at the risk of losing their relationship with their main milk provider. Even without these, if there are sufficient economies of scale we might feel that Fonterra may be extracting rents (which we normatively judge as unfair), even though the price is lower than it would be in the face of inefficient competition.

    I’m definitely not arguing for these points – my prior is that Fonterra just charges the global price and that the supermarkets are competitive. However, I would be remiss to act as if there is no way there could be competitive issues.

  • Lots of Christchurch dairies have signs out saying “2 Litre Farm & Gate Milk, $2.65”, or “Two 2-Litre milk, $5.10”. Prices generally seem a bit better than supermarkets.

  • @Eric Crampton

    Nice. I’m glad to see it.

    I’m surprised supermarkets aren’t doing what the Aussie ones are – cross-subsidising using milk, given peoples current responsiveness to milk prices. Get people in the door for milk and then sell them more expensive cereal.

  • steven

    I disagree that the supermarkets are competitive,

    A likely possibility is that the Warehouse couldn’t make competitive in-roads into the supermarket business because the supermarkets have market power in their supplier markets. That is they pay less for the goods that they purchase as they have market power in negotiating prices with their suppliers (a “duopsony” if that’s the right concept) and then have monopoly (duopoly) prices in the retail market (which might appear as competitive since warehouse couldn’t compete but are in fact not). I would be surprised if this is the case for Milk as they purchase from NZDF and Fonterra Brands, but certainly could be the case for other products. We certainly hear about this type of complaint from meat, fruit and vege growers, that they have pressure put on them by their customers such as meat processors and the supermarkets (but not in milk as it is a cooperative). It also helps explain those produce stores which are significantly cheaper than the supermarkets because these stores are not able to charge the monopoly prices that supermarkets can.

    I agree with the prior that Fonterra just charges the global price but not that supermarkets are competitive. I would like to see the analysis on whether they have market power in their supplier markets AND in the retail markets. If there is market power in the supplier markets, the monopoly prices may appear competitive (for most products) but in fact supermarkets are extracting excess rents from their suppliers.

  • @steven

    “I disagree that the supermarkets are competitive”

    Fair call, a lot of people, and economists, would agree with you.

    “A likely possibility is that the Warehouse couldn’t make competitive in-roads into the supermarket business because the supermarkets have market power in their supplier markets”

    I believe that is one of the arguments that was made at the time as well. One thing we can take out of this though is that the potential entry of an organisation like the Warehouse will keep prices below some given level.

    Even when we say that the supermarkets have market power over their suppliers, if we are going to bemoan the price that consumers are paying we still need to make an argument regarding why this duopoly can extract rents from consumers (as without market power at this level, the rents from the lack of competition for suppliers will get passed on to consumers).

    Again, in this case we need to be able to make an argument for tacit collusion – or some form of capacity restriction. My impression is that there is a strong belief in the fact that their is tacit collusion in the industry, and that the initial merger involving Woolworth’s should never have happened – however, even if this is the case it isn’t clear we can improve outcomes now.

  • @Matt Nolan
    Has the ComCom looked at market power in input markets. Surely it would be illegal for the supermarkets to use their market power in input markets to push out an entrant. I imagine there would be some pretty hefty legal action taken if there was evidence of that.

  • @rauparaha

    No idea. Would be surprised if it was an issue they hadn’t thought about analysing though.

    I know that there are clauses that would not allow a number of suppliers to supply a competitor to whatever supermarket they are supplying goods to – but in that case surely its a case of a new competitor spending time building up their own supply network.

    Obviously the Warehouse Extra stores couldn’t achieve that – or were unwilling to given the time and effort involved. This suggests to me that potentially there isn’t room for a third firm in the market … just saying

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  • steven

    There was an investigation to get clearance prior to Woolworths buying progressives, but this was all prior. I would like to see how this analysis actually panned out in reality. I remember looking at the case in university and I thought the decision was a little on the knife edge.

    “Even when we say that the supermarkets have market power over their suppliers, if we are going to bemoan the price that consumers are paying we still need to make an argument regarding why this duopoly can extract rents from consumers (as without market power at this level, the rents from the lack of competition for suppliers will get passed on to consumers).”

    The fact that they can prevent others from entering the retail market by preventing them from entering the input market means that they also have power in the retail market. thus with cournot competition, yes some rents savings get passed on to consumers, but it is still monopoly (duopoly) pricing (just with lower input costs)

  • @steven

    “I remember looking at the case in university and I thought the decision was a little on the knife edge”

    At the time it definitely felt knife-edge.

    “The fact that they can prevent others from entering the retail market by preventing them from entering the input market means that they also have power in the retail market”

    Yar, of course we have to ask how much of this is due to relationship building rather than straight competitive pressure.

    “thus with cournot competition, yes some rents savings get passed on to consumers, but it is still monopoly (duopoly) pricing (just with lower input costs)”

    I was covering this when I said “or some form of capacity restriction”, as Cournot competition is just Bertrand pricing with a first stage where capacity is chosen. When its framed in this way I just find the Cournot model slightly inappropriate for modeling supermarket competition – there is definitely a large amount of capital, and other inputs can be shifted relatively quickly.

    Closing out competitors from the input market is very concerning, I agree. But we still need to make sure our mechanism that drives this into prices consumers face is clear.

  • Greg

    @Eric Crampton #1
    We’ve had this, down my way – someone selling town supply milk to dairies, that is.

    It doesn’t work. The reality is that nearly all people do nearly all their shopping at supermarkets because they are full range retailers. Dairies pick up the scraps.

    I heard (yes, hearsay, hah, worse than anecdote) that pressure was exerted on the local supermarkets to refuse to stock the “alternative” milk. And as the alternative supplier didn’t have a full range of dairy products, the supermarkets went along. I like the econo-euphemistic way Matt @ #10 describes this as “relationship building”.

  • @Greg

    “econo-euphemistic way”

    I like that term, I like it a lot.

    I would note that the “relationship building” I mentioned is genuinely separate from the concept of bargaining power in input markets (which is the fair point you are raising). However, that doesn’t stop the term econo-euphemism being awesome.

  • Miguel Sanchez

    @Matt Nolan
    “I’m surprised supermarkets aren’t doing what the Aussie ones are – cross-subsidising using milk, given peoples current responsiveness to milk prices. Get people in the door for milk and then sell them more expensive cereal.”

    The Aussie supermarkets are trying to build up some goodwill before Aldi enters the market, which from what I’ve heard is a few years away from becoming an issue here.

    Curiously, I’ve also heard that a growing number of Aussie dairy farmers are sending their product to New Zealand because they fear the price war will destroy their margins. That’s right, New Zealand is now importing milk from Australia.

  • @Miguel Sanchez

    That makes sense. And I’ve got no problem with them entering our market – all for competition.

    The supermarket in NZ issue is interesting, it is extremely interesting. There is a common feeling that the duopoly MUST be anti-competitive, but I would really like to see some work on it.

    However, as I learned as a 15 year old economics student – the supermarkets are epically protective of there commercial data.

  • Miguel Sanchez

    Information gaps are more of a feature of uncompetitive markets, right? 😉

  • @Miguel Sanchez

    Not necessarily.

    If firms release information that can be used for collusion that is anti-competitive. For example, if a firm released information on its “capacity” it could “commit” to lower levels of output and tell other firms so – and then they could tacitly collude. Or they could use that announcement to commit to a higher level of output in order to become a “stackelberg leader” thereby making the industry more competitive – but lets just ignore that …

    As a result, the information gap could actually be a signal of intense competition … 😉