The distributional consequences of rising world dairy prices

In the week before Christmas, the New Zealand Herald reported that Fonterra will raise the price of milk for its domestic customers:

Fonterra - the country's biggest dairy company - said in a letter to customers that pricing across the range of fresh milk, flavoured milk and UHT products would increase by 9.1 cents a litre and fresh cream by 41.4 cents a litre, effective from January 2.

"We try and absorb the fluctuations in dairy commodity prices as far as possible, they've been steadily rising over the last six months, so we're having to make an increase to our wholesale list price in the new year," the co-operative said in a subsequent media statement.

Dairy product prices have been rising sharply over the last few months in response to declining production in the major dairy producers - New Zealand, Australia and the European Union.

There are both good news and bad news stories in this. Higher world prices for dairy products obviously make New Zealand dairy farmers better off, and this will flow through to greater spending in the economy by those farmers, and so on. However, higher domestic prices for dairy products make consumers worse off. Both of these effects are illustrated in the diagram below. Say that the initial world price of milk is PW0. Notice that the world price is higher than the domestic price (PD), which is why New Zealand is an exporting country (since farmers, i.e. Fonterra, can obtain a higher price for milk on the world market than they can in the domestic market). This is also why the domestic consumers have to pay the world price - why would the farmers (Fonterra) sell to the domestic market for PD, when they can sell on the world market (and receive PW0) instead? The consumers will only demand the quantity Qd0 at that price, but the farmers can sell much more (Qs0), with the difference (between Qd0 and Qs0) being the quantity of exports. Turning to measures of economic welfare, the consumer surplus (the difference between the maximum consumers are willing to pay, and what they actually pay) in this market (with the price PW0) is the area ABK, the producer surplus (the difference between the price the farmers receive and their costs) is the area KCD, and total welfare is the area ABCD.

Now, if the world price increases to PW1, farmers will receive a higher price but consumers must also pay a higher price (as in the article linked above). Domestic consumer demand will fall to Qd1, but farmers will be willing to supply more at the higher price (Qs1), and the quantity of exports increases (to the difference between Qd1 and Qs1). In terms of economic welfare, consumer surplus falls to the area AFG (consumers are made worse off, because they must now pay a higher price, and they buy less as a result), producer surplus increases to the area GHD (farmers receive a higher price, and they sell more milk), and total welfare increases to the area AFHD (society overall is made better off).

However, it is worth unpicking that last point a little bit more. Although society as a whole is made better off (on average) by the increase in the world milk price, this ignores any distributional impacts. Domestic consumers are being made worse off, and on top of that the increase in the price of milk is likely to be regressive - since low income people probably spend a higher proportion of their income on dairy products than do high income people, the impact of the change in milk prices is likely to be more keenly felt by those on lower incomes. Changes in world dairy prices are often reported here as being good for New Zealand when they rise, and bad for New Zealand when they fall. It is worth thinking through all the consequences of these changes though, since the distributional impacts are clearly important.

One final point is that the above analysis assumes that Fonterra doesn't have the ability to influence the global price of milk. Clearly that assumption doesn't really hold. If milk prices rise and New Zealand farmers respond by supplying more milk, that additional supply will go into the export market, lowering the global milk price. For more on this (and related points) see my earlier post on the cobweb model and the NZ dairy market.