Fonterra, monopsony, and market power

This week in ECONS101, we will be discussing firms with market power. Market power refers to the ability of the seller (or sometimes the buyer) to have an influence over market prices. In our case, we will be focusing on firms who have market power over markets into which they are selling. In those cases, the firm will raise the price above the price that would arise in a more competitive market (and will consequently sell a lower quantity, but at a higher profit). At the extreme end of market power are monopolies, where there is just a single seller of the product and where there are no close substitutes.

Sometimes though, it is the buyers who have market power. Think about the case of a single employer in a small isolated town (like a company town, for instance). If people in the town want a job, they have to work for the single employer. This gives the employer market power, and they can react by lowering wages - after all, the employees aren't going to go work for some other firm, as there are no other employers in the town. This is an example of a monopsony.

That brings me to Fonterra. It isn't quite a monopsony (there are other dairy companies in New Zealand), but it does have a high degree of market power due to its dominant position as a buyer of milk from farmers. If Fonterra was to act on its market power, it could easily drive down the price of milk paid to farmers. Until relatively recently, this wouldn't have been worthwhile, because the farmers were also the shareholders of Fonterra, so any profit gains obtained from buying milk more cheaply from farmers would have simply been returned to the same farmers in the form of higher profits. However, Fonterra underwent a capital restructure in 2009-2010, so the concordance between farmers as sellers of milk and shareholders as receivers of dividends from Fonterra profits decreased.

Despite that, there are still a couple of things that keep Fonterra's monopsony market power in check. The first is the existence of smaller dairy companies. If Fonterra screwed its farmers over too badly, they could jump ship to the competition. However, those other dairy companies are small and their ability to absorb large numbers of new farmer suppliers is limited. So, Fonterra could get away with offering a slightly lower price than its local competitors offer.

The second restriction on Fonterra's market power is the legislated requirement that it must accept all milk that its farmer suppliers offer to it. That is why this proposal should be a worry:

Fonterra, a farmer-owned cooperative with listed units, has long pushed back against the DIRA requirement that it take all milk offered to it, which has resulted in the company having to spend hundreds of millions on new stainless steel processing capability as annual milk production climbed in recent years.

Fonterra argues this capital requirement erodes its strategy to move from processing commodities to value-add products, and is helping its internationally-backed competitors.

DIRA is the Dairy Industry Restructuring Act 2001, which was the legislation that enabled the creation of Fonterra, through the merger of New Zealand Dairy Group and Kiwi Co-operative Dairies, the two largest farmer cooperatives at the time, and the New Zealand Dairy Board, which was the exporting agent for all of the country's dairy cooperatives. DIRA is currently under review, and unsurprisingly Fonterra wants the shackles removed. They are arguing that:

The industry had become "highly competitive" particularly with the relatively large number of new entrants in the past five years.

"These international new entrants are often backed by deep capital and global businesses. They do not need an extra leg-up via milk from New Zealand farmers. Given this new competitive environment, the issue of open entry – which means having to accept all milk from new suppliers – is a critical part of the review," it said.

"Open entry limits our farmer-shareholders and the industry's ability to maximise value for New Zealand. It distorts investment decisions and leaves Fonterra's farmers underwriting risk for competitors who cherry-pick their suppliers."

Fonterra still collects over 80 percent of the milk production in New Zealand. Its competitors are much smaller. If the Government removes the requirement for Fonterra to accept all milk offered to it, then its market power naturally increases. If a farmer wants Fonterra to accept milk, and Fonterra doesn't have to accept it, then Fonterra can say, "We'll take your milk, but only at a discount of X%". How large X% is will depend on whether the competition could feasibly take the milk. In areas where there isn't local collection by Synlait, Westland, Tatua, etc., those farmers are at very real risk of being seriously screwed over by such a change.

There may well be benefits to Fonterra's shareholders from freeing Fonterra up from the requirement to accept all milk offered to it. But that doesn't mean that the proposal won't also come with real costs to farmers attached to it.