Market power and milk prices

Domestic milk prices have been in the news again recently. For instance, Federated Farmers recently called for consumers to revolt against the market power of supermarkets and buy their milk from dairies:

Federated Farmers is calling on Kiwis to stage a revolt against supermarkets and buy their milk from dairies instead.

The call comes after Bodo Lang, a University of Auckland marketing professor, slammed milk pricing in New Zealand as "astoundingly high".

Federated Farmers' dairy chairman Chris Lewis told the Herald he avoids the supermarket altogether when buying milk for his family.

Instead he buys two 2 litre bottles of milk for $6 from his local Waikato dairy.

Lewis questions what goes on between the product leaving the farm and entering the supermarket for the prices to be quite as high as they are currently.

He said farmers got about 60 cents per litre of milk sold.

A Foodstuffs spokesperson said retail prices took into account the wholesale cost from suppliers, which could change according to the price they could achieve on the global market...

Mark Johnston also recently asked, Global Dairy Prices down but why does NZ have such high milk prices? Johnston concluded that:

Milk in Germany is much lower in price because of the high levels of competition with multiple [supermarket] chains operating there. In New Zealand however the price consumers pay reflects the concentrated nature of the market.

The argument is often made that New Zealand domestic milk consumers pay high prices because of two things. First, the supermarkets and other retailers must match the world price for milk. Second, because there are essentially two main players in the supermarket sector, the duopoly gives them market power and allows them to raise the price of milk (and other products as well). However, this argument ignores the fact that the supermarkets are not the only players in the market here with market power. Fonterra dominates the market for milk supply, giving it some market power as well.

Consider a market with international trade, as shown in the diagram below. If the domestic market was competitive and not open to international trade, the market would operate at equilibrium, with a price of PD and QD milk would be traded. The world price is PW - it is higher than the domestic price, which illustrates that New Zealand has comparative advantage in milk production, because it can be produced and sold at a lower price domestically than in the rest of the world. If the market was open to international trade, the price would increase to PW because the domestic sellers would prefer to sell at that price than the lower price PD. Domestic buyers have to match the higher price, so the quantity of domestic demand decreases to Qd0, while the quantity supplied increases to Qs. The difference between Qs and Qd0 (which would normally be excess supply), is exports.

Now consider what would happen if the domestic sellers in this market had some market power. Instead of operating at the world price PW in the domestic market, they can operate at the price and quantity that maximise their profits from the domestic market. This occurs where marginal revenue meets marginal cost, so they would restrict the quantity of milk sold in the domestic market to Qd1, and sell it at a higher price of PM. The quantity of milk supplied remains Qs, as Fonterra can simply supply more to the world market when it supplies less to the domestic market.

You might rightly ask, why wouldn't domestic milk consumers buy from the world market at the lower price PW, rather than from the domestic sellers at the higher price PM? Buying from the world market entails a higher transport cost than buying from the domestic market, so there's at least some reason to believe a premium on locally produced milk would be accepted. Fonterra's market power is limited by the availability of milk from the world market. However, that doesn't mean that Fonterra doesn't have some market power, and so the actions of the supermarkets (who clearly do have market power as well) is not the only source of high milk prices in New Zealand.