Middlemen take advantage of dairy compact

by Chris Braithwaite

The idea behind the Northeast Dairy Compact was economically sophisticated,
politically optimistic, and ultimately persuasive.

Despite the best efforts of federal regulators, milk prices at the farm swing widely
and unpredictably.

The middlemen, milk processors and retailers, had organized affairs in the
complex economic territory between farmers and consumers both to protect
themselves from the harsher consequences of these swings, and to profit by them.

The results were simple: farmers stayed poor; consumers paid too much.

To deal with the risks that come with sharp price fluctuations, the middlemen
were believed to be extracting a "risk premium" as they passed the product along.
Just a little something extra against the day they would get caught by sharp price
increases.

And to take advantage of the fluctuations, they were believed to be indulging in
what economists call "asymmetric price behavior." Others in the business call it
the "ratchet effect." As the terms imply, the middlemen tended to follow farm
prices up, but not down. Bumps in the farm price were immediately reflected on
supermarket shelves. But when farm prices fell, retail prices fell slowly and
incompletely, if at all.

Thus while they caused periodic crises on struggling New England dairy farms,
sudden drops in the farm price left consumers little better off. The missing
difference went into the middlemen’s pockets.

The idea behind the compact was simple: remove the violent fluctuations in the
farm price and both these mechanisms would disappear. Middlemen would no
longer need to add the risk premium to their profits; and the opportunity to enrich
themselves when farm prices fell would be eliminated.

The way to do that, the creators argued, was to put a reasonable "floor" price
under the farm price of milk that would be bottled for fresh consumption.

If the weirdly complex federal milk pricing system sent prices below that floor, the
region’s middlemen would pay farmers the difference. But since they hadn’t been
passing on those lower prices anyway, consumers would be no worse off.

The middlemen’s profits were so high, advocates argued, that market forces would
compel them to absorb the premiums.

The final result: the survival of New England farms that could supply consumers
with a good, fresh product at reasonable and stable prices. Everybody would be
better off — if you didn’t count the middlemen.

Not surprisingly, the middlemen despised the idea from the outset. Alan Rosenfeld,
an economist hired by the International Dairy Food Association, warned the new
Compact Commission in December 1996 that any compact premium would be fully
passed on to the consumers, and result in permanently higher milk prices. In
blunter terms, it would be the consumers, not the middlemen, who put more
money in the farmers’ pockets.

Mr. Rosenfeld’s argument did not, the commission said, "respond in any way to the
comprehensive literature suggesting precisely the opposite conclusion."

Perhaps not. But the industry spokesman’s comment turned out to be less of a
prediction than a promise.

The commission hadn’t reckoned on the raw market power the middlemen could
impose on milk prices.

Indeed, the middlemen did far more than pass on the compact’s premiums. They
seized on the new compact as an opportunity to fix the very high profit margins
they were enjoying when the program took effect in July 1997. And, of course,
they blamed it on the farmers.

They used their market power to line their pockets and — in a stroke of
particularly perverse brilliance — used those profits as a political weapon against
the compact they so despised.

These bleak conclusions emerge from a scholarly study entitled "The Public
Interest and Private Economic Power: A Case Study of the Northeast Dairy
Compact."

It is written by Ronald Cotterill and Andrew Franklin of the Food Marketing
Policy Center at the University of Connecticut.

The study reduces its findings to numbers. They come from the scanners at
supermarket cash registers across New England. Supermarkets are the leading
distribution channel for fluid milk, the study notes, and account for about 40
percent of total sales.

In the compact’s first three years, from July 1997 to July 2000, the study
estimates, higher supermarket milk prices accounted for a "total consumer loss" of
$68.4-million.

But the study attributes just $19-million of that to the compact itself. The other
$49.4-million, it says, is due to "the exercise of market power by supermarket
retailers and processors."

The study was not requested or financed by the Compact Commission, and its
findings are not entirely welcome to the compact’s supporters.

Contrary to their predictions, it does find that the compact itself cost supermarket
shoppers $19-million.

But the study’s primary targets are clearly those middlemen. "The compact," it
says, "served as a focal point for tacitly collusive price conduct by retailers and
processors."

Tacit collusion happens in markets dominated by so few players that they don’t
need to get together and agree on how to fix prices. They simply opt to avoid price
competition, and follow one another’s lead.

In detail, the study says that the farm price of milk averaged 6 cents a gallon
higher in the compact’s first three years, compared to the months before it took
effect. During a quarter of that time, the federal price mechanism twice pushed
the fluid milk price above the compact’s floor, and the compact had no effect on
farm prices. Allowing for that, the study cuts the compact’s share of the farm price
increase to 4.5 cents.

Those two periods when the price was above the floor added another 6.5 cents, for
a total increase on the farm of 11 cents. Meanwhile, the study says, the
middlemen’s other operating costs rose by 7 cents a gallon, for a total cost increase
of 18 cents.

But over the same period, the average retail price of milk rose from $2.49 to $2.78
a gallon, an increase of 29 cents.

Subtracting the 18-cent increase in cost from the 29-cent increase in price, the
study says, "the difference, 11 cents per gallon, is increased profits due to the
exercise of pricing power by market channel firms."

Higher milk prices, of course, tarnished the already-controversial compact as it
enriched the middlemen.

"Key players in the New England milk industry appear to be fighting the compact
in the marketplace as well as in public and political forums," the study concludes.

It cites a sign posted in many New England supermarkets after the compact took
effect:

"Due to the increased cost of milk caused by the new ‘Northeast Compact’
authorized by the U.S. Congress and signed by the U.S. Secretary of Agriculture,
we have had to increase our milk prices. We hope this poses no inconvenience to
anyone."

In fact, the study says, in the 18 months before the compact took effect, the
middlemen enjoyed so much power over the market that the farm price hardly
mattered to them.

Over that period, it finds, "there is absolutely no relationship between farm and
retail prices. Farm price fluctuates widely about its $1.40 per gallon average price
over the 18 pre-compact periods, but price transmission from farm to retail is
virtually non-existent. Retail prices march to a different drum and increase in a
steady fashion throughout the period."

The actual price data from those 18 months suggests, with the wisdom of
hindsight, that neither of the theoretical underpinnings of the compact were going
to have much real effect.

Profit margins were already so wide that middlemen didn’t consistently follow
farm price increases with retail increases. They didn’t need to bother to ratchet
prices up. And, given the middlemen’s easy indifference to farm prices, it is hard to
see the risk that the compact might help them avoid.

In a lengthy aside, the study sets the reality of the New England milk market
against the textbook model of a free market where prices respond to supply and
demand.

"One of the primary reasons for the shift to the ill-fated Freedom to Farm Policy in
the mid 1990s was the hypothesis that ‘free market’ agriculture would allow prices
to allocate resources more efficiently than government price stabilization and
production control programs....

"Yet the Freedom to Farm policy was predicated upon a competitive marketing
channel and responsive retail prices to help dampen volatile farm prices. In fact,
unresponsive or perverse retail prices have exacerbated farm price volatility.

"This, coupled with farmers’ perennial tendency to overproduce and enmesh
themselves in the classic over-production trap, has generated an agricultural
depression that has required more, not less, federal dollars for farm relief since
passage of the Freedom to Farm Act."

In the New England milk market by July of 1997, the study says, "the spread
between the retail and farm price was historically very wide. In fact, it was wider
than at any other time during the before-compact period because the farm price
was in a deep trough. This was the time to put a program such as the compact into
effect. Farmers clearly needed price relief and marketing firms had such fat
margins that they could absorb an over-order premium without elevating retail
prices. At least this is what reasonable observers would conclude after viewing the
retail and farm price trends from February 1996 through June 1997 and the
crystal clear lack of relationship between them."

What made the reasonable observers wrong?

Part of the problem, the study suggests, was a major change in the region’s milk
processing industry.

"The market structure of milk processing in New England collapsed during this
period to a single dominant firm, Suiza Foods, with extensive private label
processing and Garelick fresh milk brand.

"In July 1997...Suiza purchased the Garelick Company and entered New England
in a major fashion. In July 1998 it purchased another leading New England milk
processor, West Lynn Creameries, and in August 1998 it purchased yet another
leading processor, Cumberland Farms....Thereafter Suiza purchased Natures Best
Dairy in Rhode Island and attained control of New England Dairies in Hartford,
Connecticut....

"Finally, on June 1, 2000, Suiza/Garelick commenced supplying private label milk
as well as Garelick brand milk to Stop & Shop. Prior to that, for the entire period
from February 1966, Stop & Shop processed its own private label milk in addition
to processing and distributing the Hood milk that it sold in its supermarkets....

"After the June 2000 closing of the Stop & Shop plant Suiza controls 64 percent of
the New England supermarket channel."

Finally, the study seeks to bring the industry’s structure and its pricing patterns
together:

"Given this very major increase in processor concentration in the New England
market, we conclude that the Garelick and private label retail price moves in 1999
and 2000 that widen the marketing margin are at least in part due to price
leadership by Suiza-Garelick at the processor level as well as the exercising of
market power by supermarket chains at the retail level."

Though its name has an unfortunate ring of collusion, the compact’s creators saw
it as a friendly compact between consumers and farmers — an agreement that
they would all be better off in a less volatile market.

Given the modest 4.5 cents that, according to the study, the compact added to
processors’ costs, it was perhaps a reasonable assumption that the middlemen
could absorb it and leave consumers unaffected.

But in believing the middlemen would absorb it, the compact’s creators
underestimated their market power, their political acumen, their greed, or all
three.

And farmers, surely, can’t be blamed for the 11-cent price increase that, the study
says, is pure profit to the middlemen.

How has it worked out for farmers?

Quite well, according to the study. Its impact on dairy farm income in New
England is far greater than the $19-million the consumers have contributed.

That’s because, on the farm if not in the supermarket, it has worked they way its
creators thought it would.

In round numbers, the study agrees with the Compact Commission’s finding that it
generated more than $120-million in increased farm income. Over the study’s
three-year period, it puts the number at $128.5-million. The supermarkets’
40-percent share of that is $51.5-million. Subtracting the $19-million paid by
consumers leaves another $32.5-million.

And that, says the study, came from the periods when the federally regulated price
fell through the compact’s floor, and the middlemen paid the premium.

It’s worth noting that compact premiums are never good news for farmers. They
arrive only when the federally regulated price drops sharply. Premiums are no
bonanza for farmers, just a thin cushion as their income collapses.

In one of its strongest passages, the study proposes another service the Compact
Commission could provide.

"There is a need to monitor the price and margin performance of the New England
milk industry," it says. "There is a need to ensure that competition is effective, and
that consumer milk prices accurately reflect the cost of producing, processing, and
distributing milk. The commission’s work could contribute to future antitrust
enforcement or eliminate the need for enforcement if firms respond competitively
to public scrutiny."

In their close study of the New England market for milk, Mr. Cotterill and Mr.
Franklin came to a conclusion that has disturbing implications for the nation’s
public policy on dairy farming.

It has to do with an economic concept called price elasticity.

That’s a measure of how sales respond to price. If elasticity is low, an increase in
price will pretty much be captured whole as an increase in revenue — and hence
profit.

If elasticity is high, a price increase can reduce sales so much that revenues will
actually decline.

Economists try to draw elasticity curves for particular products. They change
along with price, approaching the critical point where another price increase will
only reduce revenues.

Milk is a complex product because it’s used in so many different ways. Each dairy
product has its own elasticity curve — a calculation that reflects how badly people
want it, and what substitutes are available.

Federal policy on dairy prices is calculated to clear the market. The price for milk
that goes into manufactured dairy products reflects the market value of those
products, particularly of cheese.

But fresh milk has a special place in the American diet, and no real substitutes.
Over time, mothers may be deciding to put less milk on the breakfast table. But
those decisions probably aren’t based on a drop in the price of Coke.

In economic terms, the demand for fresh milk is not very elastic. And that gives
federal regulators an opportunity to put higher prices on fresh milk and keep a
region’s dairy farms alive.

But if middlemen enjoy enough market control, the study worries, they may
eventually push fresh milk prices far enough up the elasticity curve to make any
further increases counterproductive.

If that happened, the federal dairy pricing system would collapse, and New
Englanders would have to get used to milk that is trucked in from Wisconsin or
California.

Here is how the University of Connecticut report concludes:

"The need for effective competition is even more critical in the fluid milk industry
than other food industries. Increasing concentration and the exercise of market
power in the channel by processors and retailers is a direct attack on the classified
pricing system of the Federal Milk Marketing Order system and the Northeast
Dairy Compact.

"Classified pricing sets a price for milk sold to processors of fluid milk (the inelastic
product) that is higher than the price for milk used in manufacturing (elastic
products).

"Since the 1930s, the U.S. Congress and state legislatures have used or authorized
the use of classified pricing to stabilize and increase dairy farm income. In an
effectively competitive milk marketing channel, the inelastic fluid market demand
curve can only be exploited by government and in a fashion that is deemed in the
public interest."

But private market control can end that, the study warns:

"As milk channel firms exercise market power to elevate prices, inelastic demand
becomes more elastic. As a result, the ability of public agencies to increase dairy
farm income via classified pricing is reduced. If milk prices are elevated to the
level where market demand is elastic, then public classified pricing programs are
completely ineffective.

"Is this the future of the U.S. dairy industry?"