The Price of Milk – domestic, world markets and Fonterra

Milk seems like such a nice friendly product, but in New Zealand the rising cost of the essential good is getting everyone annoyed. In the past 5 years the price of dairy products in New Zealand has risen by 50%. Most assume that because of New Zealand’s comparative advantage (good weather, soils, grass growth and livestock) farmers produce milk in such great quantities that it should therefore also be cheap for consumers at the local shop. Our understanding of international trade is that it alters the domestic market, might suggest that firms who export on the global market are focused and motivated by world prices.

The NZ milk market

Fonterra is a virtual monopsony in New Zealand. This is like a monopoly except that the cooperative it is the sole buyer of raw milk products in New Zealand. It then sells 95% of its production of refined milk products to consumers around the world. The company supplies around 40% of global dairy product exports, and is by far New Zealand’s biggest company.

The world market for milk

Milk is a commodity that is traded on the international market and is traded according to the forces of world supply and world demand. These forces and the equlibrium of this market determines the world price of milk. Over the past five years more consumer globally in countries such as China, Indonesia and India have entered the middle income group and have begun to consume dairy products and feed their babies milk formula. In theory this will have likely caused a gradual shift of market demand to the left, we can also assume that as technology becomes more efficient global production has increased slowly at each price level.

The diagram above shows the link between the domestic and world markets. NZ producers milk at a low price due to the it’s comparative advantages. This means that suppliers see an attractively higher price available on the international markets. Assuming free markets NZ farmers will sell their milk products in global markets at higher prices. They therefore also charge New Zealand milk consumers the same high world price as there is no incentive to offer the quantity of milk to NZ consumers at a lower price. The main loser in the trade situation is the NZ family who has to pay more for milk. As you can also see when the world demand increases, the world price rises also forcing the NZ price to rise to NZ consumers to reduce consumption of milk. (shifting left along the demand curve)

Articles from Fonterra explain the upwards price forces currently working in the global milk market…

“Looking forward global food prices are expected to remain strong. This is not just an issue for dairy or just an issue for New Zealand. There has been a fundamental change in supply and demand for food internationally which has pushed prices to their current levels.

“While these prices are good for food exports and the New Zealand economy, New Zealanders are feeling the effects of this in their shopping trolley.

Should Fonterra morally sell milk to NZ consumers at lower prices?

Economically there is no incentive for them, but morally maybe there is and this is why the NZ government has stepped in and ordered and euquiry to how milk prices are determined. Fonterra voluntarily froze milk prices recently which seems like an odd policy from a company. Maybe firms are also motivated by factors other the profit, see comments from the above Fonterra press release here…

”We recognise milk is an important part of the diet in New Zealand and we want to ensure that future generations of New Zealanders grow up enjoying it every day. It would be great to see retailers getting in behind this commitment for the benefit of New Zealand consumers.

Fonterra Brands New Zealand Managing Director Peter McClure said: “Global price increases will continue to impact the price that dairy manufacturers like ourselves pay, however, we want milk to remain an every day part of the Kiwi diet so we’ve made a commitment to absorb any extra costs for the rest of the year.“

Morally maybe the company should offer milk at lower prices, milk is known to be a positive externality for children and adults. The company also used New Zealand’s natural resources to produce the milk. It is also a cooperative so the owners of the company are the farmers who sell the milk to the Fonterra factories. They also want to maintain profitability even if only 5% of the companies production is sold domestically.

To me this is an interesting case study. Firms who trade internationally face an interesting dilemma on the impact on domestic customers but generally this is considered an acceptable downside of trade. Fonterra in NZ after much public and political pressure have gone down a different track.

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