Milk Prices at the Farm and at the Store: What Gives?
Milk Prices at the Farm and at the Store: What Gives?

Dr. E. Bruce Godfrey
USU Extension Economics Specialist

     One complaint often voiced by dairy farmers is the difference between the price they are paid for milk and the price of fluid milk in the grocery store. Consumers also complain that supermarkets �gouge� consumers by raising the retail price of milk faster and farther than the prices paid dairymen increase. A number of reasons can be given for these differences, but they all center on a term referred to as marketing margin�the difference between retail and producer prices. One reason why the total marketing margin has increased over time stems from the fact that a smaller portion of the milk produced is going into fluid consumption, and the portion that is consumed as fluid milk is increasingly low fat milk. All of these changes require processing and handling activities that increase the total marketing margin. This however, does not explain all of the differences that may exist.

     No research has been done in the intermountain area on marketing margins, but some insights can be gained by a recent study done by Dr. Hoy F. Carmen at UC-Davis concerning marketing margins in the Los Angeles, San Francisco and Sacramento markets from January 1985 through March 1997. The following quotes from a paper by Dr. Carmen were taken from a recent article published in Choices (First Quarter 1999) and outline some of the reasons why differences in the price of fluid milk at the farm and retail levels may exist.

     �Contrary to the perceptions of many, I found a strong direct relationship between California retail and farm-level milk prices in each market area. Retailers increased their prices in response to free on board (FOB) price increases and they also reduced prices in response to FOB price decreases. I found no statistical difference in the total amount that retail prices increase or decrease in response to a one-dollar producer price increase or decrease. Retailers do, however, take a month longer to fully respond to a farm price decrease than to a farm price increase, and this delay can benefit retailers at the expense of consumers.

     I cannot fully explain the cause of this asymmetric timing of retail price adjustments. Other economists have observed the same lags for other perishable commodities. Some portion of the observed price behavior could be due to the actions of processors and wholesalers in response to farm price changes, but I do not have data for these sectors. Lag differences could also be due to the nature of competitive price adjustments in food retailing, or they could result from market power. One hypothesis holds that the observed price behavior is consistent with supermarket pricing practices for goods, such as milk, which have inelastic demand. With inelastic demand, total revenue increases with a price increase and decreases with a price decrease. Thus, retailers may be much more reluctant to reduce prices than to raise them. This reluctance is especially evident when using gross margin pricing because of the adverse impact of price reductions on gross margins, even for goods with elastic demand. Retailers may not respond to a price decrease until they observe a decrease in unit sales, or until they become concerned about an actual or possible loss in market share. . . . When producer prices decrease, however, each retailer can temporarily improve profit margins by slowly reducing prices in response to the consumer search process. As customers gain knowledge of comparative prices and respond, prices (and margins) will be pushed down to a competitive level. Finally, the observed price behavior could be the result of price leadership in markets with a few large participants. Using this explanation, large retailers would wait for their major direct competitors to reduce prices before following, in order to avoid the adverse effects of �price war� type behavior on profits.

     While there are several possible explanations for the observed relationships between farm and retail fluid milk prices in California, the specific reasons have not been isolated. What I can conclude, however, is that the false perception that California retail milk prices tend to only increase and not respond to producer price decreases appears to be largely due to the one-month lagged delay of retail price decreases in response to farm price decreases.�