By Koos Coetzee, MPO economist
“It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity, but to their self-love.” – Adam Smith (1723–1790)
Adam Smith’s writings clearly emphasise the philosophy that translates into deregulated markets. The South African dairy value chain is one such deregulated market, where prices determination is left to the free market.
In theory prices are determined by the interaction between supply and demand. If the supply increases, the price will decrease and discourage production. If production decreases, prices will increase to encourage higher production. This also applies to a change in demand. Higher prices will lead to a drop in demand, which in turn will lead to lower prices. According to Smith, fondly known as the father of modern economics, everyone’s selfishness and self-interest are the cause of prices which bring supply and demand into balance.
This almost magical effect of the market mechanism takes place through what Smith calls ‘an invisible hand’. However, a market has to meet a number of requirements to accommodate perfect competition, thereby bringing supply and demand into balance.
The key requirements are, among others, that market players on the supply and demand side must be equal. This means that they should have equal market force.
Firstly there needs to be a great number of role-players on both sides. Secondly, the product has to be homogenous and uniform and preferably not perishable. Thirdly, it must be possible to adjust production to demand, and consumers need to actually react to prices by buying more or less. There shouldn’t be any significant limitations on entry or exit from the production and demand sides of the chain.
It is clear that the requirements of perfect competition do not apply to the farm-to-table dairy value chain. The product is perishable and there are numerous producers – currently 1 650 – supplying to a smaller number of processors, of which the four biggest ones handle approximately 56% of the total supply. Processors supply dairy products to retailers, and the largest four handle approximately 75% of all dairy products.
Milk production is a biological and non-industrial process. Therefore, producers cannot readily adjust production to price signals. The large capital investment in the primary dairy industry makes it rather expensive and difficult to gain entry into the industry.
Research by Prof Johan Kirsten of the University of Pretoria (UP), commissioned by the National Agricultural Marketing Council (NAMC) and the Milk Producers’ Organisation (MPO), clearly indicates that the strongest market force is in the hands of the large retail chain stores.
In practice, retailers determine the shelf price, decide on an acceptable margin and declare what they are prepared to pay the processor. Processors in turn decide individually what they are prepared to pay milk producers. This is usually just enough to ensure production.
Milk producers will continue to produce if the price covers their variable costs, even if it doesn’t cover their overall expenses. This means that producers can be intimidated for a while by prices that do not cover their total costs.
Producer price determinants
From the above it is clear that Smith’s ‘invisible hand’ does not determine prices in the dairy value chain. In 2014 the MPO tasked the Bureau for Food and Agricultural Policy (BFAP) at UP to conduct an empirical study into the factors determining producer prices.
The following factors were found to significantly influence the average producer price:
- Retail prices.
- Livestock feed prices.
- Import parity.
A regression model based on these three factors provided a reasonable fit to the available data. This model, however, has not worked as well as a prediction model, mainly since it could not accommodate external shocks such as a unilateral price reduction by Dairy Belle. Currently the model is being evaluated to determine whether it has possible predictive value. From the analysis it would appear that retail prices have to increase before an increase in producer prices are possible.
Can producers influence prices?
Milk producers can influence prices to a lesser extent. Producers can ensure that they have precise production cost information to convince buyers that producer prices need to increase. Actions leading to increased compliance with the requirements for perfect competition, will lead to a more equitable distribution of market forces.
Producers can increase their bargaining power by establishing joint businesses. A good example is Coega Dairy in the Eastern Cape. Such a business should add value to the product, and not only represent a bargaining forum. Members of these types of businesses should not expect better producer prices, but rather share in the profits of the enterprise over the long term.
Individual producers can move upwards in the value chain. Many producers process their own milk and sell their dairy products to retailers or even directly to the consumer. In such cases it is essential to add value to the products and not simply enter the market based on the lowest cost. There is danger in another producer being prepared to supply products to the market at an even lower price.
Role of the MPO
Competition legislation prohibits the MPO, and even groups of farmers, to collectively negotiate prices. The role of the MPO is to influence the macro-environment within which milk producers operate as far as possible, in order to ensure fair competition.
In the free market, prices are determined by those who possess market power. In the case of the dairy value chain, the largest share of market power is in the hands of retailers, while a smaller share is in the hands of processors. Milk producers possess virtually no market power, but they can take steps to ensure a fairer price.
For more information, phone Dr Koos Coetzee on 012 843 5600. Visit the MPO website at www.mpo.co.za for more information.