Peter Lyons: Trade truths behind great milk 'rip off'

Exporting milk and dairy products reduces the supply available for our local market, which pushes up prices. Photo / Paul Estcourt

So now we are having a parliamentary select committee on the price of milk sold in New Zealand. Our politicians are keen to be seen to be responding to the public outcry at the perceived price gouging by Fonterra or the supermarkets or both.

I have been teaching my students the basic theory of international trade, so it seemed an ideal task to get them to investigate whether Kiwi consumers are being ripped off in what they pay for milk. The theory suggests that local consumers should be paying about the same price as overseas consumers after adjustments, transport costs and exchange-rate fluctuations.

Economic theory predicts that if a country is an exporter of a good, then this reduces the supply available for the local market. This should push up the price of the good towards the world price. Firms will seek the market that provides the highest margin for their product. Much of the milk produced in New Zealand is processed into export products such as cheese, butter and milk powder. Although we don't export much drinking milk, the theory should still apply.

I sent my class off to investigate the retail price of 2 litres of whole milk in New Zealand and other countries to see if the great milk rip-off was a reality or a beat-up. One of the difficulties the students encountered was the variety of prices that retailers charge within each country. Retailers are aware that consumers have different shopping preferences and so charge accordingly.

Some supermarkets cater for the affluent and image conscious who would not be seen dead buying a Pams or Budget brand. Other supermarkets cater for budget-conscious consumers who represent the bulk of the population. We focused on the supermarkets that cater to the more price-conscious consumers and converted prices to NZ dollars.

The figures in the accompanying table represent an unscientific survey of mainstream retailers. The results are an average price for the particular retailer as prices can vary significantly between stores in different locations. This is likely because of transportation costs.

Several things become apparent in such a quick survey. Rising milk prices are a major concern in most countries, with the glaring exception of one. Australia has bucked the trend with significant retail-price falls. This is a likely reason why the milk-price debate is so heated in New Zealand. How come we are paying so much more than our neighbour when we are acknowledged as the more efficient producer?

There are several reasons. Milk is not subject to GST across the Ditch. The two main supermarket chains in Australia (Coles and Woolworths) have been engaged in a milk-price war to attract customers through the door. They have been selling drinking milk at a loss, hence the remarkably low prices. Ironically the Australian Commerce Commission launched an inquiry into the low prices for milk and whether this was harming the dairy industry in Australia.

There is a further reason for the low prices of retail milk in Australia. Their milk-processing industry is struggling, particularly in New South Wales and Queensland. The margins between what they have to pay their farmers and what they get for exports, such as cheese and butter, are too low. The likely reason for the high farm-gate prices is that farmers in these regions need higher prices to stay in business because of the less-favourable growing conditions. This means that milk is not being processed into higher-value products for export. The output of these dairy farms is being dumped on the local market as drinking milk, which further depresses retail milk prices. The lower milk prices are a symptom of an ailing industry that struggles to compete in the lucrative export market for processed milk products.

None of this is to deny that there may be some price gouging going on in the wholesale or retail milk market in New Zealand. But the size of the problem is not as excessive as it first appears when retail prices are compared with Australia.

The high retail prices that New Zealand consumers are paying for milk, cheese and butter are the flip side of the cheap televisions, cars, mobile phones, clothing, computers and electronics that we buy from overseas. We are a country that has embraced free trade as an economic policy. This means much of the stuff that we produce, because we are good at making it, is put into ships and planes and sent overseas. Ships and planes then bring back the stuff that we are not good at producing.

This is how international trade works. In such a world, having lots of cows and sheep does not ensure that we get cheap milk and meat.

* Peter Lyons teaches economics at St Peter's College in Epsom and has written several economics texts.