An Approach To Ensuring Efficient Price Setting By Global Dairy Company

6 April 2001

Charles River Associates

1. INTRODUCTION

   The proponents of the Global Dairy Company (GDC) have indicated that they are committed to retention of the co-operative form of business organisation. This means that farmers must invest capital in the "processing" operations of GDC in proportion to the milk that they expect to supply. Efficiency requires that farmers may enter or exit¹ GDC at the fair market value of their investment but there is no external market mechanism to establish that value. A fair market value for the processing assets of GDC, and for the raw milk that farmers supply is necessary to ensure that the performance of investment in different assets can be assessed. Efficiency also requires that the milk supplied to and the capital invested in GDC earn competitive returns for farmers despite the absence of effective domestic competition in this market. The returns paid to farmers will provide a benchmark against which the pricing of wholesale milk contracts for processing companies may be benchmarked.²

   In our view, an effective and efficient means of ensuring efficient pricing by GDC is to ensure that GDC has incentives to use that information that it has to establish fair market values, and that the management of GDC bear the consequences of the pricing decisions that they make. As we explain below, open entry to and exit from GDC is a necessary condition for GDC to have the incentives to set and make a market at the efficient prices.

2. THE ECONOMIC EFFICIENCY OF CO-OPERATIVES

   Dairy co-operatives in New Zealand currently have the power to decline applica-tions for membership and to inhibit exit by retaining the value of the exiting farmer's processing capital in the co-operative for up to five years. If dairy farm-ers had a choice of co-operatives then all institutional structures in the dairy indus-try, including restrictions on entry to and exit from each co-operative, and all prices set within the industry, would be competitively determined. In this case, there would be no economic efficiency issues raised by the institutional structures and pricing policies in the industry. The situation with respect to the Global Dairy Company (GDC) is different because its initial market position will approximate that of a monopsonist (a monopoly purchaser of raw milk and manufacturer of dairy products). This means that whatever the competitive origins of specific practices and institutional structures, these practices have the potential to be used in ways that will reduce efficiency. Under conditions of monopoly, GDC will have the information to calculate the efficient prices for milk and the true value of its equity shares, but it may lack the incentives to publicise and pay these prices.

3. THE USE OF INCENTIVES TO REDUCE REGULATORY COSTS AND PROMOTE MARKET EFFICIENCY

   In this section we explore a proposal that creates the potential to create incentives for GDC to set efficient prices even though it will have a near monopoly position in the market.

   3.1 IS BUNDLING INEFFICIENT?
   We begin by considering whether bundling is, in itself, a barrier to efficiency in the dairy industry (as has often been claimed). The claimed problems with bundling arise from two sources. The first is bundling the return on processing capital in the pay-out to farmers. This is inherent to co-ops in that these entities arise, or result in, situations where there is not a competitive contract market for raw milk and hence no price determined in a thick market. However, this form of (processor) bundling need not predispose economic inefficiency because farmers will consider their supply cost of raw milk and the capital requirements as their (marginal) cost of entry. Entry may be too high, too low or just right depending upon a number of factors that include economies of scale. There is no requirement for products to be sold in competitive (commodity) markets for this result to hold. It remains valid providing that the co-operative is earning a competitive return in processing marketing and product differentiation investment and there is open entry and exit.

   The second form of bundling is where the returns from milk in high value markets are bundled together with returns from milk commodity markets and result in a bundled price to farmers that will predispose inefficient over-production. Because milk is essentially homogeneous, the efficient milk price to farmers is the price in its lowest value use (the commodity milk price). Any higher returns from, for example, product differentiation will be included in the returns to processing and marketing and thereby reflected in the valuations of these activities. Co-operative shareholdings are also tied to the milk that farmers supply, but if the value of any excess returns is reflected in the capital required of farmers for entry or exit then efficiency can be approximated under the co-operative structure.

   3.2 INCENTIVES FOR GDC TO SET THE EFFICIENT PRICE AND FAIR VALUE
   The operation of a vertically integrated dairy company is a complex business requiring knowledge of domestic and international markets. GDC has the most complete information about its business and the markets in which it operates, and therefore is more informed than any other party about the milk price and share value associated with its business.

   GDC will have strong incentives to set the correct valuation of processing capital (equivalent to the fair value price) and the efficient price for milk. If it over-values the capital relative to milk there will be a demand for exit by farmers: if it sets this value too low there will be a demand for entry. In short there may be strong incentives for the co-operative to set the "right" value of process capital however it does the estimation.³ It is noteworthy that GDC has every incentive to consider future prices, costs and performance in its pay-out and capital valuation, in addition to the demands of the present.⁴ The pay-out therefore is to a significant degree forward-looking, and the separation of the milk price and the return on investment in the co-operative will therefore provide the best public estimate of the value of the processing capital.

   However, a necessary condition for GDC to have the right incentives in setting the valuations is that entry and exit of farmers be completely uninhibited: farmers have to be able to respond to GDC's price signals and GDC has to control entry only through the pay-out and exit-entry capital requirements that apply to all farmers. A parallel can be drawn with telecommunications where the incumbent cannot prohibit connection to its network, but the interconnect price remains to be determined. In this case GDC must allow entry and exit but at a price set by GDC, and, we shall argue, with minimal regulatory oversight.

   Open exit simply means that the exiting farmers get the value of their capital at the time they exit.⁵ Open entry means that GDC has to accept any farmers' planned supply of milk if accompanied by the appropriate share capital. Despite the limitations resulting from the lumpiness of investment in factory capacity, GDC will be able to manage free entry with near monopoly coverage and planning periods of one dairy season in length. In short, by open entry we mean that GDC should be open to any planned entry by farmers but we do not mean that GDC has to accept milk that a farmer supplies opportunistically (e.g unplanned output expansion) or attempts to supply without supplying shareholder funds.

   By the right amount of entry and exit we mean that the last co-operative farmer member just covers its on-farm costs of supply and (annualised) payment for the processing capital it must provide. This will generally be economically efficient given the choice of a co-operative structure.

1. By entry and exit we mean, unless otherwise stated, expansions and contractions in supply by existing farmers as well as entry and exit of farmers.

2. We note that the actual price paid by a purchaser or to a seller of wholesale milk will be endogenous to other terms of the contract (such as the allocation of risk-bearing relating to price fluctuations through time).

3. We do not prescribe how this price should be set. A range of approaches, from formal modelling based on expected future cash flows to simpler rules of thumb based on observed demand for entry or exit are feasible.

4. Although it be applied to the previous season's production.

5. Exit would be greatly facilitated by prohibiting GDC from owning or controlling any on-farm assets: performance, including quality, to be assured by contractual means.