Political market power reflected in milk pricing regulations.(Report)

Government policies that control quantity supplied or price may have effects on the market that are similar to those of monopolists or oligopolists that exercise market power. Numerous studies examine the effects of these policies but relatively few studies investigate the political power of producers that make these policies possible. Often, the political power of producers imputed by policies is assessed in the context of political equilibrium between interest groups, as in Krueger (1974) and Zusman (1976). The political equilibrium attained by policies has often been explored using the policy preference function, as in Rausser and Freebairn (1974), Gardner (1987), Beghin and Foster (1992), Buccola and Sukume (1993), and Dutt and Mitra (2005). (1)

In the policy preference function approach, the implementation of policy is understood as the regulator's decision to maximize a weighted social welfare. Different sets of welfare weights between interest groups yield different levels of implemented policy. The welfare weights in the policy preference function indicate political power, since the regulator's assignment of welfare weights to each interest group is affected by relative political power between those groups. In this context, studies assess political power using the welfare weights imputed by the observed level of policy. Notable examples include Rausser and Freebairn (1974), Gardner (1987) and several articles surveyed in de Gorter and Swinnen (2002). However, these studies do not address the link between the implemented levels of policy and market power, and do not consider politically created market power. We extend this literature by drawing the explicit parallel with Ramsey pricing (Grossman and Helpman 1994).

This paper explores revealed political market power reflected in prices of a government-organized cartel that practices price discrimination, but does not control overall production. We develop methodology to assess the market power created by policies that are driven by the relative political power of interest groups.

First, to incorporate key characteristics of milk price policy, we develop a model of price differentials that simultaneously allows monopoly solutions in regional beverage milk markets and a Nash equilibrium in the national market for manufacturing milk products. This approach extends an oligopoly model to characterize government-sanctioned regional cartels that act as monopolists in regional beverage milk markets and oligopolists in the national market for manufacturing milk products. We simulate the implied price differentials with representative parameters for demand and supply elasticities. The announced price differentials are about 7% of simulated price differentials, implying that the government-set prices are far below those that maximize producer returns and are consistent with a significant role for buyers and others in the political process.

Second, we also develop a model of policy preference functions that allows for several regional regulators. In this model, regional administrators consider the effects of their local price regulations on both the regional markets for raw milk used in beverage products and the impact on the national manufacturing milk price. As with the oligopoly model, we conduct a simulation using broadly accepted elasticities from the literature. In this case, we derive welfare weights that are implied by actual price differentials. The derived welfare weights imply that the political market power of milk producers is also about 7% of that implied by full monopoly power.

The U.S. dairy industry is large, geographically diverse, and governed by a complex array of government programs. The farm value of milk production in the United States was about $34 billion in 2007 and the retail value of dairy products was several times this value. Thus understanding the effects of political market power in milk pricing is of interest in its own right. Furthermore, examining market power implied by the government-run dairy cartel is helpful in understanding government regulation of industry pricing more broadly.

A Conceptual Framework for Assessing Political Market Power

The standard form of policy (or political) preference function considers producers and consumers as interest groups in the political market. Consider the following equation:

(1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where w is the welfare weight, Z(P) is the surplus for consumers, [PI] (P) is the surplus for producers, and P is a policy instrument. In this setting, the observed policy level [bar.P] is understood as the one that maximizes the policy preference function, equation (1), given the welfare weight w.

The Relationship Between the Policy Preference Function Approach and Ramsey Pricing

The policy preference function can be understood in the spirit of Ramsey pricing (Ramsey 1927). The Ramsey price is typically described as the price that maximizes consumer surplus subject to a constraint of some fixed level (often zero) of firm profits. Milk marketing orders use price discrimination to shift surplus from consumers to producers. Thus the context is different but the same idea is applied.

To frame the regulation that shifts surplus from consumers to producers in a standard Ramsey pricing scheme, we consider the maximization of consumer surplus subject to a constraint that sets producer profits at a positive value, [[PI].sup.R]. We define this problem as [Max.sub.p] Z(P) subject to [PI] (P) [greater than or equal to] [[PI].sup.R], where Z(P) is the total surplus obtained by consumers, and P is a policy instrument. An equivalent mathematical expression of the problem is to maximize producer profits subject to a constraint on consumer welfare (i.e., [Max.sub.p] [PI](P) subject to Z(P) [greater than or equal to] [Z.sup.R]). When the policy instrument is price, this problem is the same as the standard Ramsey pricing problem, which is one form of second-best pricing for a regulated firm (Ramsey 1927; Baumol and Bradford 1970; Ross 1984).

The Lagrangian for this problem is

(2) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

We can rewrite X in equation (2) as w/(1 - w) and equation (2) becomes simply a different expression of equation (1). The policy level [bar.P] that maximizes equation (1) also maximizes the objective function of equation (2). Hence, we can understand the policy preference function in the spirit of the regulator's application of a Ramsey-Pricing scheme.

To interpret equation (1) in a Ramsey pricing framework, [lambda] must be positive, since the welfare weight w is understood to be between zero and one (neither group figures negatively in national welfare). In this case, positive [lambda] means producer profits will be [[PI].sup.R] by the condition of complementary slackness ([lambda]([PI] (P) - [[PI].sup.R]) = 0 and [lambda] [greater than or equal to] 0 or [PI](P) - [[PI].sup.R] [greater than or equal to] 0). Therefore the profits attained by producers at the policy level [bar.P] reflect the profits that the regulator wants to achieve and larger values of [lambda], or larger values of w, correspond to higher producer profits.

Two Ways of Assessing the Degree of Political Market Power

We develop two distinct but related approaches to measure the degree of political market power. The first is to measure the welfare weight w or its transformed value, [lambda]. The policy preference function of equation (1) includes three interesting special cases as presented in table 1. When the welfare weight is 1, the problem defined by equation (1) is the profit maximization problem of a monopoly or cartel of producers. When the welfare weight is 0.5, maximizing the policy preference (with equal weights for the two groups) is equivalent to maximizing social welfare, so the solution is a competitive equilibrium. When the welfare weight is between 0.5 and 1, the policy solution, for the government-set price in our case, is between the competitive equilibrium and the monopoly. This yields price and producer surplus that are between a pure monopoly and a competitive industry and therefore equivalent to an equilibrium in an oligopoly market. We assume in our application that producers have more weight than buyers and that producers will not restrict output below the monopoly optimum. These cases help us see the translation between political power and analogous market power.

In our application we show later that there is a one-to-one relationship between w and policy level P, and between w and the degree of market power. Therefore, we can employ two methods of assessing the degree of political market power reflected in the observed policy level [bar.P]. If we derive the welfare weight [bar.w] that is implied by the observed policy level [bar.P], we can assess the degree of political market power reflected in [bar.P] by calculating ([bar.w] - 0.5)/(1 - 0.5). This is our first definition of political market power. It measures the degree to which the welfare weight diverges from the competitive solution in percentage terms.

Next, we can derive the policy level [P.sub.m] (the monopoly price), which is the solution of equation (1) under w = 1. The degree of political market power reflected in [bar.P] can be measured by ([bar.P] - [P.sub.0])/([P.sub.m] - [P.sub.0]), where [P.sub.0] is the policy level that yields the competitive solution. (In a Ramsey pricing setting, [P.sub.0] is the competitive price determined by supply and demand). These two approaches are closely related, but, as we find below for several regions, the two approaches do not yield the same numerical result as elasticities of demand vary. The correspondence between our two indexes of political market power depends on the slopes of demand functions as represented by the elasticity of demand.

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