Wednesday, 10 November 2010

Economic theory suggests an investigation of the milk market

One of the most common complaints by students when teaching economics is the fact that the government has not done anything to reduce the price of milk in Cyprus. The government has first tried by suggesting an unwise maximum price and then has done nothing over the issue as it is unsure if the high price is due to illegal price fixing.

Yet economic theory suggests that the government should do more to pressure the milk firms. The milk market is an oligopoly market: there are very few firms and their revenues are directly influenced from each other. As a result firms in an oligopoly market are directly dependent to each other in terms in terms of their pricing policy and profitability.

Thus, oligopolistic firms, such as the milk companies, face a dilemma. They dislike competing on price: if they decide to reduce their own price, it might lead to the reduction of the competitor’s price, reducing the profit of all firms in the market. However in such markets there is keen non-price competition as firms they strive to convince the consumers that their product is better in order to make consumers loyal even if the competitor has a price advantage. A good example of a successful loyalty campaign is by coka-cola: how many people do you know that would not drink Pepsi if “Coke” was not available?

Oligopolistic firms in Cyprus do compete using non-price means through mass advertising and product differentiation. You can pretty much bet that 9 out of 10 advertisements on the TV are from firms in oligopoly markets, striving to convince consumers that their products are different and better: banks, diapers, sanitary pads, broadband services and supermarkets in Cyprus spend massively on advertising but are less keen to compete on price.

This is where the milk market is suspect. The non-price competition of the milk market has been lukewarm at best; when was the last time you remember a two for one special offer on milk? There is some advertising and some product differentiation for premium products, but its intensity is nothing like the other markets under oligopolistic competition in Cyprus. Thus an investigation by the government would be suggested by the theory as milk companies might be co-operating in illegally fixing prices as suggested by the relative paucity of their non-price competition.

Other factors also point out that the Cypriot milk market is a ripe contender for collusion. The limited number of companies makes secret price fixing negotiation easier. In addition unlike other oligopolistic markets, the milk market is quite isolated from non-Cypriot competition. Our lack of rapid direct access to other European markets means that the Cypriot companies are not facing the same level of competition than in other Cypriot markets by foreign companies: we buy Danish and Greek cheese as it does not spoil as easily as fresh milk, but it is difficult to see Cypriot consumers preferring Greek fresh milk as there would be valid doubts about its freshness.

The wise solution is not a maximum price of milk as this could lead to chronic shortages of such a basic commodity. The solution is the beginning of an formal investigation, in a national or EU level, with the promise of immunity from damages to any company that first provides evidence of a price fixing cartel. This will reduce the incentives of anyone in the cartel, and allow companies to damage the competition by admitting to price fixing. This common practise of the EU might provide the answer to whether there is collusion, of the market, and give the possibility to firms to clear their name and satisfy my students that the current price of milk is the lowest these companies can aspire.

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