The dairy paradox

British dairy farmers are leaving the industry in large numbers, but world milk and milk product prices are heading upwards fast. How can one explain this paradox? The simple answer is, of course, that the key UK liquid milk market is largely insulated from world market factors.

Wholesale milk has doubled in price on world markets over the last year. One factor is the surging demand for milk products in China and the Middle East as diets change in respond to surging incomes. Drought problems in Australia which crippled the country's dairy output has raised the wholesale price of skimmed milk powder by 60 per cent over six months. This is an input widely used by the food processing industty and over year it has increased in price from $2,000 per tonne to $4,800.

The latest Milk Development Council survey shows that 16 per cent of dairy producers, some 3,000 in total, intend to quit. Of course, some of those may have been departures anyway given the lack of successors. It is also worth noting that they tend to be smaller producers, as the loss of 16 per cent of producers is assumed to produce a 7 per cent fall in output (although this in part depends how far larger producers increase output).

Campaigners for dairy farmers often state that many of them are not making a profit. These statements need to be treated with a little caution as generally accounts include family labour as a cost before profits are calculated. Nevertheless, the sector has been under pressure.

The decision by Tesco to pay 22p a litre for retail milk sets something of an industry standard and is a lifeline for producers. Views differ about whether it was the result of the Competition Commission's increasingly vigorous interest in Tesco or the outcome of campaigning by dairy farmers through the NFU and other bodies. However, milk used for other products like cheese and butter generally yields a poorer return.

Some of this is feeding through into consumer prices. The home delivered pint at 48p per litre is likely to go up by a penny at most, but within the past year, the supermarket price of a pint of double cream has gone up from 91p to £1.12p, an increase of almost a quarter. Processed foods and cheese are likely to see a substantial impact, while Domino's Pizza is forecasting a 30 per cent rise in the cost of its products due to cheese price increases. Chocolate manufacturers have also taken a hit, although that has often been felt more in terms of a profits squeeze than by consumers.

Export refunds for dairy products have now been phased out which is a significant gain given they were at a level of €3.01bn in 1988 and even amounted to €725m last year. They could be reinstated if the market falls, but it is currently so buoyant that the Commission is talking of reducing the meetings of the Dairy Management Committee from twice to once a month. If export refunds remain at zero, EU spending in the dairy sector would be lower than revenue from superlevy, making the sector self-financing.

The Commission is determined to phase out dairy quotas by 2015, although discussion of how to achieve a 'soft landing' continues. There have been expressions of concern from economically marginal but politically influential dairy areas like Bavaria. One solution could be to use a 'national envelope' device to provide assistance.

The EU has historically had a structural surplus of milk, while Britain has not been self-sufficient because of its historical reliance on imported dairy products from the Commonwealth. A more market oriented system should benefit larger scale UK producers, who are among the most efficient in Europe, but pressure on smaller, more marginal and more peripheral farms would continue.