Price Elasticity and Milk Market Supply & Demand

Introduction to Milk Market Dynamics

The market for milk provides a useful case study for applying fundamental microeconomic principles. By examining how different shocks — shifts in consumer behavior, disease outbreaks, price changes, and government regulation — affect supply and demand, it is possible to trace short-run and long-run market adjustments. The following analysis also considers the price elasticity of demand for milk and its implications for producer pricing incentives.

Demand and Supply Scenarios for Milk

If more people start eating cereal for breakfast, the demand for milk will increase. While some consumers will use soy milk or other milk substitutes, the vast majority will use dairy milk on their cereal. Assuming there is no slack demand in the milk industry, suppliers will not be able to increase supply immediately, because they are constrained by the need to purchase cows and equipment. Thus, in the short run, demand for milk will rise while supply remains unchanged. In an unregulated market, this increase in demand without a corresponding increase in supply will result in a higher price. Rising prices will increase profits for producers, encouraging new producers to enter the industry or existing producers to expand capacity. Over the long run, this will increase the overall supply of milk in the economy.

If a mad cow disease epidemic occurs, demand for milk should be expected to decrease. Consumers would either cut back on milk consumption, eliminate it altogether, or seek out substitutes. The quantity demanded would decline in the short run. At the same time, producers would not be able to reduce production immediately, since investments in cattle would already have been made. With decreased quantity demanded and no immediate change in supply, there would be a short-run surplus of milk. This problem would be compounded by the fact that, in the event of a mad cow outbreak, other nations would likely close their borders to American milk exports, preventing producers from selling their surplus elsewhere. The result would be a glut of milk on the market, forcing prices to fall in order for producers to sell all of the milk they produced. In the long run, the combination of low demand and low prices would force many producers out of the market, ultimately reducing the quantity of milk supplied.

If the price of milk increases, the quantity demanded will decrease. However, milk is a staple product and is not easily substituted for most people. As a result, demand will not fall sharply even with a price increase; the quantity demanded will only decline modestly. Producers are likely to see a net increase in profit. They will sell a slightly lower quantity of milk and make small adjustments to their supply, but they will earn more on each gallon produced and therefore will see total profits rise.

If the government implements a price ceiling on milk, the intention is presumably to help consumers afford milk. However, the costs associated with producing milk would not be subject to the ceiling. In the short run, if the price ceiling is set at a reasonable level, there will not be much immediate change in the milk market — consumers will demand roughly the same amount, and producers will supply roughly the same amount.

Over time, however, the price of milk will eventually hit the ceiling. At that point, producers will see their profits reduced, because rising production costs can no longer be passed on to consumers. Profits for milk producers will decrease, and over the long run some producers will leave the market. The producers that remain will be those capable of producing most efficiently, with the lowest per-gallon cost of production. The total supply of milk might remain stable initially, because these high-efficiency producers may still be able to earn profits at that level of output.

In the long run, however, the artificially low price will sustain demand at above-equilibrium levels while keeping available profits below equilibrium levels. As producers reach a point of diminishing returns in their efforts to cut costs, the market will become increasingly distorted. The government will ultimately be forced to raise the price ceiling to ensure that enough producers remain in the market. In this way, the price ceiling creates a situation in which active, ongoing government management is required simply to maintain a functioning milk market.

There are several factors that contribute to the price elasticity of demand for milk. One factor is the availability of substitutes. For milk, many substitutes exist, including soy milk, almond milk, and other plant-based alternatives. A closely related factor is the propensity to substitute. For most consumers, there is a relatively low propensity to substitute milk with other products. However, as milk alternatives become more mainstream, this propensity is likely to increase over time.

Factors Affecting Price Elasticity of Demand

Another factor is how essential the product is. For many people, milk is an important part of their diet — if not directly, then in the form of dairy products such as cheese, butter, yogurt, or ice cream. Because milk and its derivatives are staple goods, consumers are hesitant to reduce consumption, contributing to a low level of price elasticity.

A fourth factor is the cost of the product relative to the consumer's total budget. Products that represent only a minor portion of household spending tend to exhibit low elasticity. For example, a 10% increase in the price of milk might amount to an increase of about 30 cents per gallon — perhaps 30 to 60 cents per week for a typical household. By contrast, a 10% increase in the price of gasoline could translate to a similar per-gallon increase but represents $3 to $6 more per week, a far more significant burden. Because milk spending is a small share of most household budgets, consumers are less sensitive to its price changes.