Milk quota removal could cost EU farmers €4 billion

The elimination of milk quotas as currently foreseen in 2015 will result in a loss to producers of €4 billion, and a gain to consumers of €3.7 billion, according to research by economists at the Institut d’Economie Industrielle in Toulouse. The group were asked to evaluate the impacts of the expiry of the EU milk quota system, comparing particularly a ‘soft landing’ scenario in which milk quotas are gradually increased between now and 2015, and a ‘hard landing scenario’ in which quotas are maintained until 2015 and then eliminated in that year. The ‘hard landing’ scenario postpones the adverse effects for producers both in competitive milk-producing countries (where quota rents are currently high) as well as in countries which currently are not meeting their quota. The analysis helps to explain why the Commission’s proposals in the Health Check to gradually increase the milk quota are being firmly resisted by a number of member states.

Methodology

To carry out their analysis, the Toulouse group use a quantitative model which is designed to capture the main characteristics of the EU milk production and processing sectors as accurately as possible although, as with all models, there is some inevitable simplification.

The model is a partial equilibrium one, meaning that it focuses only on the milk sector and does not take into account interactions with other commodity sectors. It is a dynamic model which is calibrated to the year 2005 and then used to construct a baseline out to 2015 and subsequently 2020. The impact of the quota removal scenarios is then compared to this baseline. World prices are assumed sufficiently high in the baseline that the EU is able to export dairy products without export subsidies and there is no demand for intervention. However, in the quota removal scenarios the projected fall in the butter price requires both re-opening intervention and the use of export subsidies.

The model takes account of the EU-25 as well as four importing regions (Commonwealth of Independent States, Africa and Middle East, Asia and the Americas) and one other exporting region (Oceania). The impact of changes in the EU’s net export surplus of dairy products on world market prices is an important element in the overall impact on EU economic welfare of quota removal.

A feature of the model is that it distinguishes between the two main components of milk, that is fat and protein, and requires a balance between the supply (in the raw milk) and uses (in final dairy products) of these two components. The model implicitly assumes that fat and protein are valued at the same level in all dairy products, which creates a very strong link between SMP and butter prices, on the one hand, and the prices of other dairy products, on the other hand.

Apart from the model structure, the main drivers of the results are the assumed price responsiveness of the milk supply and the quota rent at the time the milk quota is relaxed or abandoned. Supply response is captured in an own price elasticity ranging between 0.2 and 0.3 in the current year with much smaller impacts in following years. The information on milk quota rents is used to derive the value of the shadow milk price and thus marginal costs in the initial year. In EU15 member states, the medium-run marginal costs range from 50 to 70% of the farm milk price while the long-run marginal costs (which are the ones used in the analysis) are approximately 20 to 30% higher.

What do the results say?

The impact of removing milk quotas is projected to lead to an increase in EU milk production of 5.0% and a 10.3% decrease in the farm milk price (from the higher level it reaches under the baseline scenario). The decrease would be greater were it not for the assumption that intervention for butter kicks in and supports the butter price in the quota removal scenario. As compared to the baseline, producer income decreases by €4 billion while consumers benefit from the decrease in price to the tune of €3.7 billion. Taxpayer costs increase (due to the cost of sustaining the butter price) while there is a small increase in processor income. Overall, however, there is a small decline in EU net welfare.

This paradoxical result is explained by the fact that the EU is a significant player in world dairy markets, and increased production and net exports of dairy products after the removal of quotas drives down the world market price below its baseline level. Thus some of the gain from lower EU milk prices accrues to the countries purchasing EU exports rather than to the EU itself. In effect, by removing the milk quota, the EU reduces the unit value of its dairy exports and turns the terms of its dairy trade against itself.

In interpreting these results, it is important to point out that the baseline assumes a continuation of the status quo in policy terms. Thus it does not take into account the impact of a Doha Round agreement on the milk sector. Bound tariffs on butter, SMP, WMP and cheddar cheese are all greater than 50% and could face tariff reductions of between 62 and 73%, depending on the final outcome and whether dairy products are declared as sensitive or not by the EU. A Doha Round agreement, if implemented over the period 2010-2016, would come fully into effect in the same year as quotas will be abolished.

The value of quota rents (and thus the stimulus for EU dairy farmers to increase production when quotas are removed) could then look very different to what is assumed in the Toulouse study, although this will also be dependent on the level of world prices which will determine whether imports will enter the EU even at these lower tariffs. Previous analyses of the impact of a WTO agreement on EU dairy prices suggest rather limited effects, in part because they assume relatively buoyant world market prices, and in part because the significant product differentiation in the EU dairy industry will help to protect it from the full blast of lower-priced third country competition.

Policy implications

The main purpose of the report is to compare the consequences of different scenarios to reach this point where milk quotas are eliminated. The report compares an early quota removal scenario (in which quotas are removed already in 2009, which is hardly relevant), two ‘soft landing’ scenarios in which quotas are increased by 1% and 2% per annum respectively between 2009-10 and 2015-16, with quotas removed in the latter year; and the ‘hard landing’ scenario in which quotas are left untouched until 2015-16 and then removed in that year.

In the baseline scenario, milk prices are assumed to increase because EU production cannot respond to the slow but steady growth in EU dairy demand. Dairy prices hold firm in the ‘soft landing’ scenarios as production increases in line with this growth in demand, while in the ‘hard landing’ scenario EU dairy farmers first benefit from the rise in milk prices when production remains restricted, but then experience a sudden collapse in the year when quotas are removed.

Other studies come up with different results…

The precise magnitudes of the projected changes depend on the model construction and the parameter values used, and the authors test the impact of varying these values in their sensitivity analysis. In an previous study for the Commission using an earlier version of this model, the authors projected a 12% production growth and a 40% decline in the EU milk price by 2015 relative to 2000. These results played a role in the Mid-Term Review negotiations which resulted in substantial decreases in butter and SMP intervention prices.

In a 2005 study by Lips and Rieder which removed quotas as well as export subsidies but held tariffs constant, EU milk production increases by 3% and prices decline by 22%. A more recent study in 2007 by the FAPRI-Ireland team projected that the removal of milk quotas would lead to a 4% increase in EU milk production but only a 7% decrease in the EU milk price relative to the baseline in 2016.

…but basic story concurs

Despite these variations in the numbers, the story told in the Toulouse report is a plausible one. It helps to explain why some farm ministers will fight to restrict the increase in quotas agreed in the Health Check to the smallest minimum amount, also taking into account the uncertainty over whether there will be a Doha Round agreement or not as well as continuing uncertainty over the future level of world prices. However, it is clear the ‘hard landing’ scenario would impose more significant adjustment costs on both the farm and processing sectors which are not explicitly considered in the report.

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4 Responses to “Milk quota removal could cost EU farmers €4 billion”

  1. Jack Thurston →
    May 12, 2008 at 09:29 #

    These are interesting findings, Alan. But wherever there are losses, there are also gains. Do the studies in question who will be the winners from the phasing out of milk quotas? I would expect that some farmers would do better, and of course there will be gains to consumers from cheaper prices. Will the losses be concentrated among certain countries/regions?

  2. Alan Matthews →
    May 14, 2008 at 22:37 #

    Indeed, some farmers in some EU countries will come out winners from the removal of quotas but if the numbers in this study are correct, they will be relatively few. They will be farmers in countries with low marginal costs of expanding milk production. Bear in mind that milk prices on average will fall by over 10% in this study compared to the baseline, and because of the shape of the marginal cost curve it would require a much greater percentage increase in milk production for farmers even to maintain income, let alone increase it.

    A 10% reduction in price translates directly into 10% less revenue and income, but a 10% increase in production requires farmers to incur costs so will not be sufficient to offset the income consequences of the price cut.

    And there are relatively few countries in the Toulouse study where milk production is expected to be more than 10% higher when quotas are eliminated. They include Belgium, Spain, Ireland, Netherlands and Austria. In all other countries production increases by less than 10% or could even fall. So in these countries not only the income of dairy farmers but also the value of the dairy sector in terms of gross output will fall.

    Among producers there will be very significant restructuring as many small farmers who have been kept in existence by the quota regime will simply disappear.

    Consumers of course will be the main beneficiaries, but some of these beneficiary consumers live in importing countries and their gain in welfare is not included in adding up the totals for the EU. In fact, EU dairy policy had the paradoxical effect of putting a floor under world prices, to benefit of dairy farmers in third countries including developing countries, but hurting consumers depending on imported EU milk powder and butter oil. With the removal of quotas, EU milk production will expand, reversing these effects.

  3. Alan Matthews →
    May 14, 2008 at 22:46 #

    I should have added in that last comment that one of the ways in which farmers’ incomes are safeguarded when quotas are removed is that the cost to those farmers who are leasing quota in order to expand production falls away, thus providing some immediate compensation for the fall in price. However, most dairy farmers own the majority of their quota and so do not enjoy this cushion of flexibility.

  4. Jack Thurston →
    May 16, 2008 at 18:51 #

    How do costs of production in the EU compare with dairy farmers in other parts of the world? Are they higher? How much higher, and how much of this is due to the need to buy or rent quota. I have met dairy farmers in the Netherlands who say that quota is their main cost of doing business.