Essays on the fluid milk industry

Abstract

Industrial organization deals with how seller concentration, product differentiation, and conditions of entry affect firms' behavior and market perform. In particular, the U.S. fluid milk industry is characterized by concentration. As a result of mergers and acquisitions among fluid milk processors in the late 1990s, the national four-firm concentration ratio grew faster than any other food processing sector and it accounted for approximately 45% in the late 2000s. The U.S. fluid milk industry is also marked by co-operative associations. Marketing co-operatives might play a role in counterbalancing the processor's buyer power. In addition to concentration, an organic label is considered a key strategy for differentiating products in the fluid milk industry. As consumers are willing to pay a premium for the organic attribute, organic labels are commonly considered a profitable marketing strategy in the fluid milk industry. These two key features of the U.S. fluid milk industry, 1) concentration in milk processing and the existence of co-cooperatives and 2) a way of product differentiation, organic labeling, have led to using an empirical industrial organization approach to study these two issues in U.S. fluid milk industry. The first essay examines the role of upstream and downstream market power in determining the effect of potential supply shocks on price transmission. To do this, I develop a conceptual framework, which extends Villas-Boas and Hellerstein (2006)'s model of successive oligopoly, to illustrate the effect of supply shocks on price accounting for 1) market power and 2) sequential vertical-pricing games. A structural econometric model is employed to estimate demand, downstream and upstream firm’s supply and market power parameters which are derived from the conceptual model. Using the estimated parameters, I simulate how market power impacts the effect of supply shocks on prices. The conceptual framework shows the following propositions. First, the effect of a negative supply shock on the change in output price is diminished by the degree of its' market power. The effect of upstream firms' market power on the change in upstream firms' output price is larger than that of downstream firms' market power on the change in downstream firms' output price. Second, the effect of a negative supply shock on the change in downstream firms' output price is diminished by the degree of upstream firms' market power. Third, the impact of downstream firms' market power on the change in upstream firms' output price caused by a negative supply shock is ambiguous. Fourth, the effect of a negative supply shock on the change in upstream firms' output is larger than on the downstream firms' output price. The empirical framework suggests that the assumption of perfect competition for upstream and downstream firms in the U.S. fluid milk industry is rejected. The simulation analysis indicates that perfect competition assumption overestimates the effect of supply shocks on both upstream and downstream firms' output prices. Thus, it is important to account for the presence of market power when considering the impacts of supply shocks. In the second essay, I investigate new econometric evidence on the economic value of organic labels in the fluid milk market from a producer's standpoint. To do this, a structural econometric model is used to estimate organic and conventional milk demand. Given the demand estimates, I simulate two counterfactual analyses in which 1) organic milk products are replaced by conventional milk products and 2) organic milk producers go out of business by 1) removing organic attributes from both consumer utility and marginal costs and 2) removing organic brands from the choice set. The demand estimates show that consumers are willing to pay a significant premium for organic milk products. Consumers' willingness to pay for the organic label is $2.47 per half gallon of milk. The counterfactual analyses suggest that the presence of organic label increases market share and producer surplus for organic milk brands by approximately 33 (when removing organic attributes) to 100% (when removing organic brands) while it decreases market share and producer surplus for conventional brands. Also, the impact on price, share, and producer surplus for conventional brands are greater when removing organic products from the choice set compared to removing organic attributes.