Producers maximize profits, a fundamental assumption to all economists. Profit maximization to economists is akin to what the law of gravity is to physicists.
Some Extension colleagues recently pointed out to me that many dairy producers see dairy farming as more of a lifestyle than a business enterprise. I was shocked, and then wondered what this means for Midwestern dairy producers. I invite you to think like an economist and see what is happening in the dairy industry based on fundamental predictions of economic theory.
Economists recognize that producers differ in their management skills, strategies and resources, which can lead to varying levels of unit cost of production and, hence, varying profitability. But the most important prediction of economic theory pertains to “zero profitability,” which is inevitable when a competitive commodity market, such as milk, satisfies a condition for “free entry.” “Free entry” means there are minimal barriers for a new agent starting the same business and competing in the market.
Economies of scale
A similar situation also occurs under scalable production. That is, an existing business can expand without facing an increasing unit cost of production. The prospect of positive economic profits invites new businesses and expansions, gradually saturating the market and bidding down the price of the commodity. A lower price renders high-cost producers unprofitable and drives them out of the market. Low-cost producers, on the other hand, continue to enter and scale up, further bidding the price down. In theory, the process continues until the producers of the lowest cost can barely break even.
How fast agricultural markets change primarily depends on how fast farmers expand (for example, by increasing acreage, building additional barns and expanding herds). Thanks to progress in agricultural technology and access to large-scale capital, modern confinement livestock operations can scale up quickly. This has led certain livestock industries to experience an accelerated pace of industry consolidation under “free entry.”
Egg and poultry production became highly scalable decades ago. And more recently so did much of the swine industry. For dairies, limited availability of feed, milking labor, land and processing capacity had long been major barriers to expansion, leaving large-scale operations to business-minded Californian dairy farmers for decades up to the 2000s.
This situation has evolved, and the share of milk production by large-scale dairies has expanded in many parts of the country. Low-cost producers still make positive profits, but their business model increasingly requires a larger scale of operation to generate sufficient returns as profit margins decrease.
To economists like me, near-zero profitability in dairy production appears an inescapable outcome in the not-too-distant future. Milk, as an agricultural commodity, almost guarantees a competitive market, and increasing scalability of production brings the industry closer and closer to the “free entry” environment. In the past decade, the U.S. dairy market certainly experienced supply and demand shocks (particularly from the international market), yet the most fundamental change, in my view, was the remarkably rapid expansion by large-scale dairy operations.
Dairy as business
Dairy farming is a business because the situation today demands it. Here are some ideas to consider if you need to reboot your farm business.
Keep pace with the lowest cost farms
Meticulously cut excess, while minimally adopting technology upgrades. Data show that a small fraction of small-scale dairies achieve competitive cost levels with large-scale farms, but the vast majority of these dairies appear to be economically unsustainable.
Pay attention to the unit cost of new producers, which reveals what is happening at the next unit of milk added to the supply. Strive to match their cost.
Build flexibility in production
Recognize that managing risks is a valuable service to the economy as a whole. Find ways to be flexible and, if you can, offer to adjust your milk outputs in response to price changes. In effect, you would be offering your risk management service to the actors who shop around for prices to lock in. Since that in turn means an increased risk for you, manage this by diversifying your sources of income like crop and livestock sales, custom work, or off-farm employment.
Explore alternative approaches to low-cost production
Management-intensive (rotational) grazing offers a system for reducing costs in feed, capital and labor in ways that conventional confinement operations cannot do.
Converting crop land to pasture could seem like a wasted opportunity, but a dairy enterprise’s goal is not generating bountiful harvests, it is achieving the lowest production cost for milk.
Venture into niche markets
Expanding food labels (for example, organic, pasture-raised, cage-free) show rapidly changing consumer demands and adaptation by food companies. Many niche-market products appeal to the overarching theme of environmental sustainability, local food production, and the congruent image of healthier, tastier and safer food originating from happy animals well-cared for by family farms.