Econ 1101 Reading

Econ 1101 and Econ 1165—Reading 3

International Application

Cap and Trade for Milk

By Thomas J. Holmes, Dept. of Economics, University of Minnesota

Revised September 2018

The term Cap and Trade frequently shows up in the news as a potential policy to reduce carbon emissions. The idea is to “cap” levels of emissions, but at the same time let firms “trade” emission rights. Cap and trade has also been used to reduce sulfur dioxide emissions (the cause of acid rain). The concept goes beyond environmental applications. For example, New York City runs a cap and trade program for taxis. The policy is also sometimes used for agricultural products. The dairy market in Canada is one such case.

When cap and trade is imposed of pollutants, the ultimate goal of the policy is to reduce the level of the pollutants. The motivation for cap in trade in the Canadian dairy industry is completely different. There isn’t a problem of children drinking too much milk, or too many people ordering extra cheese on pizza. Rather, the purpose of the policy, plain and simple, is to make milk more expensive.

To illustrate the issue, consider supply and demand in the market below where the unregulated market price is $5 per unit. (To keep things simple, we are using the Econland demand and supply curves from class.) Suppose policy makers would like the price to be P = $7 for whatever reason. The fundamental problem with a price equal to P = $7 is that the quantity supplied is Q^S=7, while the quantity demanded is only Q^D=3, resulting in an excess supply of Q^S – Q^D= 4. In the United States, farm policy typically addresses the excess supply by expanding demand. (In the past this has included the government actually making direct purchases of the excess supply.) In the Canadian dairy industry, the strategy instead is to push back the supply. The Canadian policy is an example of a supply management approach.

Figure 1: Example Supply and Demand Curves

table1

The policy in Canada works like this. To produce milk in Canada, a dairy farm needs to own quota and quota are limited in supply. The more milk a farmer wants to sell, the more quota a farmer will need. For our numerical example, suppose the government limits the amount of quota to three units, Q^Quota = 3. This means the quantity of milk produced in the market will be Q = 3. To determine the price of milk, we look at the demand curve and evaluate demand at the quota quantity. The price of milk on the demand curve when the quantity of milk is Q = 3 is $7. So $7 is the price of milk under the quota.

Figure 2: Equilibrium under Q^Quota = 3

When cap and trade for milk was set up in Canada 50 years ago, the quota rights were initially distributed for free to the dairy farmers in the industry at the time. Total amount of quota issued put a “cap” on the amount of milk that could be produced. The quota rights became an asset that the dairy farmers could buy and sell amongst themselves, the “trade” in “cap and trade.” Trades take place in a Quota Exchange. Each Canadian province has a separate quota system and a separate exchange. The Canadian Dairy Information Centre provides information about the current market price of quota in each province.

In the British Columbia exchange, the current quota price is $38,500 (in Canadian dollars), and in Manitoba (on the northern border of Minnesota), it is $29,300. One quota unit entitles the holder to sell each day an amount of milk with one kilogram of butterfat in it. This is about 7 gallons and is approximately what one cow produces in a day. The price of this amount of milk at the “farm gate” is currently about $10 (Canadian) or about $1.40 a gallon. At the “farm gate” means what the farmer gets paid, not the retail price. Cap and trade has been successful in keeping milk prices high. Canada’s farm-gate prices are more than twice “the world price,” the price Canada would pay for imported milk. Obtaining quota is the most expensive part of being in the dairy business in Canada.

Let’s go back to our numerical example. We have already figured out that with cap and trade, the price of milk will be $7. Our next step is to figure out the price of a unit of quota in the quota exchange. I will first explain the rule to use for determining the price of quota. I will then try to explain why the rule makes sense. To calculate the price of quota, draw a vertical line at the quota quantity. (This is the thick orange line in Figure 2.) Take the point where it intersects the demand curve (here $7) and subtract this from the point where it intersects the supply curve (here $3). The difference is the equilibrium quota price, P^Quota = $7 – $3 = $4. Let’s use the notation C^Marginal to mean the cost of the last producer in when the quantity of milk is 3. Another way to state the rule is that the equilibrium quota price equals the price of milk minus C^Marginal.

To explain why this works, I first need to make an argument about how profit-maximizing farmers will behave in this industry. The economic idea of opportunity cost plays a big role in this argument. Consider a farmer who is thinking about being in the dairy business. If the farmer did not inherit any quota from her parents, the farmer will naturally factor the cost of the quota into the decision of whether to be in the industry. But even a farmer who inherited quota must consider the opportunity cost of keeping the quota rather than selling the quota in the quota exchange. To clarify the analysis, it is useful to think of a farmer as potentially making profits in two distinct businesses: the milk business and the quota business. To calculate profit in the milk business, the farmer subtracts out the price of quota on the quota exchange, because this is the opportunity cost of using the quota for the milk business. The profit on the quota business equals what the farmer can sell the quota for in the quota exchange.

So now we can see why the equilibrium quota price must be $4. The marginal producer in the industry when the quota is at 3 units (we this producer “S3” in class) has a production cost of C^Marginal= $3. This is the cost of feeding cows and maintaining equipment. In order to calculate the total cost of being in business, the marginal producer must also factor in the opportunity cost of using quota. At a quota price of $4, total cost is $7 = $3 + $4 and this exactly offsets the milk price of $7. So S3 just breaks even. Suppose the quota price were higher than $4. Then S3 would lose money from being in the milk business. S3 wouldn’t want to be in the milk business and the number of people wanting quota would be less than 3. The supply of 3 units would exceed the demand and this would cause the price of quota to fall. Consider the opposite case where the price of quota is less than $4. Then S3 would make a positive profit. But so would other farmers with cost just a little bit higher than S3. The demand for quota would be more than the supply of 3 units and this would cause the price of quota to be bid up. At the quota price of $4, S3 is just indifferent to being in the market, and the demand for quota exactly equals the supply of 3 units.

Table 1 below analyzes the impact of cap and trade on total surplus and the division of the surplus among producers, consumers, and owners of quota. Figure 3 is the graph. In constructing the table, I have divided farmer profit into two categories, profit from the milk business (denoted PS^Milk) and profit from the quota business (denoted PS^QuotaPS^Milk off of that net price. Profit on the quota business equals the number of quota units times the price of each quota, PS^Quota = 3×$4 = $12.

Figure 3

Cap and trade policy reduces total surplus to $21, compared to $25 in the free market. Let’s be the economics doctor and offer a diagnosis of the source of the inefficiency. The problem is a violation of the principle of efficient quantity. The efficient level is at 5 units; this is where the marginal value of the last unit consumed equals the marginal cost of the last unit produced. The quantity produced under cap and trade is only 3 units; for the last unit in, consumers value milk at $7 a unit while producers can make it for only $3. The deadweight loss is the yellow triangle in the figure.

You may be thinking, “This looks a lot like a tax.” You are absolutely right! You can think of what is happening here as being just like a tax of $4. The only difference is that instead of the tax money going to the government, it goes to the holders of quota.

While cap and trade makes the overall pie smaller, it is clear why it is popular with farmers. If we add the PS^Quota to PS^Milk, we get a combined return to farmers of $16.5. This is much bigger than the return in the free market of $12. Moreover, if cap and trade were ever discontinued, the owners of quota would suffer huge capital losses. Suppose a dairy farmer in British Columbia owns a farm with quota for 200 cows. Quota for one cow is currently selling for $43,500; the value for all 200 cows is $8.7 million. If the quota system were discontinued tomorrow, the quota would be worth zero. It should come as no surprise that dairy farmers in Canada want to preserve this system.

Table 1: The Effects of Cap and Trade

Variable	Definition	Free Market	Cap and Trade Q^Quota=3	Change from Policy
P^Milk	Milk price consumers pay	5	7	+2
Q^Milk	Quantity of Milk	5	3	–2
P^Quota	Price of quota at quota exchange	0	4	4
CS	Consumer Surplus	12.5	4.5	–8
PS^{Milk Business}	Profit farmers make on their milk business when the opportunity cost of using quota is subtracted out	12.5	4.5	–8
PS^{Quota Business}	Return from owning quota	0	12.0	+12
PS^Combined	= PS^Milk + PS^Quota	12.5	16.5	+4
TS	Total surplus = CS+PS^Combined	25	21	– 4

Canada’s supply management system is currently in the news, related to the Trump administration efforts to renegotiate that NAFTA trade agreement. NAFTA is a trade agreement between the U.S., Canada and Mexico that sets tariffs to zero or close to zero for most goods traded between the three countries. But if the tariff for milk were set to zero, it would completely upend the supply management system, as milk imports would flow in, depressing milk prices (and the value of quota would plummet to zero). To maintain good relations with the U.S., Canada has allowed some imports, but up to a quota. For imports below the quota there is actually a tariff, but it is relatively small (7.5 percent). However, for imports above the quota, the tariff skyrockets to 241 percent and for milk power hits 270 percent. These sky-high tariffs have attracted Trump’s attention and he frequently references them to support his claim that Canada is a bad trade partner. It turns out that in ths public relations war, Canada would have been better off banning imports above the quota, meaning the only tariff number Trump could complain about would be the 7.5 percent. Trump might complain about the quota, but as a sound-bite doesn’t sound as pernicous as a 270 percent tariff. Also, we product some of our agricultural commodies with import quotas, sugar in particular. Import quotas for sugar keep sugar prices here in the U.S. twice as high as they are in Canada.

One last point about the import quota. Canada imported about $800 million dollars in dairy products from the U.S. in 2017 under the quota. These dairy imports are valued at the high Canadian dairy prices rather than the low U.S. prices, meaning the sellers are making huge profits. In essense, some American interests are getting in on the quota profit. For more about the Canadian Dairy industry and the recent trade controversy see, “How Canada's Sacred Cows and 270% Tariffs Set Trump Off at G-7,” Bloomberg, June 2018 and “A Trumped-up charge against Canadian dairy tariffs,” Brookings, June 2018.