Dairy farming is a huge industry in New Zealand and getting ever huger in response to a massive spike in world dairy prices:

(graph from Brian Gould’s site)

Via my Dad who talked to a local farmer, I learned the following about cow economics:

One cow produces about 1.3 kg of milk solids per day at current price of NZ$7.90/kg. So about $10 per cow per day (about US$7.87/cow/day at current exchange rates). Small farms have about 300 cows, middle size about 500 cows, big size 1000 cows. Cows are milked about 300 days per year with 2 months off for everyone. So a middle size diary farm generates $5,000/day and a big farm $10,000 per day. Times 300 days, equals big money. So a lot of farmers are converting sheep farms to dairy and putting other marginal land into production, attracted by the high profits.

The interesting questions to me are how to explain the increase in dairy prices, and whether the price will stay high. The usual explanations for the price increase are an increase in demand due to economic growth China and India, and a decrease in US supply due to the biofuels policy (most US dairy cows eat corn). Looking at the graph above, what we see is that prices were pretty stable for a long time, and then more than doubled over the past year. This doesn’t seem to be completely consistent with the China/India story, since those countries have been growing rapidly for quite a long time. Biofuels could explain some of it though.

So here’s my completely uninformed hypothesis. Growth in China and India has been driving demand, but supply was keeping up with that, more or less. Then recently there were two one-off shocks. One was the US biofuels policy changes, which have lead to a one-time reduction in supply. Another was (I am really speculating here) a change in consumer preferences in Asian countries. As people in these countries got richer, demand for dairy products went up, but recently perhaps this was fuelled by something like a “keeping up with the Wangs” effect where everyone has suddenly started wanting a lot more dairy.

In addition to these one-time shocks, dairy supply is very inelastic in the short run. More milk requires more cows, which cannot be produced instantly. In fact I think it takes about 1-2 years to breed new cows and grow them to the point where they are productive. According to New Zealand trade statistics, over the past year the value of dairy exports has increased almost 70%, but the volume increased only 1.5%. This is consistent with the short-run inelastic supply.

This hypothesis is consistent with the facts — stable prices for a long time, then a sudden increase followed by a levelling off.

The other question is what happens next. As I said, in New Zealand many farmers are increasing dairy production, attracted by the high profits. Supply is a lot more elastic in the long run. So I predict that as supply expands, prices will come down. Perhaps not back to their original levels, but a good part of the way, I think. In fact I’d be willing to bet that prices will be $3500 per ton or less within two years. Where can I buy a futures contract for that?

PS: Another interesting issue is the environmental cost of dairy farming. A cow produces the effluent of 6 or 7 people, apparently.