THE CHANGING FEDERAL PHILOSOPHY ON PRICING
AFPC Policy Issue Paper 96-2
Agricultural and Food Policy Center
Department of Agricultural
Texas Agricultural Experiment Station
Texas A&M University
College Station, Texas 77843-2124
Telephone: (409) 845-5913
THE CHANGING FEDERAL PHILOSOPH ON PRICING
objectives of federal dairy policy have not changed since the enactment of the
milk price support program in 1949 and the enabling legislation for federal milk
marketing orders in 1937. Officially, price support objectives remain as
specified in the 1949 Act, including:
Likewise, the statutory federal order objectives are officially
as specified in the 1937 authorizing legislation, including:
- Ensure an adequate supply of pure and wholesome milk to meet current
- Reflect changes in costs of production.
- Ensure a level of income adequate to maintain production capacity
sufficient to meet anticipated future needs.
policy has not been nearly as stable as these underlying unchanging objectives.
Changes in policy have been a reaction to:
- Establishing orderly marketing conditions.
- Ensuring the orderly flow of the supply of milk to market throughout the
- Avoiding unreasonable fluctuation in supplies and prices.
Partially in reaction to structural changes, dairy program philosophy
evolved in the 1960s into a uniform national policy on milk pricing. This policy
involved the establishment of specific relationships among class prices, and
between federal order and support prices. Building on previous studies by
Gaumnitz and Reed; Trelogan and Herman; and Harris, this uniform policy on milk
pricing was most extensively studied, debated, developed, and explained in the
Nourse Report. This report was the product of a USDA secretarial committee
composed of many of the most knowledgeable dairy intellects ever assembled. It
subsequently and most recently was summarized, restated, and reconfirmed in the
1972 Report of the Milk Pricing Advisory Committee, USDA.
- Conditions within the dairy industry have evolved, for example, from local
to regional markets for fluid milk or to national and international markets
for manufactured markets.
- Philosophies on the role of government in markets have changed, for
example, to a more market-oriented approach shedding the production controls
mandated in the 1949 Act as well as its parity pricing concept.
(Interestingly, parity is still a stated goal, but hardly an operational goal,
in the 1937 Act.)
- Constraints on spending have evolved to the point where producers are
required to bear the costs of increases in spending.
During the 1980s and
the 1990s, there appears to have been a marked departure from, and challenges
to, the milk pricing policy and philosophy that developed in the decades of the
'60s and '70s. Ironically, national study committees assembled during the 1980s
continued to express views and recommendations on dairy policy that were
consistent with those laid down in the 1960s, while reflecting the
contemporaneous philosophy regarding the role of government and the prevailing
The purpose of this
leaflet is to restate underlying principles of milk pricing that developed
during this formative period, to evaluate apparent departures from those
philosophies, and to explain their potential impacts. The leaflet is written on
the premise that public and private institutions perform most effectively and
smoothly if their decisions are guided by a common set of principles and
These principles and
the related policies may be changed or adjusted as industry changes, but this
should be done within the context of and consistent with the remaining existing
policies. The emphasis in this leaflet is on dairy price support and marketing
Evolution of Dairy Policy
The objectives and
institutions of dairy policy pre-date and transcend both the enactment of
federal order enabling legislation and the milk price support program.
Cooperatives formed during the 19th Century to bargain were subsequently
legitimized by the Capper-Volstead Act. Their leaders and economic advisors
developed the first milestone in milk pricing philosophy that subsequently
evolved to benefit the entire industry. The core concept involved classified
pricing of milk. This concept was implemented in the early 1900s by cooperatives
as a means of enhancing producer returns and rewarding producers for quality.
Geographic alignment of prices from a local basing point located at population
centers recognized the economics of moving milk over distances. The
deterioration of cooperative classified pricing systems during the Great
Depression led to their codification initially into state law. However,
conflicts between states in pricing provisions, resulting from the
constitutional mandate not to impede the movement of goods in interstate
commerce, led to the enactment of the 1937 Act. Subsequently, a system of
federal milk marketing orders developed across the United States.
Correspondingly, the role of state orders declined, except in states such as
After World War II,
it was found that orderliness was difficult, if not impossible, to accomplish in
an environment of surplus production and in the absence of a support floor on
milk prices. The result was the enactment of the 1949 permanent legislation
establishing the price support program.
development of surplus conditions led to the appointment by the National Milk
Producers Federation (NMPF), in 1959, of a committee of land grant university
economists to consider methods of stabilizing prices and incomes to dairy
farmers. As the first in a series of producer proposals to control production,
the NMPF committee suggested that producers give careful study to a program to
limit supplies. The committee recommended a program that included negotiable
bases with a tax on excess production to cover the cost of surplus product
disposal. In addition to the status quo and production controls, alternatives of
direct payments, a self-help dairy board, and marketing restrictions on low
quality products were considered as policy options. Even though the subsequently
elected Kennedy administration espoused a production control philosophy, it was
Rapid improvement in
transportation and refrigeration technology adapted to the dairy industry in the
post-World War II economy resulted in increased interaction across markets and
conflict over the appropriate federal order pricing instruments (pay prices vs.
formulas) and basing points (local vs. regional vs. national). The result was
the Nourse report which enunciated the following paraphrased and abbreviated
federal milk marketing order objectives:
decade later, when framed in the context of both the price support program and
federal orders, the 1972 interagency Milk Pricing Advisory Committee boiled down
U.S. dairy policy to having three objectives:
- To promote orderly marketing and thereby improve producer income in the
- To equalize the market power of buyers and sellers.
- To assure consumer access to adequate and dependable supplies of high
- To complement producer organizations in maintaining economic order through
coordination of prices and marketing practices geographically and among
- To secure equitable treatment of all parties throughout the system.
- To protect established producers against loss of outlets while maintaining
freedom of choice among buyers and sellers.
attempting to rationalize, specify, and recommend policies designed to achieve
these objectives, both the Nourse report and the Milk Pricing Advisory Committee
spent considerable time evaluating appropriate relationships among federal order
class prices and the milk price support program. These relationships, which have
evolved and withstood the test of time, could legitimately be thought of as
basic milk pricing principles. They include:
- Adequacy of supply.
- Orderliness of markets.
- Stability of prices and production.
principles of federal order prices created an orderly and consistent milk
pricing system because changes in either national supply or demand were
reflected throughout the system. That is, when the price of milk used for
manufacturing (Class III) changed, all other minimum class prices adjusted
upward or downward in a consistent manner. Moreover, when policymakers adjusted
the level of the support price, all other class prices and the blend price paid
producers moved in the same direction.
- The milk price support program supports the prices of all milk through the
purchase of manufactured products. In the absence of authorization for supply
management, the Milk Pricing Advisory Committee notes that the support program
can operate only on the philosophy that the support level could not long
exceed the market clearing level without creating disruptive surpluses.
- Price levels under price supports and federal orders should be coordinated
in a manner that assures that class prices move together and do not contradict
changes in minimum milk price support levels and policies.
- All federal order milk classes should be standardized across all markets.
- Prices of milk used for manufactured products (Class III) should recognize
the existence of interrelated national markets. Product prices should be
allowed to adjust to reflect market demands while a single uniform price is
maintained for milk utilized to manufacture butter, NDM, and cheese. That
price has been the M-W price.
- Prices of milk used for soft products (Class II) should be a fixed
differential over manufactured product prices (Class III) that recognizes the
cost of making the Class II products from reconstituted manufactured products
(butter and NDM).
- Prices of milk used for fluid products (Class I) for markets east of the
Rocky Mountains should be priced utilizing a single basing point in the
predominant excess supply source area (Eau Claire, Wisconsin) and arrayed from
that point on the basis of a fixed differential over the basic formula price
plus a fixed per mile charge to represent transportation costs. While the
principle of a fixed transportation differential has been followed, it has
never been precisely followed, in part because of congressional mandates such
as the Class I differential increases contained in the 1985 farm bill. A
separate basing point has existed for markets west of the Rockies.
- Receipts should be pooled in a manner where all producers serving a market
area are treated equally.
- Federal order class prices were specified as minimums under the law. Until
the 1970s, these minimums tended to be the actual prices charged. In the
1970s, it became USDA policy not to discourage the charging of premiums over
federal order prices, but to allow their levels to be determined by
competitive market forces.
- Under law, cooperatives were given the privilege of paying its producers
less than the federal order blend price. This principle was derived from the
notion expressed in the Nourse report that orders were established to benefit
producers. Moreover, competitive, supply, and cost relationships operating in
the market create pressures for the cooperative to pay prices that are
competitive with those of independent producers and vice versa.
The central purpose
of the 1972 Milk Pricing Advisory Committee was to determine whether the M-W
price series, as the basic formula price, was still a reliable indicator of
prices of milk used for manufacturing and to determine an appropriate substitute
mover of milk prices. While the study concluded that the M-W was still reliable,
it recommended that USDA proceed to develop and be ready to implement a
substitute. The Committee determined that product formulas offer the best
alternative to the M-W price series. It took over two decades for the M-W series
to be modified. While it still considers only Grade B prices for milk that is
used for manufacturing, it now updates the M-W for changes in product prices.
About a decade
passed before the NMPF commissioned an autonomous Dairy Policy Study Committee
to analyze federal dairy price programs and to advance recommendations for
adjusting programs to better serve their public purposes. The majority of its
membership were land grant university economists. The Study Committee's purpose
was In its first and only report concentrating on price support issues, the
Study Committee recommended a market-oriented safety-net dairy policy.
The Study Committee
specified a rationale for government involvement in dairy that was consistent
with the earlier Nourse and Milk Pricing Advisory Committee Reports. This
rationale reflected contemporary thinking regarding the role of government in
agriculture and was designed to be more consistent with the approach taken on
other commodities, including:
recommending, the Study Committee determined the use of the price support
program to enhance price and income as being inappropriate. This conclusion was
based upon the resulting resource misallocations, excessive costs, arbitrary
price determinations, and negative consumption impacts. It likewise rejected
supply controls because they reduce competitiveness, impose market access costs,
impede economically justified adjustments, and involve too high a level of
regulation that is difficult or impossible to eliminate.
- Mitigating resource adjustments that are inconsistent with long-run supply
and demand forces.
- Reducing instability as a primary policy consideration.
- Providing an economic safety net of a market-oriented nature.
- Expanding markets for dairy products.
- Minimizing the level of government costs.
results of the Study Committee became the basis for successive reductions in the
milk price support level and the adoption of a CCC purchase trigger for reducing
price support levels. Clearly, the milk price support level has been at safety
net levels since the completion of the work of the Study Committee.
Commission on Dairy Policy was established by the 1985 farm bill to study the
milk price support program and the future of U.S. milk production. The
Commission was composed of a cross-section of leading U.S. milk producers. In an
environment of increased concern about regional divisions in dairy policy, the
thrust of the Commission's report recognized the need for a national dairy
policy. It rejected regional differences in policy such as the higher California
make allowance. In doing so, it rejected the use of price supports to protect
The Commission was
critical of disruptive short-run adjustments in dairy policy, opting for policy
to be established on a long-run basis without substantial change. It suggested
that price support policy should:
As a result, it recognized that parity was outdated as a
standard for milk pricing. It stated that historical average pricing used in
other commodities has appeal. However, the Commission departed from the NMPF
Study Committee Report by recommending a standby two-tier pricing system to
accomplish production adjustment. Except for this last recommendation, the
Commission report was quite consistent with the policies that had developed for
the milk industry over the past three decades.
- Account for advances in technology.
- Account for changes in economic conditions.
- Operate without disruptive revisions.
- Account for shifts in supply and demand.
Beginning in the
1970s, the milk pricing system and its underlying principles were increasingly
challenged. Incremental policy changes were advocated and sometimes made
apparently without consideration of how they fit into the historically accepted
philosophy of milk pricing. Was there a new set of principles being developed in
reaction to fundamental change within the industry or was a system being created
that had no underlying principles? Some of the principle events that led to this
- The increased prevalence of over-order premiums being charged by
cooperatives reduced the extent of control that policymakers could exercise
over the price of milk. As early as 1972, the Milk Pricing Advisory Committee
noted that the result was reduced assurance that actions by the Secretary, for
example, to reduce the price support would be experienced in all markets. As a
matter of public policy, however, farmers and their cooperatives were
encouraged to "get it from the market" as the philosophical policy approach
shifted toward greater market orientation.
- Contrary to the advice and admonitions favoring a market-oriented
approach, in the late 1970s, the milk price support program was overtly
utilized to enhance producer income by maintaining the support price at 80
percent of parity. Strong economic incentives to increase production resulted
in record CCC purchases and government costs. The NMPF Dairy Policy Study
Committee found that this policy placed long-run costs on the industry, gave
the price support program a "black eye," attracted too many dairy cows that
later needed to be "purchased" in the diversion and buyout program, led to
excess processing capacity, adversely affected the demand for NDM, and
resulted in subsequently depressed prices. Policies that foster excess
production inevitably lead to higher levels of government involvement,
expenditures, and controls.
- Sharply increased production in "nontraditional" dairy regions of the West
and Southwest raised increasing questions regarding the notion of a single
basing point east of the Rockies. The existence of increased CCC purchases out
of California and the Pacific Northwest could be justified on the basis of
their efficiency in producing at a lower price. This was not the case for the
Southwest where Class I prices aligned out of Eau Claire helped to foster
increased production. Questions arose whether prices in this region should be
aligned as a new basing point or from a California basing point.
- Action by Congress in the 1985 farm bill raised Class I prices on a
selective market basis that was not always consistent with the Eau Claire plus
cost of transportation basing point pricing system. Previously, USDA had
consistently refused to increase the transportation differential in the more
market-oriented policy environment of the post-1970 era. The reason offered by
USDA was that higher prices were not needed to generate adequate supplies
and/or producer receipts. Concurrently, the Upper Midwest argued that regional
price differences should be reduced or eliminated -- a position that remains
contentious and devisive. However, studies by Lasley, Babb, and Novakovic have
consistently shown that the federal order geographic structure of milk prices,
generally, is quite consistent with that which could exist under an
efficiently organized competitive system.
- In areas where milk production is increasing much more rapidly than
demand, such as the Southwest, Class I differentials may be too high. The
chronically deficit Southeast, especially Florida, may actually be able to
justify a higher differential. The research findings of Lasley, Babb, and
Novakovic have not satisfied Upper Midwest producers and cooperatives who in
1990 petitioned for a national hearing with the key issue being the
appropriate Class I differential in each order. Their desire was for a Class I
price structure that allowed them to share in the higher Class I prices and
utilization in markets to the East and South. Lacking success in convincing
USDA of an inequity, these producers have sought relief in court.
- Whether all milk used for manufacturing should be priced at the M-W price
was a festering issue that contributed to the establishment of the Nourse
Federal Milk Order Study Committee. While an outgrowth of that report was the
adoption of uniform pricing of Class III milk, uniformity has not been
maintained. Initially, deviations from the uniform pricing principle occurred
in South and Southeast orders where it was argued that a lower price for
butter and powder was justified by the costs incurred due to seasonality of
the milk supply (balancing).
- In 1991, three federal order markets (Pacific Northwest, New England, and
Middle Atlantic) began using a Class III-A price which priced milk used to
manufacture nonfat dry milk (NDM) significantly lower than the M-W. The
reasons stated for the change were that the M-W price primarily reflects the
value of cheddar cheese and does not reflect the value of milk used to make
NDM. In 1992, Class III-A pricing was extended to the remaining 29 federal
The long-run impacts of Class III-A pricing are not readily apparent. In
the short run, however, it is clear that a significant amount of cheese and
soft products will be made with NDM because of its lower than Class III price
rather than with whole milk. If, as expected, Class III-A pricing leads to
increased use of NDM to manufacture cheese, this would lead to increased
market inefficiencies. The addition of Class III-A pricing is in direct
conflict with the basic milk pricing principles set forth earlier.
Changes in the
principles of milk pricing are appropriate as the economic forces underlying the
dairy industry change or as the statutes themselves are changed to reflect new
or different policy objectives. For example, changes in the milk price support
program may be required if market access and related GATT provisions effectively
undermine the operation of the program.
Policy changes made
incrementally without evaluation of their implications for the underlying
principles of milk pricing almost certainly lead to inefficiencies. More
significantly, they run the risk of undermining the federal order and price
support programs. It seems unlikely that is what the dairy industry is seeking.