AFPC Policy Issue Paper 96-2

The statutory 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:

• Ensure an adequate supply of pure and wholesome milk to meet current needs.

• Reflect changes in costs of production.

• Ensure a level of income adequate to maintain production capacity sufficient to meet anticipated future needs.

• Establishing orderly marketing conditions.

• Ensuring the orderly flow of the supply of milk to market throughout the marketing season.

• Avoiding unreasonable fluctuation in supplies and prices.

• 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 budget constraints.

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 philosophical underpinnings.

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 order 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 California.

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.

The subsequent 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 never implemented.

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:

• To promote orderly marketing and thereby improve producer income in the long run.

• To equalize the market power of buyers and sellers.

• To assure consumer access to adequate and dependable supplies of high quality milk.

• To complement producer organizations in maintaining economic order through coordination of prices and marketing practices geographically and among products.

• 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.

• Adequacy of supply.

• Orderliness of markets.

• Stability of prices and production.

• 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:

• 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.

Arguably, the 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.

The National 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 certain producers.

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:

• 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 challenge included:

• 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 order markets.

  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.