Envisioning a Deregulated Dairy Industry

AFPC Policy Issues Paper 97-1

John W. Siebert, Texas A&M University
David P. Anderson, Texas A&M University
Mark W. Stephenson, Cornell University
Craig S. Alexander, Cornell University
Robert A. Cropp, University of Wisconsin
Harold M. Harris, Clemson University
Ronald D. Knutson, Texas A&M University
Andrew M. Novakovic, Cornell University
Robert D. Yonkers, Pennsylvania State University

Agricultural and Food Policy Center
Department of Agricultural Economics
Texas Agricultural Experiment Station
Texas Agricultural Extension Service
Texas A&M University

May 1997

College Station, Texas 77843-2124
Telephone: (409) 845-5913

Envisioning a Deregulated Dairy Industry

Fundamental changes are occurring in the $22.7 billion dollar US dairy farming sector. The Federal Agricultural Improvement and Reform Act of 1996 (FAIR) will temporarily eliminate the dairy price support purchase authority on January 1, 2000. FAIR also requires a consolidation of Federal Milk Market Order (FMMO) areas by April of 1999. Furthermore, the Basic Formula Price (BFP), which serves as a foundation for almost all FMMO minimum prices, is undergoing change due to factors related to the decline in Grade B milk volume.

Sweeping change is in large part a consequence of the views held by many producers and handlers that our present regulatory system has major flaws. Perceptions of advantages given to some at the expense of others, particularly on a regional basis, have led to protracted debate. The multifaceted character of this debate has pitted dairy farmer against dairy farmer, dairy farmer against handler, handler against handler, and even economist against economist. In this climate of debate, the Secretary of Agriculture will submit FMMO consolidation proposals for producer referendum on an order by order basis. Without industry cohesiveness, it is conceivable that an impasse could be reached resulting in the elimination of FMMOs, at least in some areas of the country, as early as April 1999.

Because of this potential, it is important that everyone understands the consequences of a deregulated US dairy industry. It is hoped that the ideas presented herein will prove beneficial in three regards:

Functions of Federal Milk Market Orders

The regulatory functions of FMMOs pertain both directly and indirectly to transactions between milk producers and milk handlers. FMMO regulations came about due to an imbalance of power between dairy farmers who had a continuous supply of perishable product to sell, and handlers who had to market a largely undifferentiated product, often on the basis of lowest price. The fluid milk price wars of the 1930s were resolved by the initiation of regulations which set minimum prices for producer milk. Although the precise regulations of FMMOs have changed over the years, these regulations have been, and are, designed to create orderly milk marketing such that the imbalance of bargaining power mentioned above can be held in check.

This paper examines the following ten FMMO functions and asks what would happen if they were discontinued. For the purposes of this analysis, other regulations such as those pertaining to public health, product standards of identity, product labeling, and environment are all assumed to remain unchanged.

  1. Minimum classified milk prices and minimum component prices would no longer exist. FMMOs set minimum class prices on the basis of end use by handlers. Elimination of minimum classified prices means that price would become solely a function of aggregate local and national supply and demand conditions. For example, in the corn industry within any small region a relatively similar price exists for corn delivered to any number of different elevators, feed manufacturers, and wet-corn milling plants. Generally speaking, corn buyers do not pay a different price simply because they use the corn for a different purpose. Given deregulation, when milk processors need special services for things such as unique delivery timing or exceptional quality, premiums would be expected to occur. In parallel fashion, discounts would be expected to occur when producers delivered lower quality milk or needed special services for such things as extra pickups.

    At present, minimum Class I milk prices are set one month or more in advance. Without FMMOs, it is likely that milk prices will become a greater point of competition amongst handlers as well as amongst producers and their cooperatives. This will likely lend advantage to larger businesses relative to smaller businesses. Furthermore, prices in a deregulated environment can be expected to change more frequently in response to differing supply and demand conditions. This would entail more seasonal price variation and also more variation induced by short-run factors such as holidays, weather changes, and any sudden outside forces.

    Most individual states would be limited in their ability to influence milk prices due to the close proximity of other neighboring states. Policy coordination between neighboring states would only be possible with Federal legislation authorizing a compact, such as the Northeast Dairy Compact. The success of this type of strategy will depend upon both the willingness of states to cooperate, and the legality of such compacts and the functions they are allowed to perform.

    What impact would the elimination of classified pricing have on producer returns? It stands to reason that if the employment of classified pricing in FMMOs has increased producer returns, its elimination will decrease returns. The basis for higher producer returns lies in the more inelastic demand for milk used for fluid purposes. For example, without minimum classified prices, fluid processors may no longer need to pay the higher Class I price to acquire milk, but could instead pay a lower "blend" or average price. Because the demand for fluid milk is highly inelastic, any fluid milk price decrease will result in a relatively small increase in sales volume. In contrast, processors of manufactured products would also pay the new "blend" price for milk which would be higher than the manufacturing class prices paid in the past. A price increase in manufactured products would be expected to reduce the sales of cheese, butter, and powder more than fluid sales would increase because the demand for manufactured products is more elastic (i.e., more price sensitive) than that of fluid milk. Taken together, these forces of supply and demand indicate that the average milk price received by producers will be lower. Therefore, producer returns will decline and less milk will be produced.

  2. No uniform pool blend prices. A primary equity function performed by FMMOs is to guarantee that a milk producer will receive the same minimum price regardless of the identity of the processor buying that producer's milk. This marketwide pooling function will cease upon the elimination of FMMOs. Thus, it is clear that in a deregulated environment, individual milk producers will lose the guarantee that their regulated price will be the same as their neighbor's.

    Considered by itself, the loss of marketwide pooling prices would likely help processors who have traditionally paid above the blend price (mainly fluid bottlers) but would hurt processors who have traditionally paid below the blend price (mainly cheese, butter and powder manufacturers). Bottlers would no longer be obligated to contribute equalization fund payments to the market order administrator for distribution to all other producers. Conversely, cheese, butter and powder manufacturers would no longer be able to ride the pool, thus benefitting their shippers through the payment of these same equalization funds made available by the market order administrator.

    Continuing with this line of reasoning, should Class III and Class IIIA manufacturing milk prices increase in response to deregulation, then such an increase will be most greatly felt in those areas of the country which emphasize manufacturing. Such areas tend to have the lowest cost of production and are located in the West and Upper Midwest. Given that cheese, butter and nonfat dry milk can be shipped long distances at low cost, there is some potential that the elimination of FMMOs could increase milk production in certain areas (West and Upper Midwest) while decreasing milk production in others (South and Northeast).

  3. No specified regional price differentials, zone prices, transportation credits or marketwide service payments. The elimination of FMMO minimum area pricing, zone pricing and credits will impact producers and handlers differently depending upon location and the types of policies in effect in a particular FMMO. Such policies have generally been used to move milk from areas of production to points of usage. Producers and handlers who rely on such pool payments to provide incentives for milk movement will likely be hurt. However, other producers and handlers who either fund such payments or compete with those receiving such payments may be helped. In the end, market forces will determine price differentials between and within former FMMO areas. Due to the interstate dimensions and impacts of many of these provisions, most individual states will be unable to effectively perform functions of this type.

  4. No timely payment enforcement. FMMOs presently require that payment for milk be made promptly. For example, in Federal Order No. 30 which, regulates the greater Chicago milkshed, milk purchased on the 1st through the 15th must be paid for by the 3rd of the following month. All remaining milk purchased during a month must be paid for no later than the 18th of the following month. The elimination of this requirement would increase processor bargaining power and significantly reduce the bargaining power of milk producers and their cooperatives.

    Retailers have considerable bargaining power when purchasing food products, raw or processed, for resale. Under FMMOs, raw milk sellers serving retailers have a much easier time collecting their bills than do the sellers of processed food items. In this area, individual states could be able to step in and fill the void left by FMMO regulations. In fact, many states already maintain prompt-pay provisions regarding producers.

  5. No compensatory payments. Compensatory payments levied by FMMOs can create an incentive to bottle local fresh milk for Class I in preference to reconstituting fluid milk by using nonfat dry milk (NDM). Compensatory payments equal the lower of either one of the following amounts: (a) the local Class I-Class III differential at the point of bottling less $1.00/cwt. or (b) the FMMO Class I-Class III differential at the NDM manufacturing location. The elimination of these policies means that reconstitution has the potential to become more competitive with local fresh milk.

  6. No milk payment audits. FMMO auditors would no longer examine handler records to ensure that milk payments are in compliance with the law. Because over eighty percent of all raw milk is marketed through farmer-owned cooperatives, elimination of this and other FMMO functions will directly impact cooperatives and, in turn, most milk producers. The loss of this oversight role would reduce the bargaining power of all milk producers and, consequently, could be expected to widen farm-to-retail price spreads. Presently, when FMMO auditors detect regulatory violations, prompt restitution is required to cooperative sellers (as well as to independent producers who are sellers). Since auditing undergirds the classified pricing system, its absence is a key factor in undermining pricing on the basis of use and uniform minimum prices to producers who are not members of cooperatives.

  7. No enforcement of standards regarding accurate milk component testing and weights. Each milk pick-up is weighed and tested for its milk component percentages. For this reason, the verification services of FMMOs are valued by both producers and handlers. Many FMMOs also verify finished product tests. Although independent third-party testing would be expected to become more popular without FMMOs, such testing would not be easily enforceable unless the parties involved agreed to abide by third-party results. Perhaps State Health Departments and State Departments of Agriculture can take on additional verification responsibility.

  8. No audits for compliance regarding special fund payments. FMMO auditors review handler records to ensure that special assessments for government programs are being paid. Auditors examine both pool and non-pool plants which purchase Grade A milk. Today, these special assessments pertain to the dairy farmer's National Dairy Promotion and Research Board, the Class I bottler's Fluid Milk Promotion Order, and also to certain state promotion programs. In the absence of FMMOs, an issue would develop over collection auditing.

  9. Loss of data. Dairy is often credited with having the best data available for a single commodity group. Without FMMOs, information availability will suffer because dairy will have to compete with other commodity groups for the limited resources of Federal and State statistical programs. The focal point for such functions with USDA is the National Agricultural Statistics Service (NASS), including its state affiliates and the Agricultural Marketing Service (AMS). Furthermore, FMMO data comes from a complete census of regulated plants and is collected with the power of audit and enforcement behind it. In contrast, most Federal and State information is simply a statistical estimate that is obtained voluntarily and without audit. The following indicates how the specific data services provided by FMMOs might be affected by order elimination.

    FMMOs measure handler raw milk purchases which can, in turn, be used to estimate milk production by market order area and also by state. In the absence of FMMO information, NASS estimates of milk production will no longer be able to use this FMMO data benchmark. Furthermore, NASS will no longer be able to use FMMO information for the development of producer sampling interview lists.

    In regard to fluid beverage milk consumption, the following information would disappear: (1) all production volume, (2) all consumption volume including total, whole, reduced fat and nonfat sales, (3) fluid sales volume by package type, and (4) volume by user type such as grocery, schools, etcetera. NASS independently generates information on the production of soft, cultured, and frozen dairy products as well as cheese, butter, and powder.

    With the exception of the M-W price, state Grade A prices, state Grade B prices, and state average producer milk prices, all other plant milk price information would be lost. This would include the following: classified prices, pool blend prices, announced cooperative prices and mail box prices. While NASS does obtain information on the number of producers by state, the usefulness of this series suffers from the fact that small non-commercial dairy farms with as few as one cow are included.

  10. No administrative hearing process. If FMMOs are eliminated, there will be no administrative recourse to resolve problems faced by producers and handlers. Those seeking government-implemented changes will instead need to rely on judicial, legislative, or other conflict resolution means. To some extent, this role could be transferred to state marketing orders. However, the creation of state orders, their operation, and their interstate coordination all represent difficult issues to resolve. Additional legislative hearings could be anticipated at the Federal and state levels as producers vent their frustrations through the political process.

Sector Impacts

Table 1 presents a summary of deregulation impacts on producers, cooperatives, processors, and consumers. For example, line 1 indicates that if classified pricing is eliminated, producers and cooperatives are negatively impacted. Processors are anticipated to be impacted negatively if they run manufacturing plants but positively if they run fluid plants. Consumers may benefit, although the amount of any benefit is expected to be small due to the likelihood that decreases in fluid milk prices would be partially offset by increases in cheese, butter, and powder prices.

The elimination of pool blend pricing is anticipated to hurt producers because the total revenue paid for farm milk is anticipated to decline. In contrast, cooperatives may or may not be hurt depending upon the size and breadth of their organization. Small cooperatives oriented toward manufacturing will likely be hurt. Large cooperatives serving a diversity of buyers may not be impacted as significantly. Processors bottling milk will experience reduced cost due to the fact that pool equalization payments will be discontinued. Processors making frozen and hard dairy products will likely experience higher costs due to the loss of pool equalization payments which allowed them in the past to pay producers the blend price. Consumers of fluid milk could experience benefits in terms of lower prices while consumers of other products would lose.

The loss of zone price levels within FMMOs, transportation credits, and marketwide service payments will help some and hurt others. Enforcement of timely payment (Line 4) is an order feature very valuable to producers and cooperatives. However, processors would gain payment flexibility if they did not have to cope with this enforcement. To the extent any of these benefits were to reach consumers, then consumers would also benefit.

If the discontinuation of compensatory payment requirements resulted in the replacement of local milk with milk powder, local milk producers would be hurt. However, it is unclear as to the likelihood of such practices due to uncertainty regarding the price of powder relative to fluid milk, as well as the consumer acceptance of reconstituted fluid milk. Thus, the impact on each sector is difficult to determine.

FMMOs were created in large part to assist milk producers, thus a reduction of FMMO auditing (Line 6) is likely to hurt producers and their cooperatives. The discontinuation of such audits may help handlers and also indirectly help consumers in so far as handlers pass on any costs savings. In regard to equal raw product cost, some handlers may come to miss the level playing field provided by audits. From an equity perspective, all sectors of the industry benefit from accuracy in testing, weights, and measures (Line 7). Auditing special fund payments would need to be handled in a different manner, but this would be a minor inconvenience. Due to greater market power, loss of data (Line 9) would be of greater help to processors than to producers. The same is true of the loss of the hearing process.

Futures Markets

Should deregulation occur, the dairy industry will need a new price discovery mechanism. For other commodities, futures markets have a proven track record. It is anticipated that dairy futures contracts will grow in importance.

At present, all FMMO milk is commercially priced relative to the announced FMMO price. Although the minimum pricing role of FMMOs cannot be replaced by futures contracts, the benchmarking role can be replaced. Thus, in a deregulated environment, the role of cheese, butter, NDM and/or raw milk futures contracts will become more important. While a raw milk futures contract has the most direct link to the value of farm milk, the hard product futures contracts are likely to prove most useful for pricing purposes due to the reduced influences of unique local conditions and perishability. Suitable premiums, discounts, and yield coefficients will be used to transform the value of these cheese, butter and/or NDM contracts into local milk delivery prices.

The growth of forward pricing by proprietary plants will be enhanced without orders. Currently, it would be illegal for a proprietary plant to pay below the announced minimum price for milk. If a processor forward-prices milk and the classified minimum milk price increases in the future, then the processor would be forced to pay the new minimum price regardless of the lower forward contracted price. Thus, proprietary plants currently have little incentive to offer forward pricing based upon futures markets or forward contracts. These restraints would disappear with the elimination of FMMOs and the use of contracts would be substantially increased.

Allied Industry

Suppliers to dairy farmers such as companies in the areas of feed, equipment, animal health and livestock sales will lose their ability to use rules of thumb to determine a farmer's milk price and thus have some idea about a farmer's ability to pay. Bankers and others doing dairy financing will have to spend a lot more time understanding how each individual dairy farmer's milk is arranged for sale. This is because uniformity of prices between dairy farmers will decrease while, at the same time, volatility of all milk prices will increase.

In a post-regulatory environment, it is anticipated that the role of milk brokers would increase. Roles currently played by brokers include selling raw milk for dairy farmers on a short- or long-term basis, procuring raw milk, cream, and condensed milk for manufacturers, and buying or selling hard dairy products such as cheese, butter, and powder. The loss of FMMOs may mean that individual producers would perform more marketing functions. Brokers may find more opportunities to move milk between buyers and sellers in the uncertain post-FMMO environment.

Without orders, the price blending and risk sharing functions of cooperatives are expected to grow in importance. However, it should also be noted that under current regulations only cooperatives are allowed to pay producers below the minimum announced price. Thus, in a post-regulatory environment, both proprietary processors and brokers will gain pricing flexibility, perhaps leading to their growth in performing the milk supply balancing function -- particularly in an environment of increased handler contracting with producers for the available milk supply. However, the most costly dimensions of balancing could still be borne by cooperatives.

Manufacturers of dairy processing equipment may have an opportunity to make new sales to firms which find it necessary to change their production and procurement practices due to the effects of deregulation. New equipment and technology may need to be purchased in the following areas: evaporation, drying, reverse osmosis, ultra-filtration, loading and receiving facilities, and re-blending and mixing facilities. In some instances, entirely new milk processing facilities will be built while others may be closed.

State Regulations

Because milk and its products move in interstate commerce, FMMOs have always had the power to regulate milk pricing across state lines. Recent court decisions suggest that states are quite limited in what they can do to price milk. These limitations will become more apparent in the absence of FMMOs. In the eyes of some, dairy compacts offer hope in providing more support. But compacts, themselves, would come under legal challenges. Moreover, in the absence of FMMOs, compacts can be expected to be less effective in setting the price of milk.


FMMOs provide a variety of functions that would be lost with their phaseout. However, one point seems clear from the previous discussion -- the dairy industry dynamics would change with the loss of FMMOs. The FMMO system was established to solve many problems in the dairy industry, but in particular those problems involved in providing an adequate supply of a highly perishable commodity -- milk.

Milk remains a product that is impacted by seasonal production, particularly the spring flush period of high supplies and the summer short-supply period. Classified pricing provides minimum prices for milk. In the absence of FMMOs, no regulated minimum prices would exist and, therefore, more price variability would be expected. That would mean, in essence, higher highs and lower lows. Producers' responses to lower prices in the spring could exacerbate tight milk supplies later in the year when milk supplies are normally shorter. In addition, lower producer revenue due to the loss of classified pricing would reduce production in milk deficit regions, adding more prices variability in those areas. The overall result would be more milk price variability for producers, handlers, and consumers.