The Federal Agriculture Improvement and Reform Act of 1996, hereinafter referred to as the 1996 Farm Bill, mandated reform of the Federal Milk Marketing Order (FMMO) system. One aspect of this reform process specified by the Farm Bill included the assessment of alternatives to the Minnesota-Wisconsin (M-W) price series. For the past 35 years, the M-W has played the very important role of serving as a mover/adjuster for changes in FMMO prices. As such, the M-W has often been referred to as the Basic Formula Price (BFP) because of the key role it has played in milk pricing. (In 1995, the BFP was institutionalized in FMMO regulations by updating the M-W price with product prices. This action was taken as a temporary measure pending the installation of a more permanent BFP).

The M-W price series is derived from a monthly survey of the prices paid by manufacturing plants for Grade B milk. One problem is that the quantity of Grade B milk has continuously fallen as its producers either went out of business or converted their dairies to meet Grade A standards (Figure 1). In the absence of a sufficient supply of Grade B milk, there can, as a practical matter, be no reliable M-W price. In addition, it is often asserted that excess manufacturing capacity in the Upper Midwest and related structural adjustment leads to regionally higher milk prices. The University Study Committee (USC) concludes that there are sufficient concerns regarding the reliability of the M-W price that the Secretary needs to move swiftly to install a replacement.

The need for an alternative BFP has been recognized for over two decades. In 1973, Assistant Secretary Lyng's Milk Pricing Advisory Committee recommended that the Department initiate research to develop an alternative to the M-W price series (AMS, 1973). In 1991, the Dairy Division of the Agricultural Marketing Service issued a report which developed and analyzed over 16 alternatives to the M-W series (AMS, 1991). In May 1995, it modified the M-W series to include changes in manufactured product prices as a temporary measure to shore up the validity of the series, pending the development and adoption of a permanent replacement. To reduce confusion in this report, the BFP both before and after May 1995 will be referred to as the M-W price series.

As a result of its 1996 Farm Bill mandate, the Agricultural Marketing Service authorized the establishment of this University Study Committee (USC). The USC represents a geographic cross-section of economic expertise on marketing and pricing of agricultural products, including milk. A number of members of the USC have devoted much of their professional careers to studying the economic dimensions of the dairy industry. Two committee members served in administrative positions in USDA, one was an economist for a major dairy cooperative, and another has served as a cooperative director.

The AMS Dairy Division requested the USC to:

• Identify alternative BFP procedures and update those contained in the 1991 study.

• Evaluate how each alternative procedure would be expected to perform relative to the objectives of the Agricultural Marketing Agreement Act of 1937, as amended (hereinafter AMAA).

• Specify, for those BFP procedures best meeting the criteria, the data and operational requirements for effective performance.

USC approached the problem of evaluating a replacement for the M-W price series from the perspective of the AMAA which states that the Secretary shall set minimum prices -- not necessarily the price for milk. In so stating, the framers of the AMAA recognized the difficulty of setting and administering prices. Increasingly, over time, the Secretary's FMMO decisions have recognized the importance of setting minimums rather than attempting to set individual prices.

USC concludes that in the absence of an effective price support, and, after 1999, no price support at all, minimum Class III pricing takes on special significance in that the market for manufactured products must clear. This requires that the Class III price be set sufficiently low that the market will clear. At the same time, USC recognizes that an important objective of the AMAA is to stabilize and enhance producer returns. It can, however, do so only within the bounds of market relationships and forces affecting the supply and demand for milk in different use classes.

As indicated previously, there are numerous options for setting the BFP -- the 1991 study analyzed 16 basic alternatives. These 16 options, plus 16 more, were identified and analyzed in this study. As indicated in Table 1, these 32 options fall into four broad categories:

• Competitive pay price.

• Product price formula.

• Economic formula.

• No BFP.

Step 1 Criteria

USC agreed on a set of criteria that any BFP option had to satisfy. Options failing to satisfy these criteria were dropped from further consideration. The Step 1 criteria were as follows:

• Long life. There is no point in going through this exercise every few years. Those options that were concluded to have a useful life of less than 10 years were eliminated in Step 1. There is nothing magic in 10 years except to indicate if USC concluded that a particular option had a limited foreseeable life, it was excluded from further consideration. The most obvious example of an option with a limited useful life is the M-W price itself because Grade B milk is disappearing.

• Understandable/transparent. Economists can develop many different means of pricing milk. Some of these involve the use of complex economic models. Such models may do a very good job of pricing milk used for manufacturing. But, to have confidence in the pricing system, people must understand how the price is determined. It cannot be derived from a black box that is difficult to either explain or understand. In other words, the procedure must be transparent in that people can see and understand how the BFP is derived. In this study, we operate under the assumption that complex models and statistical methods are very useful to evaluate the BFP options but not to develop prices.

• Geographically uniform. Manufactured dairy products compete in a national market. This contrasts with Class I products which compete in regional markets. A national market for manufactured products suggests a uniform BFP.

  The arguments in favor of a national market for milk and, therefore, a uniform BFP, have become increasingly strong over time as production of milk for manufacturing has expanded rapidly beyond the Northeast and the Midwest into the West and Southwest (Knutson, Schwart, Ernstes, Outlaw). On the demand side of the market, population has become more dispersed with rapid expansion throughout the South and West. The effect is to make both the supply and demand side for milk used for manufacturing and the resulting products to be more national in scope.

  The result tends to be a more uniform distribution of both production and consumption of manufactured products, although processing is concentrated in the Upper Midwest, Northeast and West. With manufactured products being storable and transportable at a relatively low cost, greater uniformity of consumption and production provides a compelling economic argument for a geographically uniform BFP.

  This does not mean that prices of milk used for manufacturing will be absolutely uniform throughout the country. It is quite reasonable to anticipate that manufactured product prices will be different geographically and related to the location of population/demand centers, production/supply centers, and transportation costs. Market-determined geographical differences in prices of milk for manufacturing are facilitated by the minimum pricing principles encompassed in the AMAA. The complexity of the Federal order regulatory system would be significantly increased if geographically different prices were to be charged for milk used for manufacturing from two or more basing points. Moreover, in establishing such higher levels of regulation, little or nothing would be accomplished in terms of the objectives of AMAA.

  This criteria raises questions regarding the consistency between California regulation and Federal regulation. USC looked closely at the California regulatory system and believes that regulators of both systems can learn from each other. That is, there are virtues in both systems. Taking the best of each would improve the performance of the FMMO system.

• Reflect manufactured milk market. The BFP must reflect market conditions for milk used for manufacturing. This requires that the BFP be an interface between the supply and demand for finished products, namely butter, NDM and cheese, and the supply and demand for raw milk. Local competitive conditions for milk should not be a prime BFP determinant. Manufactured product prices do not all move together uniformly. If the supply and demand for manufactured products is to be reflected in the price of milk for manufacturing, as stated or at least as implied by the AMAA, then all major products (butter, NDM and cheese) must be directly reflected in the BFP. Moreover, in order to direct milk to its highest valued manufacturing use there must be a single manufacturing milk price. USC recognizes that this criteria is controversial because its effect is to exclude several product formulas from being the BFP and raise questions regarding how tenable IIIA pricing is -- an issue which will be addressed separately in Chapter 5.

Each of the BFP alternatives that survived Step 1 screening was compared to the M-W price series. An adjusted M-W price series was developed to take into consideration known flaws in the M-W series. That is, the adjusted M-W series modifies the M-W price by standardizing for protein, as is done for milkfat, and by adding hauling subsidies. People will differ on how useful comparisons with the M-W and adjusted M-W series are since both have problems and a very limited useful life. For industry participants, the comparison with the M-W is a useful reference point in terms of price levels generated by the options relative to those that were actually paid for Class III milk. However, the adjusted M-W series is clearly preferred by USC to the current M-W because the former takes into consideration protein premiums and hauling subsidies.

Step 2 Criteria

The options that survive the Step 1 criteria are subjected to the econometric analyses of Step 2. (The same analysis was applied to those options that did not survive Step 1 and their results are contained in Appendix D. The econometric analyses generally supported the Step 1 decision.) The Step 2 analysis involved statistical tests designed to determine the extent to which the following three evaluation criteria were satisfied:

• Reflect national supply-demand conditions for manufactured products. The BFP needs to reflect national supply and demand conditions for manufactured products. AMAA explicitly notes that prices under orders should reflect market supply and demand for milk and its products. USC interprets this as meaning that the price for milk used for manufacturing should reflect the supply and demand for milk used in making manufactured products. In reading the 1995 BFP decision, reflecting supply-demand conditions appeared to be the most frequently mentioned consideration by all hearing participants and by USDA in choosing among the options (AMS, February 1995).

  USC spent considerable time and effort studying and deliberating over the best way to measure whether a price reflects supply and demand conditions. Economic theory and applied research relating to this issue suggests that under stable, competitive market and policy conditions prices tend to closely reflect stock levels (Tomek and Robinson). That is, when stocks increase, prices often decline and vice versa. In agricultural market analysis, stocks-to-use ratios are frequently used as price change/trend indicators (Newbery and Stiglitz).

  In this study, the basic statistical procedure utilizes a time series analytical procedure known as vector autoregression (VAR). This procedure allows for consideration of the feedback effects between the milk price and manufactured product prices as well as the effects of product prices on milk prices. While the conventional theory of price discovery indicates that the price of milk for manufacturing is determined by product prices, it can also be inferred that milk prices influence product prices. Recent research supports this notion (Perera, Outlaw, and Knutson). Both of these directional effects are captured by the VAR procedure explained in Appendix C.

  In the application of the VAR technique, manufactured product stocks were measured on a total solids milk equivalent basis. Total solids were measured giving milkfat a 40 percent weighting and solids not fat a 60 percent weighting. The VAR procedure allowed USC analysts to simulate the impact of a change in the level of stocks and determine its effects on the price generated by each BFP option. In the simulations, stocks were changed by one standard deviation from the trend based upon monthly U.S. stocks data for the period 1991-95, which is 248 million pounds of milk equivalent or roughly 24.5 million pounds of cheese. Four statistical measures were used to determine the degree to which the BFP reflects national supply-demand conditions:

  When stocks were increased or decreased in the simulation, did the price of milk move in the appropriate direction? The expectation is that an increase in stocks would lead to a decrease in the BFP. A movement in the wrong direction is viewed by USC as warranting a rejection of the option.

  What percentage of the variation of changes in the monthly milk price is explained by changes in the milk equivalent of manufactured product stocks? The preference is given to the BFP option where changes in stocks explain a larger proportion of the price change as measured by a higher coefficient of determination (R2).

  What is the magnitude of influence of stocks on price at the end of 12 months? In other words, how much has the price of milk (BFP) changed in response to a 248 million pound milk equivalent increase in stocks? A larger price decrease is preferred, although there is a tradeoff against the stability criterion.

  What percentage of the price variation is explained by stocks at 12 months after the shock in stocks? In other words, over the 12-month period after a shock equivalent to 24.5 million pounds of cheese, what share of the price variability was accounted for by the change in stocks? A larger percentage is preferred, although once again there is a tradeoff with the stability objective.

• Reflect the changes in the value of milk used in manufacturing. The BFP must reflect changes in the value of milk used in manufacturing. This criterion more directly links the BFP to the price of manufactured products than the previous one, although they clearly overlap. The tie here to the AMAA is that of providing an orderly flow of products, avoiding unreasonable fluctuation in supplies and prices and assuring a level of income to maintain production capacity. In a sense, this is a producer equity criterion -- seeing that the producer gets a fair share of product values.

  In this case, the VAR statistical procedure was used to measure how well the milk price responds to the three manufactured product prices sequentially from cheese, to butter to NDM. The statistic utilized is a coefficient of determination (R2 ) which measures the percent of the variation of changes in the monthly milk price accounted for the combined change in prices of the three products. Once again, the VAR statistical procedure allows for consideration of the feedback effects between milk prices and product prices as explained in Appendix C.

  Subsequent to measuring the impact of changes in all product prices, each BFP option was analyzed to determine the percentage of the variation in the BFP accounted for by changing each individual product price -- cheese, butter and NDM.

• Provide price stability. The BFP should generate prices that are relatively stable. This criterion relates to the AMAA objective of avoiding unreasonable fluctuation in prices. In the absence of an effective support price floor, milk prices have become considerably more unstable (Figure 2). Thus, if stability is to be considered a policy goal, it will need to be through the Federal order pricing mechanism, one component of which is the BFP.

The second measure of stability is the amount of price variation resulting from the simulated change in stocks utilizing the VAR analytical procedure. In this case, the standard deviation from the mean was measured at 12 months. One would want the deviation 12 months after stocks were increased or decreased in the simulation to be relatively small, indicating a more stable milk price and a more rapid return to long-run equilibrium.

Any policy decision involves tradeoffs -- otherwise the preferred option would be obvious. For example, the option that indicates the greatest responsiveness to a change in stocks may also be the option that is the most unstable. Economic analysis of the type contained in this report may provide information about the nature and magnitude of these tradeoffs.