The 1996 farm bill mandated reform of the Federal Milk Marketing Order (FMMO) system. Part of this process is assessment of the role of the Minnesota-Wisconsin (M-W) price as the base month price in the Basic Formula Price (BFP). The M-W price series is derived from a monthly survey of the prices paid by manufacturing plants for Grade B milk. The reliability of the M-W price has become suspect because its quantity has declined to less than 5 percent of U.S. production.

The University Study Committee (USC) for the (BFP) was assembled by AMS/USDA to evaluate the performance of alternative BFP pricing procedures. Thirty-three BFP options were evaluated including six competitive pay prices, 22 product formulas, two economic formulas, and three options with no BFP.

This briefing paper analyzes the Modified Product Value (MVP) as an alternative BFP as requested by the House Agriculture Committee. The MVP is proposed as a Class III BFP alternative by the Western States Dairy Trade Association. The MVP is evaluated according to the same criteria, using the same methods as the other BFP alternatives analyzed by the USC. The proposed decoupled Class I BFP and minimum Class I price is also discussed.

The MVP has been proposed to replace the BFP for Class III milk. It is calculated as follows:

The product series price is a cheese product pricing formula:

In this formula:

• 9.87 is the proposed assumed cheese yield per cwt of milk.

• The cheese price is the Wisconsin Assembly Point.

• 0.238 is the yield of whey butter as a by-product of cheese production. Whey powder is not included in the formula as proposed.⁽¹⁾

• This series was developed using the price support make allowance. In reality the particular make allowance used makes little difference because it tends to be canceled out in the first difference procedure.

• The butter price is the Grade A price.

• The competitive series price is an adjusted A/B price which is the average of prices paid for Grade A and Grade B milk in Minnesota and Wisconsin. In this case, the A/B milk price series is adjusted to 3.5 percent butterfat and 3.15 percent protein. Hauling subsidies, prevalent in the Upper Midwest, are added. A performance premium of $0.30 per cwt is subtracted from the series. The origin of this performance premium is not known.

Figure 1 contains a comparison of the Modified Product Value and the M-W price over the January 1991 - October 1996 period. The MVP is higher than the M-W in each month and clearly lags the M-W. The MVP lags the M-W because the MVP uses the previous months A/B price.

The USC developed four qualitative criteria that any BFP alternative should be expected to meet. Each alternative was measured against these criteria.

Long Life - Any BFP alternative should have a long life. The Modified Product Value (MVP) would have a long life. Like an A/B or adjusted A/B series the MVP does not rely on the amount of Grade B milk. As Grade B milk supplies decline they will comprise a smaller part of the A/B average. The MVP satisfies this criteria.

Understandable - Any BFP should be easily understood to prevent confusion among market participants. The A/B portion (competitive series price) of the MVP is easily understood. The adjustments may be less well understood but can be explained if the precise source of the performance adjustment were specified. The product series price, as a cheese product pricing formula, could be easily understood. The MVP satisfies this criterion.

Geographically Uniform - Any BFP should be uniform across the country. The MVP satisfies this criterion.

Reflect National Manufactured Product Market - The United States has a national market for manufactured dairy products. Cheese, butter, and non-fat dry milk (NDM) can be easily shipped around the country. Any BFP should reflect this reality and the prices for cheese, butter, and NDM. The MVP only reflects the value of cheese and the cheese by-product whey butter. It does not reflect the market for butter and NDM in pricing milk. Therefore, the MVP fails this criterion. The MVP uses an adjusted A/B price lagged one month. It updates by use of the difference in the current versus the past months product series price. This provision does not violate the criteria of reflecting the national manufactured product market.

Like all other BFP alternatives studied by the USC, the MVP was evaluated using vector autoregression (VAR). This procedure is designed to analyze the relationship of economic data over time. VAR allows consideration of feedback effects between milk prices and product prices. Logically, product prices affect milk prices and the prices processors pay for milk also affects product prices. These interrelationships are considered using the VAR technique.

Price Level

Table 1 contains the means of the data of each BFP alternative reported in the USC final report (Knutson, et.al.) over the 1991-96 period. The MVP is included in this table. Over this period the MVP averaged $12.73 per cwt. It was the third highest among the alternatives, behind only the A/B and adjusted A/B. The relatively high average price level, comparable to the A/B, was not surprising given that the MVP contains an adjusted A/B price. Since the MVP also contains a cheese formula component it might reflect some characteristics of the product formulas. The other BFP alternatives were analyzed with and without by-products. The MVP analytical results are reported in all tables that follow for the sake of comparison. All of these formulas are identical and include only whey butter as a by-product.

Reflect Supply-Demand Conditions

The MVP was evaluated as to whether it reflected changes in market conditions. That is, when the quantity of products in stocks increases the MVP would be expected to decline and vice versa. The answer was yes, when stocks increased the MVP did decline (Tables 2 and 3).

The percent of price variation explained by stocks was 0.63 percent and ranked 9^th among the 25 alternatives analyzed. While the MVP did not perform as well as the pricing components and A/B options, it performed better than all but two of the product formula options.

At 12 months stocks had a $0.06 per cwt cumulative influence on the price of milk. This was a rank of 22^nd out of the 25 options analyzed. The MVP ranked 25^th in the proportion of variation explained by stocks at 12 months -- 0.43 percent.

One explanation for the lower level of performance in reflecting national supply and demand conditions is that the MVP uses a lagged adjusted A/B price. The lagged nature of this formula may have reduced its performance. In addition, the change in the product formula portion, the product price series, introduces a lagged cheese formula as well.

Reflects Changes in Product Prices

The percent of variation in the MVP explained by changes in all product prices was 15.58 percent and ranked 11^th among the alternatives (Tables 4 and 5). It performed slightly below the A/B and adjusted A/B price series. The cheese price explained about 5.4 percent of the variation in the MVP. Interestingly, the butter price was found to explain about 11 percent of the MVP variation. That is thought to result from the lagged relationships and the inclusion of the whey butter by-product.

Price Stability

Price stability has also been judged important quality on any BFP. The MVP's price stability as measured by its standard deviation was $1.2168 and it ranked 7^th among the alternatives (Tables 6 and 7). The stability of this option was probably aided by including the change in the product price series. At 12 months, however, the standard deviation was $0.48/cwt -- one of the more unstable options ranking 16^th.

Overall, the MVP option performed in the middle of the pack when evaluated with other BFP alternatives. It has the highest average price level of any option except the A/B and adjusted A/B options. Logically it performed at about the same level as the A/B options in terms of reflecting supply-demand condition, product prices and stability.

The Western States proposal decouples Class III from the Class I and II pricing by having a separate BFP to drive Class I milk. This Class I BFP -- the Fresh Milk Base Price -- is a 12 month moving average of a cheese formula.

This formula uses a higher cheese yield, 10.1 versus 9.87, than was used in the MVP. This formula includes a value of whey butter, which is a by-product of cheese production. Figure 2 plots the FMBP (the Class I and II BFP), MVP (the Class III BFP), and the M-W price over the January 1991-October 1996 period. Due to its decoupled nature, the 12 month rolling average of the FMBP BFP the Class III BFP (MVP) would have been higher than the Class I BFP (FMBP) in parts of 1991 and most of 1996.

Figure 3 contains the MVP, FMBP, and the FMBP with the $1.60 per cwt minimum Class I differential. While the minimum Class I price is above the MVP throughout the study period, the spread between the two narrowed considerably in 1996. Large month-to-month increases in the A/B price could push MVP above the minimum Class I price because of the decoupled prices and the moving average Class I price implementation. Such movements, without safeguards create incentives for substantial disruptive changes in milk utilization. In other words, the incentives to allocate milk to Class I use falls sharply.

Class I prices, in this proposal, would be calculated by adding option 1A Class I differential from the USDA report. USDA Class I differential option 1A is a Location Specific Differential. It uses a $1.60 per cwt fixed differential with multiple basing points located in the Upper Midwest, West, and Southwest. Differentials in other regions would reflect regional fluid and manufacturing milk values. This option has been estimated to generate milk blend prices somewhat close to those currently generated (AMS, Anderson, et.al.). Blend prices were estimated to increase in the Upper Midwest and decline in the Southwest although not as severely as the other options proposed for Class I pricing by USDA.

In the BFP report USC noted that decoupling Class I from Class III pricing creates the potential for distorting the price signal to producers. That is, the Class I price may be going up while the Class III price is going down. USC considered this to be disruptive behavior because timely market price signals were not being conveyed to producers.

The MVP for pricing Class III and II products would reduce the competitiveness of the United States in export market. The higher MVP price levels for A/B based price series raise the market prices for soft and hard products that have the greatest potential for being export competitiveness. Therefore, any of the higher A/B series, of which the MVP project is one, would create the need for increased export subsidies under promoting programs such as DEIP.

Agricultural Marketing Service, Dairy Division, USDA. Summary Report on Class I Pricing Options for Federal Milk Marketing Order Reform. 1997.

Anderson, David, Ronald Knutson, Andrew Novakovic, Mark Stephenson. The Economic Impacts of Alternative Class I Differentials -- AFPC Working Paper 97-4. Department of Agricultural Economics, Texas Agricultural Experiment Station, Texas Agricultural Extension Service, Texas A&M University. May 1997.

Knutson, R.D., D.A. Bessler, R.A. Cropp, L.G. Hamm, H.M. Harris, J.L. Outlaw, D.P. Anderson, T. Awokuse, J.W. Siebert, D.A. Sumner, R.D. Yonkers. An Economic Evaluation of Basic Formula Price (BFP) Alternatives -- AFPC Working Paper 97-2. Department of Agricultural Economics, Texas Agricultural Experiment Station, Texas Agricultural Extension Service, Texas A&M University. June 1997.