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UnitecTStates Department of Agriculture

Economic Research Service

Agriculture Information Bulletin Number 695

April 1994

The U.S. Dairy Pricing System

Alden Manchester^ Mark Weimar Richard Fallert

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In this report«. Pricing milk and milk products must accommodate seasonally variable supply and demand. The current system of Federal price supports and Fed- eral milk marketing orders has evolved from legislation enacted during the 1930* s and 1940* s. All farm milk is supported by government purchasing programs for manufactured products. Federal and State milk mar- keting orders provide additional pricing mechanisms to the price support program and cover nearly all fluid-grade milk produced in the United States. Federal orders set minimum prices for raw fluid-grade milk according to its use that processors must pay to dairy farmers or their cooperative. Federal orders do not determine how the milk may be used or how much milk is produced or marketed.

The U.S. dairy pricing system was created to ensure adequate milk supplies and stable prices to consumers whUe providing economic stability to producers. The system was developed because milk production and demand fluctuate seasonally, but peak supply does not match peak demand. The current pricing system pro- vides some market stability throughout the year. The dairy pricing system is primarily judged by its long- run effects on the supply and demand of milk and milk products. This report, a primer on the milk pric- ing system, explains the legislative and regulatory nature of dairy pricing.

The current system of Federal support prices and Fed- eral milk marketing orders (Federal orders or FMMO's) has evolved from legislation enacted dur- ing the 1930's and 1940*s. The Federal order system sets the minimum prices processors must pay dairy producers or their cooperatives for Grade A (fluid- grade) milk. Mük is categorized and priced according to its use. Only Grade A milk can be used for bever- age production, while Grade B milk can be used to produce only hard-manufactured dairy products, such

as cheese, butter, and nonfat dry milk. EMMO*is regu- late about 80 percent of all fluid-grade milk sold to plants and dealers. Of the remaining milk, 19 percent is governed by State legislation and regulations.

Effects of dairy price supports and IMMO's on sup- ply and demand can be evaluated by examining total purchases of surplus dairy products by the Commod- ity Credit Corporation (CCC). For example, if milk prices are too high, surpluses will be generated and ac- quired by the CCC. Any judgment of the effects of a price structure on supply and demand must be evalu- ated over a period of several years to allow for supply effects to work themselves out.

The role of cooperatives in many markets has changed dramatically since the 1970's. Cooperatives have shifted emphasis from representing the producer in the pricemaking process through the Federal order hearing process and have assumed operation of the complete procurement system, including assembling and managing fluid milk supplies, routing milk to dis- tributors as needed, and managing the surplus. As cooperatives increasingly take over these tasks, reserve storage requirements of milk decrease and both farms and plants could realize significant savings. However, if cooperative members do not produce enough milk, the cooperative may need to purchase milk from other cooperatives at a surcharge to fiilfill their contracts. Farmer-owned cooperatives currently bargain for milk prices for 82 percent of all domesticaUy produced milk. Cooperative members produce 80 percent of all mük.

Dairy Industry in Briei Milk was produced on a little over 171,500 farms throughout the United States in 1992. Of these, about 120,000 were considered commercial dairy farms.^

^Manchester and Fallert are Senior Economists and Weimar was a Section Leader in the Commodity Economics Division, Economic Research Service, U.S. Department of Agriculture.

^Commercial dairy farm is defined as a dairy farm under the Standard Industrial Classification (SIC) receiving at least $10,000 in sales from milk production, with at least 50 percent of the re- ceipts obtained from milk and dairy products.

Milk is usually picked up at the farm by tank truck every other day and is moved to one or more of the 558 fluid milk bottling plants or 1,603 dairy product manufacturing plants. Eighty percent of all milk is produced by members of dairy farmer cooperatives.

Every step of the way, the milk must be handled under sanitary conditions to guard against bacterial contami- nation and either be marketed promptly as fluid milk or processed into manufactured products, which can be stored. Milk production fluctuates seasonally~gen- erally expanding during the spring and early summer (the flush season) and contracting in the fall and win- ter (the short-supply season)-making it necessary to coordinate a supply that varies opposite of demand.

In addition, while milk production shows little daily variation, fluid milk sales vary substantially from day to day. This daily variation in sales, primarily be- cause of supermarket and consumer weekend buying patterns, becomes a significant problem in pricing and balancing milk supplies with production fluctuations.

There are two kinds of milk: fluid-grade (Grade A) and manufacturing-grade (Grade B). Fluid-grade milk

is produced under strict sanitary standards for use as fluid milk. Manufacturing-grade milk meets slightly lower standards and can be used only for manufactured dairy products because the milk undergoes processing at higher temperatures and/or for a longer period of time than in pasteurization of fluid-grade milk.

Prior to World War 11, less than half of milk and cream marketings were Grade A. But only 6 percent of all milk marketed did not meet Grade A standards in 1992, even though nearly 62 percent of all milk marketed ended up in manufactured dairy products.

How the Pricing System Evoived

Almost from the beginning of commercial milk pro- duction after the Civil War, shortrun instability in prices due to seasonal fluctuations in supply and use led to longrun uncertainty. Milk producer uncertainty and unstable prices drove substantial numbers of dairy farmers out of business, which led to even greater swings in production and prices.

Table l-Selected milk price series

Calendar year Support price

for milk^ U.S. manufacturing-

grade price^ Weighted average

all-milk price^

$/cwt.

1965 1970 1975

1980 1981 1982 1983 1984

1985 1986 1987 1988 1989

1990 1991 1992

3.22 4.57 7.36

12.04 13.10 13.10 13.10 12.60

11.97 11.80 11.28 10.60 10.73

10.10 10.10 10.10

3.34 4.23 4.70 5.71 7.86 8.75

12.01 13.05 12.72 13.77 12.60 13.61 12.61 13.58 12.49 13.46

11.72 12.76 11.46 12.51 11.37 12.54 11.15 12.26 12.38 13.56

12.34 13.74 11.05 12.24 11.88 13.10

^ Averaoe of Federal support prices set under the appropriate farm bill. ^The price of manufacturing-grade milk in the United States. n"he price received by farmers for fluid and manufacturing grades of milk. Price before deduction for hauling and govern- ment witholdlng. Excludes hauling subsidies but Includes bulk tank, quantity, and other premiums.

The U.S. Dairy Pricing System / AIB-695

It also became apparent that flow commodities such as milk, which were produced and marketed daily, could not be efficiently priced by the methods used for crops, which are harvested annually, because small changes in supply in conjunction with very in- elastic demand for fresh milk caused large swings in prices farmers received for milk. For example, auc- tions or daily negotiations between buyers and sellers could not work for milk as they did for some other commodities, so farmers attempted to organize to bar- gain with processors over milk prices.

As early as 1900, producers in a number of markets had banded together into cooperative associations to bargain with milk dealers or handlers for a flat price for all fluid-grade milk, regardless of use. However, the pressure of reserve supplies, normal to milk pro- duction, led to a breakdown of the flat-price plan.

By the 1920's, most major markets had adopted a clas- sified price system where handlers paid for fluid- grade milk according to its use. The price paid for milk used in manufactured dairy products was lower than that paid for milk sold as fluid milk, reflecting the greater costs of handling and marketing perishable milk in fluid form. Despite the seasonal variability of production, returns to producers were stabilized. Dif- ferential pricing (that is, pricing beverage milk higher than milk for manufactured products) reflected differ- ences in demand elasticities for fluid milk and manufactured dairy products and the greater cost of producing and marketing milk for fluid use. Fluid milk demand is usually considered to be more inelas- tic than manufactured product demand.

However, these systems broke down during the Great Depression in most markets as demand for milk dropped drastically, and cooperatives could no longer maintain the classified pricing systems on a market- wide basis because of the large supplies. Prices at all levels dropped sharply, and farmers were in great eco- nomic distress. The instability of milk prices and the marketing problems that arose with the Great Depres- sion prompted dairy cooperatives to ask for govemment intervention to stabilize milk marketing conditions. The Agricultural Adjustment Act of 1933 authorized the Secretary of Agriculture to enter into marketing agreements with handlers, processors, and others and issue licenses to handlers and processors to raise the prices of agricultural commodities, including milk. The Govemment also made support purchases starting in 1933. Some attempts were made to use marketing agreements to assist manufacturing milk producers, principally producers of milk used for canned milk.

Congress revised the Agricultural Adjustment Act in 1935, authorizing Federal marketing orders. They slowly replaced the earlier agreements and licenses. In addition, Congress set more specific standards for milk marketing orders. The Agricultural Marketing Agreement Act of 1937 re-enacted the 1935 act and became the foundation for the modem Federal milk marketing order system.

During World War 0, there was a great need for all kinds of food to feed the United States and its allies. Produc- ers of many products, including milk, were strongly encouraged to increase production through a number of devices. Milk production was encouraged through guar- anteed higher prices to producers. Prices to consumers were kept down by paying a subsidy to processors to offset the higher prices they had to pay for milk.

After the war ended, the remnants of the wartime pro- grams and the support activities of the immediate postwar era were modified to fit peacetime conditions in the Agricultural Act of 1949. For milk, the present price support program was established on a permanent basis. Marketing orders, which applied only to fluid- grade milk, continued under the authority of the 1937 act. There were many changes in the way these mar- keting orders were applied as technical and economic developments greatly changed the way milk was pro- duced, processed, and marketed.

Between 1949 and 1981, the support level was set leg- islatively at between 75 and 90 percent of parity but was near 80 percent of parity during most of that period- Large surpluses built up in the late 1970's and early 1980's. Since 1981, support has declined from a high of $13.49 per cwt at 3.67 percent milkfat in October 1981 to $10.10 at 3.67 percent milkfat in 1990 where it has remained since. Several programs, such as the milk diversion program (December 1, 1983, through March 31, 1985) and the dairy termination program authorized by the Food Security Act of 1985, have attempted to reduce surplus production or subsidize exports.

Producer-Level Milk Pricing

Producer prices are supported by the Federal price sup- port program and partially by Federal milk marketing orders. Areas that don't have Federal orders usually have State regulations.

Federal Price Supports

The support price underpins the entire price structure for bulk milk sold by farmers either directly to proces- sors handlers or through cooperatives (table 1). The

The U.S. Dairy Pricing System /AiB-695

support price is determined annually under provisions of the Agricultural Act of 1949 as amended by suc- ceeding farm acts.

USDA's Commodity Credit Corporation (CCC) stands ready to buy as much butter, nonfat dry milk, and Cheddar cheese as manufacturers want to sell at specified prices. These prices are designed to return the support price to the farmer. The price support pro- gram thus directly provides a floor under wholesale milk product prices and the price of milk used to manirfacture these dairy products and indirectly pro- vides support for all milk in all uses.

The current farm act sets an annual milk surplus tar- get of 3.5 billion pounds of milk, which provides a supply for government programs and a cushion m case supplies are smaller or demand is greater than ex- pected. If USDA estimates a smaller surplus, price supports are raised and estimates of a larger surplus bring lower support prices.

The price paid to farmers for manufacturing-grade milk is competitively determined and is free to move above the support level if supply and demand condi- tions warrant. It moves above the support level in the short-supply season of most years and occasionally even in the flush season. A commonly used measure for manufacturing-grade milk prices is the Minnesota- Wisconsm (M-W) price series. The M-W price is derived from a monthly survey of prices where most such milk is produced.

Because manufacturing grade milk represents less than 6 percent of total U.S. production and that per- centage is declining every year, alternative pricing methods to the M-W price are being explored. Sev- eral altematives have been analyzed since 1992.

In addition to price supports and competition in the marketplace, the price of manufacturing-grade milk re- flects: (1) the cost of manufacturing-grade milk production, (2) alternative employment opportunities (both farm and nonfarm), (3) demand for manufac- tured milk products, and, (4) indirectly through its effect on the quantity of milk used, demand for fluid- milk products.

Import Quotas as Safeguard Import quotas on dairy products are authorized when imports threaten the operation of the dairy price sup- port program under Section 22 of the Agricultural Adjustment Act of 1933, as amended. With U.S. milk prices higher than those in international markets and supported by the Federal Government, other coun-

tries could ship large amounts of dairy products to the United States and the U.S. Government would, in ef- fect, be subsidizing milk production and processing abroad. When other countries subsidize their exports, as the EC does, we could be flooded with cheese, but- ter, and other products from outside the United States.

The USDA's Economic Research Service recently studied the effects of dairy import quotas and their re- moval under different conditions.^ The conclusions of the studies are as follows:

(1) If the United States unilaterally opened the door to free trade, the all-miUc price would declme from the 1987 price level of $12.51 per cwt to $10.63 per cwt. Production would decline and prices would become more variable. If the level of imports re- mained stable, no serious disruption would be expected in the long run. However, if import levels were less stable, price variability would be expected to increase. Several other studies indicate that con- sumer gains would be greater than producer losses.

(2) However, if the EC and other adherents to the GATT were to accept hberalization in the Uruguay Round, the price of milk would decline to only $12.15 per cwt from $12.51 (in 1987 dollars).

(3) Lower cost dairy products would be available from New Zealand and Australia in limited quantities because the potential for expanding milk production there is relatively small. However, since a large part of their production is exported, these countries would be interested m dependable markets. They would regularly ship more dairy products to the United States if the market were assured than if the United States bought only occasionally.

Federal Milk Marketing Orders

What they do. Federal milk marketing orders (FMMO's) set minimum prices for raw fluid-grade milk that processors must pay to dairy farmers or their cooperative. Other provisions of the orders sup- plement the application of minimum pricing.

^Blayney, Don P., and Richard Fallert. Effects of Liberalized Dairy Imports on the Dairy Support Program, Mandated study for Congress. U.S. Dept. of Agriculture, Feb. 1990.

Blayney, Don P., and Richard Fallert. The World Dairy Market- Government Intervention and Multilateral Policy Reform. U.S. Dept. Agr., Econ. Res. Serv., Staff Report No. AGES 9053, Aug. 1990.

U.S. Department of Agriculture, Office of Econoniics. Prelimi- nary Analysis of the Economic Implications of the Dunkel Text for American Agriculture. Mar. 1992.

4 The U.S. Dairy Pricing System /AIB-695

Figure 1

Federal milk marketing orders' link with Federal price support program

Price support program Milk marketing orders

Support price for milk

Support purchase prices for dairy products

Wholesale prices for manufactured dairy products

Prices for manufacturing grade milk

^ equals Minnesota- Wisconsin (M-W) price

Class I price = M-W + differential

Class II price = M-W + -15 cents

Class III price = M-W price

f

Under the Federal order system, minimum prices are established for milk for fluid (beverage) use and for regulated fluid-grade milk used in manufactured prod- ucts. Minimum prices are determined through classified pricing (by the end use of milk). Milk used for fluid or beverage purposes is Class I, milk manu- factured into soft products like yogurt and ice cream is Class n, and milk used to produce hard products such as cheese is Class HI. Milk used to make nonfat dry milk is Class HI-A. About 42 percent of fluid- grade milk pooled under Federal orders is used for beverage products. Federal order receipts represent about 71 percent of total milk marketings.

Milk prices are established for each FMMO on the basis of specified relationships to the M-W price (fig. 1). Minimum prices for Class I are determined by fixed differentials plus the M-W price for each order. Class n prices are determined by formula and average about 15 cents per cwt above the Class III price. With a few minor exceptions, prices for milk used in manufactured products (Class HI) are at or near the M-W price base.

The structure of Class I prices should conform fairly closely to prices found in a competitive market on the basis of economic location theory. From a base point in a surplus production area, the prices increase to more distant markets, reflectmg transportation costs and local supplies and demands. The Federal order base point is in northern Wisconsin, the area with the largest supply of Grade A milk above local Class I needs. Thus, theoretically, any market in the United

The U.S. Dairy Pricing System / AIB-695

Figure 2

A simplified milk pricing class system

$/cwt

Eau Claire, Wisconsin (base point)

1,000 2.000

Miles from base point

States could be supplied from there at the northern Wisconsm price plus transportation. As long as milk can move freely from one area to another, that price plus transportation sets the upper Umit on the price in any market. If the supply in a market area elsewhere in the country exceeds local needs, the price at that pomt will be lower than the northern Wisconsm-plus- transportation price by an amount large enough to move the milk to the point where it is needed (fig. 2). The lower limit would be the northern Wisconsin price.

The intermarket structure of Class I prices established in the I960's remained unchanged until 1986, even though general inflation and petroleum prices had in- creased rapidly during the 1970's. In the mid-1980's legislation was passed to increase minimum Class I differentials, lliose differentials are currently in ef- fect in most markets.

The differential between Class I and Class III prices at Eau Claire, Wisconsin, is $1.04 per cwt and has been in effect since May 1, 1986. Class HI prices vary relatively little from one market to anotíier across the country (because the demand for manufac- tured dairy products is national), but Class I prices increase with the distance from the upper Midwest. The differential between prices for the different classes (uses) of milk would be substantial in most parts of the United States, even if the Class I differen- tial at Eau Claire were substantially reduced.

The prices previously discussed are those paid by processors for fluid-grade milk used in different prod- ucts. The price the farmer receives is an average price (or blend price) reflecting the proportions of all fluid-grade milk used to produce Class I, Class II, Class ni, and Class III-A products. The blend price in a particular market is strongly influenced by the amount of reserve milk in that market over and above that needed for fluid milk products (Class I). In other words, the greater the reserve and the more milk that is used to produce Class II and Class III products, the lower the blend price.

Because milk production and consumption patterns vary, frequent price changes are necessary to reflect changing economic conditions. Serious problems could arise in obtaining timely price adjustments to meet changing market situations if prices were changed solely on the basis of administrative hearings. There- fore, prices are changed automatically by market forces in response to changing economic conditions. Use of these methods avoids lengthy administrative procedures because changing economic conditions are appropriately reflected in milk prices. Hearings be- come necessary only when market forces do not operate satisfactorily.

What they don't do. Under Federal orders and price supports, only the prices received by farmers are regu- lated and then only by setting minimums and/or targets. In addition, FMMO's do not determine or control how the miUc can be used. Rather, handlers and processors determine the uses based on known and anticipated or- ders from their customers for fluid milk products. Milk not used for fluid milk products (Class I) is used

for manufactured products. The prices that handlers must pay for milk going into different uses are in- tended to and do influence the quantities used. But Federal orders do not determine quantities used.

In earlier years. State and local health authorities erected numerous barriers to milk movement through sanitary regulations, product specifications, and other regulations. These regulations protected local produc- ers from competition. Almost all of these regulations have been removed by court and legislative action. Today, Federal orders do not restrict milk movements among orders, although order prices do have some ef- fect. Handlers and cooperatives control milk move- ments from farm to processor or from one area to another.

No Federal order limits the quantity of milk produced or marketed, although 1965 legislation provided authority for Class I base plans. Base plans set quo- tas for the amount of milk for which dairy producers could receive the Class I price. The original authority could have discouraged entry by new producers. The act was amended in 1970 to require that new producers be provided easier entry, which effectively removed the restrictive features of Class I base plans. This is one major reason why only two milk markets originally adopted Class I base plans. The authority for Class I base plans was not extended in the 1981 farm act.

However, seasonal base plans that place limits on the amount of milk for which an individual producer can receive the base price exist in seven markets (Ala- bama-West Florida, Central Arkansas, Carolina, Georgia, Louisville-Lexington-Evansville, Middle At- lantic, and Tennessee Valley). The producers' blend price is based partially on how much they produced during the low-production season. These base price plans allow for the producer to develop base each year. The purpose is to reduce seasonal variation in milk production. Although seasonal base plans do not control production or volume marketed, they do influ- ence the distribution of proceeds among farmers and reduce the mobility of producers among markets.

State Regulations

Some States regulate milk at the farm and/or con- sumer levels. Prices are set by some States and selling practices of processors regulated in several States.

Farm Level Prices paid to producers for fluid-grade milk are regu- lated by Federal orders and by 11 States, including

The U.S. Dairy Pricing System / AIB-695

Table 2--States regulating milk prices, Spring 1993

Minimum Sales below State None producer pricing^ cosf Resale price^ Trade practice'* Bonding^

Alabama X Alaska X Arizona X Arkansas X California X X 6 X X Colorado X X Connecticut X Delaware X Florida X X

Georgia X Hawaii' X g

Idaho X Illinois X Indiana X Iowa X Kansas X X Kentucky X Louisiana' X X

Maine' X Maryland X Massachusetts* X X X X Michigan X X Minnesota X X Mississippi X Missouri X X X Montana X X X

Nebraska X Nevada X X X New Hampshire X X New Jersey

9 X X X X New Mexico X New York'' X X X North Carolina X North Dakota X X X Ohio X Oklahoma X Oregon

6

Pennsylvania^' X X X X Rhode island X 6

South Carolina X South Dakota X Tennessee X Texas X Utah X

Vemnont X 6

Virginia X X 6 6

Washington 6

West Virginia X Wisconsin X X X Wyoming X

^State sets producer prices. ^Sale below cost, however cost is defined, is prohibited. ^State sets minimum retail and/or whole- sale prices. "^Prohibitions exist on certain trade practices. ^Either an escrow-type bond or some statement of net worth is re- quired to be a milk dealer. Statute protects dairy producers in cases of milk dealer default. ^Statute is in place but not enforced. ^State enforces butterfat testing law. ^Vendor fee, which is returned to State's producers. In Maine, it is equal to $0.01-0.05 per cwt. ^Pricing set by FMMO's. ^^State licenses milk dealers.

The U.S. Dairy Pricing System / AIB-695

New Jersey and New York, which regulate producer prices under concurrent regulation with Federal orders (table 2). Federal orders regulate the prices paid to producers on about 80 percent of the fluid-grade milk sold to plants and dealers, and States regulate an addi- tional 19 percent. The share under Federal regulation has increased from about 33 percent in the late 1940's, while milk under State regulation has de- creased from nearly 25 percent. California is the largest State under State pricmg regulations, with nearly 15 percent of the milk sold to plants and deal- ers. In many cases. Federal orders were introduced after State control legislation had been repealed or de- clared unconstitutional by the courts. North and South Carolina are recent examples. Less than 1 per- cent of the fluid-grade milk sold in the United States is not covered by either Federal or State regulation.

Many States have studied and enacted legislation to raise dairy producers' prices because of dissatisfaction with price levels. Some legislation was enacted and later overturned by the courts; other legislation (in Massachusetts, Maine, and Minnesota) is still being contested. Milk pricing laws exist m some States but are not being enforced. In an attempt to put more money in dairy producers' hands, some States like Maine and Massachusetts have enacted legislation that collects a user fee from vendors. That money is then returned to producers within the taxing State. Several States have also enacted producer security trust funds that provide farmers with compensation should han- dlers go bankrupt without paying their producers.

Consumer Level

The Federal Government does not set prices for milk at the retail level. However, 6 States regulate whole- sale or retail prices of fluid milk products or both. States differ in the regulation of resale prices-some set minimum prices, some maximum prices, and some both minimum and maximum prices. For example, Pennsylvania and Montana essentially set minimum prices at every market level. In these two States, minimum prices are set at a stop-loss level (conditions based on the cost of production), and market prices are generally above them. Other States, such as Ne- vada, set prices that must be paid by the retailer, but do not restrict the price the retailer charges consumers.

There are many reasons for maintaining resale price control of milk-not the least of which is the desire to retain the backing of handlers for control at the pro- ducer level by giving them guaranteed margins. From a public policy standpoint, however, the primary argu- ment is that retail pricing is inherently unstable and frequently leads to destructive price wars. The chang-

ing structure of the milk production and marketing sectors along with the accompanying change in the na- ture of the pricing process has substantially weakened this argument.

Under the typical milk marketmg system of the 1950's, handlers provided full service to retail stores, including pricing milk and milk products, display case arrangements, and daily delivery. A typical store had from two to six brands of milk, each serviced by a dif- ferent handler. In practice, prices were effectively determined by the handlers, and the store received a fixed margin. While the handler did not have abso- lute control over prices as did a gasoline company in its leased stations, the control was still strong. If one handler reduced retail prices, other handlers with milk in the same store were under strong pressure to follow.

In the present market, retailers generally exert a stronger control over pricing. Larger chain stores often have their own bottling and distribution plants. There is typically no more than one brand per store in addition to private label, and often there is only pri- vate label. Also, chain stores purchase for a large number of stores at the division level rather than at the local level. Under these circumstances, resale price control no longer serves the function it once did.

Most States with resale price fixing authority, and many without, have authority to regulate trade prac- tices. State trade-practice laws usually prohibit all or most of the following: free merchandise, unreason- able extension of credit, secret rebates and discounts, free signs, unearned advertising allowances, loaning of money, free equipment, free repairs and services, sales below cost at the wholesale or retail level, price discrimination, and purchase price discrimination. Also, several States require a minimum markup, par- ticulariy by retailers, while others require that prices be filed with the State agency.

The potential effects of trade practice regulation are mbced. Where minimum markups are specified or price filing is required, the tendency is similar to that of resale price fixing and prices are likely to be some- what higher than they would be in the absence of trade practice regulation. However, by prohibiting many forms of nonprice competition, such as those listed above, there is some tendency to force competi- tion more strongly into the price arena.

Another effect of resale price regulation, whether achieved directly by price setting or indirectly through trade practice regulation, is maintaining the status quo. Since any change represents a potential competi-

The U.S. Daily Pricing System /AIB-695

tive threat to someone, there is usually resistance to change. Often the rate of innovation—whether new containers, new services, new products, or changes in price structure—tends to be slower in areas with such regulation than elsewhere. The nearly universal use of cost figures as justification for changes in whole- sale or retail price structures produces a strong tendency toward average-cost pricing. Thus, changes in price structures to reflect lower cost containers or methods of distribution are resisted. Prices tend to be set at levels reflecting average or higher costs of all distributors. In these cases, distributors with below- average costs cannot reduce prices to reflect their own costs, thereby removing a strong incentive to compete through lower prices. The complex price structures that exist in the milk industry at both the wholesale and the retail levels practically defy regulation. Any attempt by a pricing authority to regulate all of the variations would be futile. Minimum prices at a stop- loss level, which reflects the lowest cost attainable, could be set permitting the price structure to develop above that level through competitive pressures. Whether this is necessary to achieve public policy ob- jectives is another question.

The Changing Role of Cooperatives

The role of cooperatives in many markets has been changing since the 1970's. Cooperatives have broad- ened the scope of their operations. In Federal- and State-regulated markets, their principal effort has shifted away from representing the producer in the pricemaking process through Federal order hearings or whatever arrangements a particular State might have. In many cases, they assumed operation of the complete procurement system, mcluding assembling and managing fluid milk supplies, routing raw milk to distributors as needed, and managing the surplus. Cooperatives bargain for prices for 82 percent of milk produced. Cooperative members produce 80 percent of all milk. Milk supply varies somewhat daily, de- pending on the vagaries of production by individual cows, weather, road conditions, and other uncontrollable factors. Daily demand varies more, partly because more milk is being sold through supermarkets, with a con- centration of sales on weekends.

Many handlers have accepted full supply arrange- ments with a cooperative to reduce the high cost of procuring and coordinating a fluctuating supply to meet a variable demand. Under such an arrangement, the cooperative supplies the exact needs of each han- dler for milk for fluid use and/or for ice cream and cottage cheese. Cooperatives also dispose of the sur-

plus for other uses. Such full supply arrangements do not eliminate fluctuations, but they do reduce their im- pact on handlers by giving them a relatively simple, routine way of adjusting supply to demand with mini- mum effort and expense. Furthermore, a single agent is in a better position to make necessary adjustments and reduce the burden of uncertainty.

As cooperatives increasingly take over the task of co- ordinating supply and demand under full supply contracts or similar arrangements, substantial econo- mies of scale can be achieved. Reserve supplies of milk, which must be carried to meet fluctuations in de- mand, become smaller. Significant savings become possible in the movement of milk, both from the farm and to plants, when one agency is routing the total supply of the market. However, full supply contracts can put a burden on a cooperative whose numbers do not produce enough milk to fill such contracts. These cooperatives usually end up buying milk from handlers in other Federal orders to meet their commitments and paying a substantial premium.

Under such a system, reserve supplies of milk can be routed into various dairy products much more effi- ciently, since the supply of milk from a cooperative serving the entire market is not as variable as the sur- plus from a single processor. If each fluid handler attempted to take care of its own surplus, tremendous variations would occur from day to day in the volume being manufactured. The added efficiency in a cen- tralized supply-coordination and surplus-disposal operation, compared with a system in which each han- dler manages their own supply and surplus disposal, is probably about 20-24 cents per cwt. Such potential savings can be shared between the balancing coopera- tive and processors, the proportions depending on the relative bargaining strength of each. The economies are large enough so that both parties save substantially.

Changed bargaining relationships in the procurement market and lower operating costs associated with cen- tral supply management have helped create a climate in which cooperatives can bargain for and obtain pay- ments over minimum prices established under Federal orders to defray some of the cost of servicing the mar- ket. There were over-order payments in all Federal order markets but one in 1992, an increase from 35 percent of the markets in 1964 and 90 percent in 1975.

From the mid-1960's to mid-1973, over-order pay- ments (including both premiums and service charges) on Class I milk averaged 20-40 cents per cwt. Coop- erative blend prices paid to producers in markets with such payments were generally close to and sometimes

The U.S. Dairy Pricing System / AIB-695

below Federal order minimum blend prices. In these circumstances the over-order payments covered little more than the costs of performing marketing services.

In 1974, over-order payments increased sharply. They increased from an average of 33 cents in May to 97 cents in November for 31 cities in Federal order mar- kets. This increase was primarily due to the decline in Federal order Class I prices ($1.86 per cwt between May and September) and the efforts of cooperatives and handlers to maintain their selling prices. Most re- cently, annual average over-order payments have been in the 75- to 85-cents-per-cwt range (table 3).

Futures Contracts

With the advent of futures market contracts for nonfat dry milk and cheese, a new era in the pricing of milk may evolve. Currently, other commodities, such as live cattle and hogs, are partially being priced from fu- tures contracts. Discounts and premiums based on location, time from the fritures contract expiration date, and other factors determine the negotiated price. Futures contracts, if they become viable, may remove many of the factors which led to price instability dur- ing the 1930's. For example, many buyers and sellers are available daily to determine the price in other vi- able commodity futures contracts.

What the Milk Pricing System lUlust Do

Fluid milk products have first claim on the milk sup- ply since they return the highest price to producers. Semiperishable products, such as ice cream and cot- tage cheese, which may be made from either local milk supplies or from intermediate products (such as condensed milk, butter, and powder), are residual claimants on milk supplies.

The total supply of milk depends on the prices paid to producers of fluid-grade and manufacturing-grade milk, expected future prices, present and expected costs of producing milk, and alternative farm and off- farm opportunities. The quantity demanded of milk and dairy products, in turn, depends on the retail prices, the availability and price of substitute prod- ucts, promotion and advertising, consumer income, population growth, composition of the population by gender, race, and age, and how that changes consumer tastes and preferences.

Any milk pricing system, therefore, must recognize the total forces affecting the national supply and de-

Table 3-Selected milk price series

All-mari<et Federal order

Minnesota- minimum Effective Calendar Wisconsin Class i Class 1 year price^ price^ price^

Dollars/cwt

1965 3.27 5.03 5.39 1970 4.66 6.74 6.94 1975 7.62 9.36 9.96

1980 11.88 13.77 14.39 1981 12.57 14.69 15.25 1982 12.49 14.63 15.15 1983 12.49 14.69 15.14 1984 12.29 14.41 14.89

1985 11.48 13.88 14.47 1986 11.30 13.60 14.16 1987 11.23 13.90 14.51 1988 11.03 13.42 14.19 1989 12.37 14.51 15.29

1990 12.21 15.54 16.33 1991 11.05 13.30 14.16 1992 11.90 14.57 15.40^

^The price of manufacturing-grade milk in Minnesota and Wisconsin. ^Tiie average of all Federal order-established minimum Class I (beverage milk) prices during the year. ^The actual average price paid in all Federal orders for Class I milk. This Includes any over-order charges. ^Preliminary.

mand for milk and strive to create a balance between supply and demand over time. This requires estab- lishing and maintainmg a balance among (1) the need for producer prices to remam high enough to maintain production, (2) the v^^illingness and ability of consum- ers to pay for milk and dairy products, (3) public interest in efficient allocation of resources, and (4) the overall interest of producers, handlers, and the public in the orderly flow of milk and dairy products from the producer to the consumer.

Establishing prices at levels higher than needed to as- sure an adequate supply would cause producers to expand production to the point where milk surpluses become burdensome. Government purchases obvi- ously cannot be expanded without limit. During 1980-86, Government purchases were between 8 and 14 percent of marketings. By 1989, they had declined

10 The U.S. Dairy Pricing System /A!B-695

to 3.5 percent of marketings. Since then, they have climbed into the 4- to 5-percent range. Also, without effectively controlling production, raising prices above the level that balances supply with demand be- comes self-defeating, for as excess supplies build up, a substantial reduction in price is required to eliminate surpluses. Therefore, a built-in cyclical pattern of pro- duction and prices results. For the producer, it provides a boom-or-bust price structure with no assur- ance of consistently reasonable returns. Also, resources are misallocated as they move into the in- dustry during expansion and are forced out during periods of contraction.

The impacts of a price structure can only be judged by the effect on supply and demand over a period of time. Supply effects, in particular, take several years

to work themselves out. The biological process of production is long term, and the responses of produc- ers are relevant as they relate to longrun decisions to increase or decrease herd size or to go out of business. The wisdom of any price decision can be evaluated at the time it is proposed only in terms of anticipated supply and demand over the next 2 or 3 years. In other words, what will the resulting supply-demand balance be then? Any other criterion, especially one limited to shortrun effects, will be self-defeating.

Impacts of dairy price supports and Federal order ac- tions on the supply-demand balance can be evaluated in terms of CCC purchases of surplus dairy products. For example, if the stmcture of milk prices is too high, surpluses will be generated and acquired by the CCC.

The U.S. Dairy Pricing System / AIB-695 11

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