Dairy Industry: Information on Milk Prices, Factors Affecting Prices, and Dairy Policy Options
Published: 2004-12-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2003, U.S. dairy farmers marketed nearly 19.7 billion gallons of raw milk, one-third of which were used in fluid milk products. Farmers, cooperatives, processors, and retailers receive a portion of the retail price of milk for their part in providing milk to consumers. During 2002 and 2003, farm prices fell while retail prices did not similarly decline. This pattern raised concerns about a growing spread between farm and retail prices. Farm prices have since increased, reaching record highs in April 2004. As requested, GAO examined (1) the portion of retail milk prices received by farmers, cooperatives, processors, and retailers, how this changed over time, and the relationship between price changes at these levels; (2) how various factors influence prices and affect the transmission of price changes among levels; and (3) how federal dairy program changes and alternative policy options have affected or might affect farm income and federal costs, among other considerations.
section_title: What GAO Found
paragraphs: Between October 2000 and May 2004, on average, farmers received about 46 percent, cooperatives 6 percent, wholesale processors 36 percent, and retailers over 12 percent of the retail price of a gallon of 2 percent milk (the most common type of milk purchased) in the 15 U.S. markets GAO reviewed. During this period, in 12 of the 15 markets, the spread between farm and retail prices increased. However in some markets, the price spread between these levels increased and then moderated. Price changes at one level were most closely reflected in changes at adjacent levels of the marketing chain. Farm, cooperative, wholesale, and retail milk prices are determined by the interaction of a number of factors. For example, farm prices are affected by the supply of raw milk and the demand for milk products such as fluid milk, cheese, and butter, as well as by federal and state dairy programs. At the cooperative level, prices are influenced by the cost of services that cooperatives provide, and the relative bargaining power of cooperatives and milk processors. At the wholesale and retail levels, input costs such as labor and energy, and the continued consolidation of firms influence milk prices. Recent changes in federal dairy programs have affected farm income, federal costs, and other considerations. For example, the Milk Income Loss Contract program has supported some farm incomes but has exceeded initial cost estimates because of low farm prices. A number of options have been suggested to change federal dairy policies such as amending federal milk marketing orders and raising or eliminating the support price. In general, these options would have mixed effects depending upon whether milk prices were high or low over the short or long term. For example, options that increase farm income over the short term tend to increase milk production and lower farm prices over the long term. These options also tend to be costly for the federal government during periods of low prices.

section_title: Letter
paragraphs: In 2003, U.S. dairy farmers marketed nearly 19.7 billion gallons of raw milk  for which they received approximately $21.2 billion. Roughly one-third of  these 19.7 billion gallons were ultimately sold to consumers as fluid milk  (milk) products. The milk marketing chain that moves milk from the dairy  farm to the consumer is composed of farmers, dairy cooperatives,  wholesale milk processors, and retailers, and entities at each level receive  a portion of the retail price of a gallon of milk for the functions they  perform. These functions include producing, processing, distributing, and  selling milk. During 2002 and 2003, farm prices were the lowest since 1979,  while retail milk prices generally did not experience a similar decline. This  disparity raised concerns about a growing price spread between farm and  retail milk prices. However, in 2004, farm price trends have reversed, with  farm prices reaching record highs.
Since the 1930s, the U.S. Department of Agriculture (USDA) and some  states have operated programs designed to support dairy farmers by  ensuring that farm prices do not fall below minimum levels. These  programs include, among others, federal milk marketing orders (FMMOs),  which use formulas to establish minimum farm prices in different  marketing areas of the country; a price support program to sustain farm  prices through a standing offer to purchase certain milk products at set  prices; and trade restrictions or export subsidies to protect the U.S. milk  industry from competition from foreign milk products or reduce supplies.
Low farm prices have generated interest in new federal policies to provide  assistance to dairy farmers; however, the cost of these programs during  periods of low prices has raised concerns. For example, in the Farm  Security and Rural Investment Act of 2002 (the 2002 Farm Bill), Congress  authorized USDA to establish the Milk Income Loss Contract (MILC)  program, which provides supplemental payments to farmers during periods  of low prices. Depressed farm prices triggered $1.8 billion in MILC  payments to dairy farmers in fiscal year 2003. Additionally, USDA spent  over $1.5 billion in fiscal years 2001 through 2003 attempting to maintain  minimum farm prices at a legislatively set level through the price support  program.
Recent changes in milk prices have illustrated the volatility of milk price  cycles. For example, as of April 2004, farm prices reached record highs as  USDA announced a minimum price for raw milk used in manufacturing  cheese that was approximately 36 percent higher, at $19.66 per  hundredweight, than the March price of $14.49 per hundredweight, an  increase of nearly $0.45 per gallon of milk. This increase reflected a  number of changed market conditions that decreased the amount of raw  milk production, while also increasing the demand for some manufactured  dairy products. However, high farm prices create incentives for farmers to  produce more milk, which then tends to depress milk prices over the long  term, thereby increasing concerns about farm viability in the future.
At your request, this report examines (1) what portion of the retail price of  fluid milk is received by dairy farmers, dairy cooperatives, wholesale milk  processors, and retailers in selected markets throughout the United States,  how this distribution has changed over the period of our review (October  2000 through May 2004), and the relationships among price changes at  these levels; (2) how various factors, such as costs, influence the price of  milk as it moves from the farm to the consumer, as well as how these and  other factors affect the extent to which changes in price are transmitted  among levels as milk moves from the farm to the consumer; and (3) how  changes in dairy policies and alternative policy options have affected or  might affect farm income, federal costs, economic efficiency, and  consumer prices, among other policy considerations. It also updates other  information on milk prices included in our June 2001 report.
To update our information on the pricing distribution among the various  levels of the milk marketing chain, we analyzed milk prices in 15 selected  markets nationwide, ensuring that (1) these markets provided national  geographic coverage; (2) at least one market was located in each of the  federal milk marketing order areas, as they existed during the majority of  the period from October 2000 through May 2004; (3) the selected markets  included both state and federally regulated markets; and (4) these areas  represented similar marketing areas for which we reported information in  our June 2001 report. For these 15 markets, we obtained data from USDA,  the cognizant state milk control agency, the Department of Defense’s  Commissary Agency, and a private data collection company on the prices  received by farmers, cooperatives, wholesale milk processors, and  retailers. We limited our data collection efforts to whole, skim, 2 percent,  and 1 percent milk as sales of these milk types constitute over 93 percent of  fluid milk sales annually. We also confined our analysis to the prices of  these milk types sold in gallon containers as milk sold in gallon containers  accounts for about 65 percent of fluid milk products sold under FMMOs.  We focused our detailed data analysis on 2 percent milk sold in gallon  containers, the largest volume of reduced-fat milk sold nationwide. As a  result, our analysis may not reflect pricing trends for all types of milk and  package sizes.
To update our information on factors influencing milk prices, explore price  transmission within the milk marketing chain, and examine the effects of  federal dairy policy changes and alternative policy options, we contacted a  number of national dairy experts in academia or representing federal and  state agencies, cooperatives, processors, retailers, or industry groups. We  also reviewed relevant legislation, studies, and other publications. We  qualitatively analyzed the effects of recent changes in federal dairy  programs, as well as alternative policy options, on various policy  considerations as identified in previous GAO reports, relevant studies, and  legislation, as well as through our conversations with dairy policy experts.  These policy considerations included farm income, milk production,  federal costs, price volatility, economic efficiency, and consumer prices.  Different stakeholders in the dairy policy arena may have alternative views  on the relative importance of these policy considerations, as well as other  considerations that we did not include, which could lead to differing  perspectives on these options. We conducted our review from September  2003 through October 2004 in accordance with generally accepted  government auditing standards. We did not independently verify the data  we received from various sources. However, we discussed with these  sources the measures they take to ensure the accuracy of data, and these  measures seemed reasonable. Appendix I provides additional information  on the scope and methodology of our review.
In summary, we found the following:  Between October 2000 and May 2004, on average, farmers received 45.9  percent, cooperatives 6.1 percent, wholesale milk processors 35.6  percent, and retailers 12.5 percent of the retail price of a gallon of 2  percent milk in the 15 markets we reviewed. However, these  percentages varied widely depending on the specific market. For  example, the farmers’ portion ranged from 36.0 percent to about 58.6  percent.
Furthermore, during this time period, the price spread between farm  and retail prices increased in 12 of the 15 markets we examined.  However, in some of the 12 markets, the spread between farm and retail  milk prices increased dramatically, and then moderated. In 9 of the 15  markets, retail prices showed a statistically significant increase. In 4 of  the remaining markets, retail prices decreased over time, while in the  other 2 markets, retail prices showed no statistically significant change.  At the same time, farm prices decreased in 12 of the 15 markets and  increased in the remaining 3 markets during the 44-month period.  However, declines in farm prices, in most cases, began to reverse during  the latter months of our period of analysis. Price changes generally  correlated across levels in the marketing chain, with the strongest  correlations occurring between adjacent levels. For example, in most of  the markets we analyzed, changes in cooperative prices correlated  strongly with changes in wholesale prices. However, changes in  cooperative prices correlated less strongly with changes in retail prices.
Prices at all levels of the milk marketing chain are determined by the  interaction of a number of factors. For example, farm prices are  determined primarily by factors affecting the supply of raw milk, such as  costs of production; the demand for milk products, such as fluid milk,  cheese and butter; and the effects of federal and state dairy programs.  At the cooperative level, the difference between what cooperatives pay  farmers for raw milk and the prices at which they sell raw milk to  wholesale fluid milk processors is influenced by the types of services  the cooperatives provide, the relative bargaining power of cooperatives  and milk processors, as well as collective action taken by dairy  cooperatives. Factors that affect the difference between what  processors pay for this raw milk and the prices at which they sell fluid  milk products to retailers include input costs, such as labor, energy,  transportation and packaging; the level of services they provide to  retailers; innovations in processing technology; and changes in the  structure of the fluid milk processing industry, such as increases in the  consolidation and market share of some firms. At the retail level, costs  such as labor and energy, along with other factors such as consumer  demand and the structure of the market, help determine the difference  between what retailers pay for fluid milk products and the prices they  charge consumers for those products.
While price changes at one level of the milk marketing chain are  generally reflected in price changes at other levels, several factors can  influence the extent or speed at which these changes are reflected and  whether price increases and decreases are reflected differently. For  example, increasing concentration, resulting in greater market power at  successive levels of the milk marketing chain, may provide entities an  opportunity to influence how changes in prices are transmitted among  the different levels. In addition, other factors, such as federal and state  dairy policies, can affect prices in ways that can cause market  participants to alter the way they transmit price changes between  marketing levels. Some recent economic studies of the U.S. fluid milk  market have found that these and other factors may cause retail milk  prices to react more completely and quickly to farm price increases than  to decreases.
Recent changes in the FMMO program, adjustments to the prices of  products purchased under the price support program, and the  establishment of the MILC program have had various impacts on policy  considerations such as dairy farm income, federal costs, and price  volatility. Reforms to the FMMO system had mixed effects on farm  income depending on the geographic location of the farmer, while the  overall effects on all farmers are less clear. Further, recent adjustments  to the prices of products purchased under the price support program  have generally decreased federal costs but also decreased farm income  during periods of low prices. Finally, government payments introduced  through the MILC program have kept some small dairy farms in  business, but the program has exceeded initial federal cost estimates  because farm prices during 2002 and 2003 were lower than anticipated.
A number of options that would modify existing policies or introduce  alternative policies have been proposed or discussed. While we  examined the potential impacts of these options on a range of policy  considerations related to the dairy sector, we did not assess their overall  economic or budgetary impacts or their consistency with U.S.  international trade commitments or positions in ongoing negotiations.  As a result, the purpose of this analysis is not to take a position for or  against any of these options, but simply to discuss their likely effects on  the policy considerations we identified. Various policy options could  affect dairy policy considerations in different ways under different  scenarios, such as periods of high or low prices. Also, short-term effects  may differ from long-term effects. In general, options that increase farm  income over the short term also tend to increase milk production and  thus the potential for oversupply and lower average farm prices over the  long term. For example, the dairy support price could be raised, which  would limit the fall of farm prices and increase farm income in the short  term. However, it would spur additional production and therefore  reduce average farm prices over the long term. Such options also tend to  be costly for the federal government during periods of low prices. Thus,  extending the MILC program, which is scheduled to expire at the end of  September 2005, would allow the federal government to continue to  support farm income but could also increase federal costs if farm prices  trend downward in the future. In some cases, options that increase the  economic efficiency of federal dairy programs also increase price  volatility because they allow clearer transmission of market price  signals. For example, eliminating the price support program would  increase volatility by removing the price floor on manufactured dairy  products, but it would also increase economic efficiency by reducing  incentives to allocate resources to surplus production. Also, to the  extent that price changes at the wholesale level are passed through to  the retail level, a number of options would likely have mixed effects on  consumer prices depending upon the particular product under  consideration (e.g., butter, cheese, or fluid milk).
As a result of recent farm bills, such as those in 1996 and 2002, USDA has  studied different aspects of dairy policy, either to implement program  changes mandated by the Congress or to provide information to the  Congress on the effects of various dairy programs. For example, the 2002  farm bill required USDA to conduct studies of dairy policy issues, including  an economic evaluation of the effects of various elements of the national  dairy policy and of terminating federal dairy programs relating to milk price  support and supply management. One study required by this legislation,  which addressed the subject of changing standards for fluid milk, was  issued in August 2003. A second study, which included both an evaluation  of the effects of various elements of the national dairy policy and the  termination of federal milk price support and supply management  programs, was provided to the Congress in September 2004.
This report is divided into nine appendixes. Appendix I describes in detail  our objectives, scope, and methodology. Appendix II provides information  on average milk prices at the farm, cooperative, wholesale, and retail  levels; changes in farm and retail milk prices and how they affect the farm- to-retail price spread; and the extent to which price changes at one level of  the milk marketing chain correlate with price changes at other levels.  Appendix III compares retail prices of whole, 2 percent, 1 percent, and  skim milk. Appendix IV provides the average monthly prices and annual  prices of the four types of milk at each level of the milk marketing chain.  Appendix V describes the factors that influence prices as milk moves from  the farmer to the consumer. Appendix VI provides a technical review of  recent research examining price transmission within the milk marketing  chain. Appendix VII provides a qualitative analysis of the effects of recent  changes in federal dairy programs and alternative dairy policy options that  have been proposed or discussed. Appendix VIII presents USDA’s  comments and our evaluation of them. Appendix IX lists GAO contacts and  contributors to this report.
subsections: section_title: Conclusions
paragraphs: The difference in price between what farmers receive for their raw milk  and what consumers pay for fluid milk products has increased in recent  years. This growing spread between farm and retail prices may be  attributable to a number of factors at each level of the milk marketing  chain, including supply and demand forces, changes in input costs to  processing and retailing, and the continued concentration of cooperatives,  wholesale milk processors, and retailers. A variety of federal policies exist  to influence the prices that farmers receive. However, the effects of these  policies may not be uniform; they can affect different sizes of farms or  regions of the country in different ways. Moreover, policies that benefit  farm income may adversely affect other policy considerations such as  economic efficiency and federal costs. Given the complexity of federal  dairy policy, the decision to change existing policies or introduce new  policies requires consideration of a variety of these potential effects.  Examining the effects of policy alternatives on a variety of different policy  considerations will help the Congress formulate federal dairy policy based  on comprehensive analyses that consider these alternatives in relation to  their effects on different considerations, farm sizes, and regions of the  country. In addition, although recent USDA studies have examined some  policy options, there are other potential policy options to consider, as  discussed in this report.
section_title: Recommendations for Executive Action
paragraphs: To continue the facilitation of informed decision making by USDA and the  Congress, we recommend that the Secretary of Agriculture build on GAO’s  analysis of the potential effects of various dairy policy options as USDA  proposes future changes to current dairy laws or regulations or provides  information to the Congress in response to congressional proposals.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to USDA and DOD for their review and  comment. We received written comments from USDA’s Under Secretary for  Farm and Foreign Agricultural Services and Under Secretary for Marketing  and Regulatory Programs, which are presented in appendix VIII. USDA also  provided suggested technical corrections, which we have incorporated into  this report, as appropriate. These technical corrections were offered by  several USDA agencies, including the Agricultural Marketing Service,  Economic Research Service, Farm Service Agency, and Office of the Chief  Economist. DOD had no comments on the draft report.
In its written comments, USDA said the information provided in the report  on milk prices at the farm, cooperative, and retail levels is valid. However,  USDA said it has reservations regarding our use of prices paid for fluid milk  at commissaries as an indicator of the wholesale price of fluid milk and that  we should make clear the weaknesses of using commissary price data.  USDA acknowledged, however, that there seems to be no viable  alternative. During the course of our work, we were unable to obtain  wholesale price data because these data are considered proprietary by  industry officials. After consulting with USDA officials and other dairy  experts, we determined that commissary price data were the best surrogate  because commissaries generally sell milk at a standard 5 percent markup  from cost. Based on USDA’s comments, we expanded the discussion in the  report of the potential limitations of using commissary data.
USDA said it largely agrees with the report’s discussion of the factors that  influence the price of milk as it moves from the farm to the consumer and  the report’s characterization of economic studies of price transmission in  the U.S. fluid milk market. However, USDA expressed some concerns  regarding the report’s discussion of recent federal dairy program changes  and alternative policy options. First, USDA said that this discussion  appears to be a compilation of policy recommendations that are examined  independently and qualitatively within the existing program structure. Our  discussion of dairy policy options are not policy recommendations. As  stated in the report, to identify these policy options and their potential  impacts we relied heavily on a synthesis of the views of leading dairy  experts and the results of an extensive literature search, including our  review of more than 50 studies and other publications. Time and resource  constraints for completing our work precluded us from developing or  contracting for the use of an economic model that would have provided  quantitative estimates of these potential impacts. In addition, some of the  policy options would have been difficult to model and quantify, such as the  potential impacts of accelerating USDA’s hearing and rulemaking process  for amending FMMOs. The report also notes that we compared the policy  options identified against a baseline scenario of policies in place as of  August 2004. This baseline scenario existed at the start of our work and  was needed to provide a consistent context for our analysis.
Second, USDA suggested that we make clear the caveats of this type of  analysis. As noted in the report, we examined the impact of federal dairy  program changes and policy options on six policy considerations: farm  income, milk production, federal costs, price volatility, economic  efficiency, and consumer prices. We acknowledge that other stakeholders  may have different views on the importance of these policy considerations,  or other considerations that we did not include in our analysis. The report  also states that the potential effects of policy options on these  considerations could vary depending upon economic conditions and other  policy decisions. In this regard, we did not assess the options’ overall  economic or budgetary impacts, or their consistency with U.S.  international trade commitments or positions in ongoing negotiations. In  addition, the report does not identify a preferred option or combination of  options. As indicated in the report, each option has varying potential  impacts on the policy considerations used in our analysis. Despite these  caveats, we believe this analysis is informative and helpful to congressional  decision makers who must weigh competing interests in determining dairy  policy.
USDA also said that in some cases the report mischaracterizes the  operation of current programs and the effects that changes to current  programs or the introduction of new programs would have on program  outlays, producers, and consumers. For example, USDA noted that the  report offers several options for improving the operation of the Dairy  Export Incentive Program (DEIP), including expanding the use of this  program. However, USDA indicated that expanding the use of DEIP is not a  legitimate option because, under World Trade Organization (WTO) rules,  DEIP is bound by quantitative and monetary caps and product-specific  restrictions that limit its use to the current range of eligible dairy  commodities. We do not agree that we mischaracterized the operation of  this program. The report clearly states that USDA has announced and  awarded subsidies under DEIP to the limits allowed by WTO rules for  nonfat dry milk and various cheeses. Regarding expansion, the report  discusses options suggested by dairy experts for the additional use of this  program as an effective marketing tool, and does not call for expanding its  use to exceed relevant WTO caps or restrictions. However, we have  adjusted the language in the report to make this distinction clearer.
USDA also offered several comments regarding the FMMO program.  Among these, USDA said that the report is incorrect in stating that the  objective of this program is “to ensure an adequate level of milk  production.” According to USDA, this objective is associated with the Dairy  Price Support Program. We have revised the report to reflect this  clarification and added language suggested by USDA to better describe the  FMMO program’s objectives.
In addition, USDA raised concerns about the practicality of implementing  some of the options discussed in the report, particularly (1) adopting a  competitive pay price to establish class prices under the FMMO program  and (2) combining Class III and Class IV into a single manufacturing class.  Regarding the first, USDA said that it and a committee of academicians  spent considerable time several years ago trying to devise a competitive  price series that could be used to establish minimum class prices. However,  this effort was unsuccessful. USDA said that our report does not identify or  indicate how to create such a price series. Similarly, regarding combining  Class III and Class IV, USDA notes that no specifics are offered in the report  as to how milk in such a class would be priced. We acknowledge that the  report does not explain how a competitive price series could be created or  how milk would be priced if the classes were merged. However, these  options were identified by stakeholders during the course of our work.  Other options discussed in the report also may present challenging  implementation issues and in many cases the report discusses those issues.
Finally, USDA said that it does not believe the hearing and rulemaking  process it uses to modify FMMOs inhibits its ability to respond to changing  market conditions or the marketing of new dairy products. However, as  discussed in the report, some stakeholders cited the slowness of this  process as a concern. In addition, the report discusses USDA’s efforts to  improve this process to more quickly respond to problems or needed  changes while ensuring the promulgation of economically sound  regulation.
USDA did not comment on the report’s recommendation.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from the  date of this letter. We will then send copies of the report to the Senate  Committee on Agriculture, Nutrition, and Forestry; the House Committee  on Agriculture; other appropriate congressional committees; interested  Members of Congress; the Secretary of Agriculture; the Secretary of  Defense; the Director of the Office of Management and Budget; and other  interested parties. Copies will also be made available to others upon  request. In addition, the report will be available at no charge on GAO’s Web  site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-3841. Key contributors to this report are listed in appendix IX.
section_title: Objectives, Scope, and Methodology
paragraphs: In March 2003, Senator Snowe, Chair, Committee on Small Business and  Entrepreneurship, joined by Senators Clinton, Collins, Dodd, Jeffords,  Kennedy, Kerry, Leahy, Mikulski, Rockefeller IV, Sarbanes, Schumer, and  Specter requested that GAO examine a number of issues concerning the  pricing and marketing of milk in the United States. Specifically, they asked  us to update the information contained in our 2001 report, entitled Dairy  Industry: Information on Milk Prices and Changing Market Structure  (GAO-01-561, June 15, 2001), and to address other issues. This report  examines (1) what portion of the retail price of fluid milk is received by  dairy farmers, dairy cooperatives, wholesale milk processors, and retailers  in selected markets throughout the United States, how this distribution has  changed over the period of our review, and the relationships among price  changes at these levels; (2) how various factors, such as costs, influence  the price of milk as it moves from the farm to the consumer, as well as how  these and other factors affect the extent to which changes in price are  transmitted among levels as milk moves from the farm to the consumer;  and (3) how changes in dairy policies and alternative policy options have  affected or might affect farm income, federal costs, economic efficiency,  and consumer prices, among other policy considerations. It also updates  other information on milk prices included in our June 2001 report.
To update our information on the price distribution among the various  levels of the milk marketing chain, we analyzed milk prices in 15 selected  markets nationwide: Atlanta, Georgia; Boston, Massachusetts; Charlotte,  North Carolina; Cincinnati, Ohio; Dallas, Texas; Denver, Colorado; Miami,  Florida; Milwaukee, Wisconsin; Minneapolis, Minnesota; New Orleans,  Louisiana; Phoenix, Arizona; Salt Lake City, Utah; San Diego, California;  Seattle, Washington; and Washington, D.C. In selecting these markets, we  ensured that (1) they provided national geographic coverage; (2) at least  one market was located in each of the federal milk marketing orders  (FMMOs) as they existed during most of the period from October 2000  through May 2004; (3) the selected markets included both state and  federally regulated markets; and (4) these areas represented similar  marketing areas for which we reported information in our June 2001  report. For the 15 markets, we collected data on the prices received by  farmers, cooperatives, wholesale milk processors, and retailers for October  2000 through May 2004. We limited our data collection efforts to the prices  of whole, 2 percent, 1 percent, and skim milk because sales of these milk  types constitute over 93 percent of fluid milk sales annually. We also  confined our analysis to the prices of these milk types sold in gallon  containers because milk sold in gallon containers accounts for about 65  percent of fluid milk products sold under FMMOs.
There is no precise method for calculating the price that farmers receive  for raw milk that is ultimately processed and sold in fluid milk products  because dairy farmers receive a blend price for their milk, which is the  average price for milk used for fluid and manufactured products.  Therefore, any calculation of the value received by farmers for raw milk  that is to be used for fluid milk products is necessarily only approximate.  To estimate a farm price for raw milk used in fluid milk products, we used  data provided by the U.S. Department of Agriculture’s (USDA) Agricultural  Marketing Service (AMS). AMS developed an adjustment, which accounts  for various charges such as hauling and marketing fees, that we subtracted  from the announced cooperative Class I price to obtain the estimated farm  price for raw milk used in fluid milk products for each of the selected  markets in our review except San Diego, which is not part of the FMMO  system. AMS’s adjustment accounts for farm-to-plant hauling costs,  cooperative dues and capital assessment, mandatory advertising and  promotion costs, competitive and receiving credits, and a representative  estimate of the value of reimbursements to cooperatives for the services  performed for handlers and for transportation costs not covered by the  order minimum price. Most of the items that make up the adjustment are  not available for the specific fluid milk market that we selected, but rather  are based on information collected for milk used over wider geographical  areas. Therefore, an order-wide value used for any of these items provides  an estimate rather than the actual value for this item. Also, the values for  two of the adjustment items—reimbursements to cooperatives for services  performed for handlers and for transportation costs not covered by the  order minimum price—were not readily available so they were estimated  indirectly based on other reported data and, in some cases, on anecdotal  information provided by industry members. However, despite these  limitations, AMS believes that the estimated farm price is a good  representation of the price that dairy farmers receive for raw milk used in  fluid milk products. For the farm price for San Diego—a state-regulated  market—we used mailbox price data collected by the California  Department of Food and Agriculture. The mailbox price is the weighted  average of the prices received by dairy farmers in the market for all of their  raw milk sold and therefore is computed as the total net dollars received  for milk divided by the total pounds of milk marketed. This price is likely  to be lower than the price received for milk used for fluid purposes because  the prices for milk used for manufacturing purposes are generally lower.  However, it is the best measure we could obtain.
To determine cooperative prices, we used AMS data on announced  cooperative prices to represent prices that wholesale milk processors paid  to cooperatives. Wholesale milk processors in federally regulated markets  generally purchase milk from cooperatives and pay the federal minimum  price for milk plus premiums that are negotiated between cooperatives and  wholesale milk processors. The announced cooperative price is the Class I  milk price announced by the major cooperative in each of the markets. This  price does not apply to all Class I sales in federally regulated markets and is  not necessarily the price actually received for all of the milk sold by the  major cooperative; the announced cooperative prices have not been  verified by USDA as actually having been paid by processors. For San  Diego, we used the minimum fluid prices established by the state of  California. Data on the premiums paid in excess of these minimums were  not available for this market. (See app. V for a detailed discussion of over- order premiums.)
To determine wholesale prices, we used the prices paid at Department of  Defense Commissary Agency locations. The Defense Commissary Agency  purchases milk under competitive and noncompetitive contracts with  wholesalers. We used commissary prices as surrogates for privately  established wholesale prices because (1) defense commissaries sell  groceries at a standard 5 percent markup from cost to active and retired  military personnel and (2) wholesale price data are considered proprietary  by industry officials and were not available to us. The commissary network  of stores ranks twelfth in the United States in sales volume for supermarket  chains. We selected 39 different commissary locations near the 15 markets  we reviewed, and the Defense Commissary Agency provided us with  weekly prices paid by consumers at these locations for gallons of whole, 2  percent, 1 percent, and skim milk. We averaged these weekly prices to  obtain monthly prices. We then adjusted these monthly prices to account  for the 5 percent markup. Where we had multiple commissary locations for  a market, we averaged the adjusted monthly prices to obtain a wholesale  price for the market. We recognize that these locations may not provide an  ideal match with other price data analyzed for a given location; for  example, in some markets the available commissary locations were not in  close proximity to the selected marketing areas. Also, wholesale  processors may provide these commissary locations with different levels of  service than they do for retailers in these markets. In such cases, the  prices paid by these commissaries for fluid milk may have been different  than the prices that retailers in the selected markets paid to their wholesale  suppliers. However, these were the best wholesale data that we could  obtain. In those locations where commissaries sold more than one brand of  milk, we used the price for the brand that had the highest sales volume for  a particular period.
For retail prices, we contracted with Information Resources, Inc., a private  data collection and analysis company, to obtain average weekly retail  prices for whole, 2 percent, 1 percent, and skim milk sold in gallon  containers. These data represented a weighted average of prices at  supermarkets with yearly sales exceeding $2 million for the markets  included in our analysis. We then averaged these weekly prices to obtain  monthly prices. We were unable to obtain data from some types of  nonsupermarket retailers such as mass merchandisers, thus the retail  pricing data that we present may not be representative of fluid milk prices  at those locations. Figure 1 shows the locations of the 15 selected markets,  the corresponding commissaries, and the federal milk marketing order  areas.
To determine (1) the portion of the retail price of a gallon of milk received  by farmers, cooperatives, wholesale milk processors, and retailers; (2) how  changes in retail and farm prices affect the farm-to-retail price spread; and  (3) how price changes at any level of the marketing chain correlate to  changes in prices at other levels, we limited our analysis to 2 percent milk,  which currently represents the largest volume of reduced-fat milk sold  nationwide. Therefore, our analysis of 2 percent prices may not necessarily  reflect pricing patterns and trends for the other three kinds of milk.  Appendix II includes graphs that show the relationships among the farm,  cooperative, wholesale, and retail prices for a gallon of 2 percent milk for  each of the 15 markets. Because farm and cooperative prices reflect a  higher milkfat content than that in 2 percent milk, we adjusted these prices  to reflect the value of removing milkfat and replacing it with skim milk.  This adjustment allowed us to use farm and cooperative prices that were  comparable to the wholesale and retail prices for our analysis.
To determine the degree that farm and retail prices had changed and the  effect these changes had on the farm-to-retail price spread from October  2000 through May 2004 for each of the 15 markets, we used a statistical  procedure to estimate farm-level and retail prices at the beginning and end  of the period. We relied on estimated rather than actual prices to reduce  the influence of the starting and ending months and years selected for our  analysis in markets in which milk prices varied from month to month. We used the differences between the estimated initial and final prices to  represent the changes during the period. When our statistical procedure  did not find a consistent association between prices and time, we treated  the difference in the estimated initial and final prices as zero. We calculated  the change in the farm-to-retail price spread as the estimated retail price  difference minus the estimated farm price difference.
To describe the relationship between price changes at any given level in the  milk marketing chain and price changes at the other levels, we tested for  correlations between price changes at the various levels for each of the 15  markets included in our analysis. Specifically, we calculated coefficients  describing the degree of correlation between changes in farm prices and  price changes at the cooperative, wholesale, and retail levels; price changes  at the cooperative level and price changes at the wholesale and retail  levels; and price changes at the wholesale and retail levels. In appendix II,  we report those correlation coefficients and indicate which are statistically  different from zero at the 95 percent confidence level.
To update information provided in our June 2001 report on the retail prices  for four kinds of milk, we analyzed the retail price data that we obtained  from Information Resources, Inc. We array these data in appendix III for  each of the selected 15 markets for October 2000 through May 2004.
To update information provided in our June 2001 report on average  monthly and annual farm and cooperative prices, and wholesale and retail  prices for different kinds of milk, we analyzed data obtained from USDA,  the California Department of Food and Agriculture, the Department of  Defense Commissary Agency, and Information Resources, Inc. We report  these data in appendix IV for each of the selected 15 markets for October  2000 through May 2004.
To update our information on the major factors influencing milk prices and  explore price transmission within the milk marketing chain, we conducted  more than 50 interviews with national dairy experts working with the  federal and state governments, cooperatives, processors, retailers, or  industry groups, or in academia. We also reviewed a number of relevant  studies and publications from USDA and other sources. Where possible, we  obtained data on production costs, services provided by cooperatives, as  well as inputs to processing and retailing. We also obtained information on  concentration and market power at each level of the milk marketing chain.  We present information on the factors influencing the price of milk in  appendix V.
To compare the results and methodologies of various studies looking at the  issue of price transmission in fluid milk marketing from the farm to the  retail level, we performed a technical review of 14 academic studies  conducted over the past 10 years, looking at model descriptions,  assumptions, and results. We also spoke with the economists involved in  these studies concerning their model results and the causes of differences  in fluid milk price transmission across markets. The scope of these studies  encompassed national, regional, and city-level models of fluid milk price  transmission. Appendix VI provides a summary of our review of price  transmission and the various price transmission studies.
To identify and examine the effects of federal dairy program changes and  alternative policy options, we contacted many of the same dairy experts  previously mentioned. We also conducted an extensive literature search  and reviewed more than 50 relevant studies and other publications we  identified. We qualitatively analyzed the effects of federal dairy program  changes and policy options we identified on six main policy considerations:  farm income, milk production, federal costs, price volatility, economic  efficiency, and consumer prices. We evaluated impacts on these policy  considerations under both high- and low-price scenarios, over the short  and long terms. We identified these policy considerations by reviewing  previous GAO reports, relevant studies, and legislation, as well as through  our conversations with dairy policy experts. Different stakeholders in the  dairy policy arena may have alternative views on the relative importance of  these policy considerations, as well as other considerations that we did not  include, which could lead to differing perspectives on these options. In  addition, the potential effects of policy options on these considerations  could vary depending upon economic conditions and other policy  decisions. We compared the dairy policy options we identified against a  baseline scenario of the policies in place as of August 2004: FMMO  regulations, a Milk Income Loss Contract (MILC) program that is scheduled  to expire at the end of fiscal year 2005, a price support program at $9.90 per  hundredweight, a Dairy Export Incentive Program (DEIP), trade  restrictions, and milk regulatory policies in some states. We include a  discussion of the effects of recent federal dairy program changes and  alternative policy options in appendix VII.
We conducted our review from September 2003 through October 2004 in  accordance with generally accepted government auditing standards. We  did not independently verify the data we received from various sources.  However, we discussed with these sources the measures they take to  ensure the accuracy of the data, and these measures seemed reasonable.  Additionally, we consulted with the following dairy experts concerning the  results of our analysis of price transmission within the milk marketing  chain and the effects of changes in federal dairy programs and alternative  policy options:  Ed Jesse, Ph.D., Professor, Department of Agricultural and Applied  Economics, University of Wisconsin–Madison;  Daniel Lass, Ph.D., Professor, College of Natural Resources and the  Environment, University of Massachusetts, Amherst;  Richard Sexton, Ph.D., Professor, Department of Agricultural and  Resource Economics, University of California–Davis; and  Mark Stephenson, Ph.D., Senior Extension Associate, Department of  Applied Economics and Management, Cornell University.
section_title: Analysis of Prices at Four Marketing Levels for 2 Percent Milk in Selected Markets
paragraphs: This appendix reports on our analysis of prices at four marketing levels for  a gallon of 2 percent milk in 15 selected markets for October 2000 through  May 2004. Our analysis includes information on (1) the portion of the retail  price of a gallon of milk received by farmers, cooperatives, wholesale milk  processors, and retailers; (2) how changes in farm and retail milk prices  affect the farm-to-retail milk price spread; and (3) how price changes at any  level of the marketing chain correlate with changes in prices at other levels.
We limited our analysis to gallons of 2 percent milk because sales of milk  with reduced fat content account for nearly 52 percent of all sales of fluid  milk and sales of 2 percent milk account for about 62 percent of these  reduced-fat sales. The farm and cooperative prices used in our analysis and  presented in this appendix have been adjusted to reflect 2 percent milkfat.  This analysis may not reflect pricing patterns and trends for other kinds of  milk. We present complete data for prices for all four types of milk—whole,  2 percent, 1 percent, and skim—in appendix III.
subsections: section_title: Portion Received by Farmers, Cooperatives, Wholesale Milk Processors and Retailers
paragraphs: Between October 2000 and May 2004, on average, our data suggest that  farmers received 45.9 percent, cooperatives 6.1 percent, wholesale  processors 35.6 percent, and retailers 12.5 percent of the retail price of a  gallon of 2 percent milk in the 15 markets we reviewed. However, these  percentages varied depending on the specific market. For example, the  farmers’ portion ranged from 36.0 percent to 58.6 percent, while retailers in  12 markets received anywhere from 3.5 percent to 44.1 percent. In  comparison, the average percentages we reported in 2001 for the period  March 1998 through September 2000 were 43 percent, 5 percent, 33  percent, and 19 percent, respectively, for farmers, cooperatives, wholesale  processors, and retailers. Table 1 summarizes the price breakdown for each  market.
section_title: Changes in Farm and Retail Prices and the Price Spread
paragraphs: From October 2000 through May 2004, the spread between farm and retail  milk prices increased in 12 of the 15 markets. However, in some of the 12  markets, the spread between farm and retail milk prices increased  dramatically and then moderated. In 9 of the 15 markets, retail prices  showed a statistically significant increase. In 4 of the remaining markets,  retail prices decreased over time; in the other 2 markets, retail prices  showed no statistically significant change. At the same time, farm prices  decreased in 12 of the 15 markets and increased in the remaining 3 markets  over the 44-month period. However, these declining farm prices began to  moderate, or, in most cases, began to rise during the latter months of our  period of analysis. Table 2 provides these data for selected markets.
section_title: Correlation between Price Changes at the Four Marketing Levels
paragraphs: We found that price changes generally correlated across levels in the  marketing chain, with the strongest correlations occurring between  adjacent levels. The values of correlation coefficients presented are  estimates of the degree that price changes at one level in the milk  marketing chain are associated with price changes at other levels. The  higher the coefficient, the closer the association between changes in prices  at different levels. Changes in cooperative prices, in general, were strongly  correlated with changes in wholesale prices. However, changes in  cooperative prices correlated less strongly with changes in retail prices. As  discussed in appendix V, many factors other than farm or wholesale prices  influence the retail price of fluid milk.
Correlation coefficients between prices at different marketing levels varied  across markets. For example, correlations between cooperative and  wholesale prices in individual markets range from a high of 0.982 to a low  of –0.031. We ranked the 15 markets by the extent of correlation between  cooperative and wholesale prices. The correlation coefficient for the  market that fell in the middle of this ranking was 0.788. In comparison, the  market in the middle of a similar ranking for the time period analyzed in  our 2001 report had a lower correlation coefficient between these prices,  0.716. Similarly, correlations between cooperative and retail prices in  individual markets range from a high of 0.879 to a low of 0.214. We did a  comparable ranking of the 15 markets by the extent of correlation between  cooperative and retail prices. The correlation coefficient for the market  that fell in the middle of this ranking was 0.588. In comparison, the market  in the middle of a similar ranking for the time period presented in our 2001  report again had a lower correlation coefficient between these prices,  0.483. Tables 3 through 5 present data from our correlation analysis of price  changes across marketing levels.
section_title: Comparison of Average Annual and Monthly Prices for 2 Percent Milk
paragraphs: Tables 6 through 10 show the average annual price for a gallon of 2 percent  milk in the 15 markets for each of the four marketing levels during part of  2000, all of 2001, 2002, and 2003, and part of 2004. Figures 2 through 16  present average monthly data for the period October 2000 through May  2004 on farm, cooperative, wholesale, and retail prices for gallons of 2  percent milk in each of the 15 markets. Gaps in any of the lines shown in  the figures indicate that data were unavailable for those months.
section_title: Retail Prices for Four Kinds of Milk in Selected Markets
paragraphs: This appendix updates information provided in our June 2001 report on the  average retail prices for whole, 2 percent, 1 percent, and skim milk in 15  selected markets for October 2000 through May 2004. We found that retail  pricing patterns varied significantly across markets. For example, in the  Boston market from October 2000 through May 2004, the average price for  2 percent milk was generally the same as the average price for 1 percent  milk; however, whole and skim milk prices were generally lower. On the  other hand, for this period in the San Diego market, the average price of 2  percent milk was generally lower than the prices of whole and 1 percent  milk, but higher than skim milk prices. Figures 17 through 31 provide  information on the average retail price for the four kinds of milk in the 15  selected markets for October 2000 through May 2004.
section_title: Average Monthly and Annual Farm, Cooperative, Wholesale and Retail Milk Prices in Selected Markets
paragraphs: This appendix updates information provided in our June 2001 report on  average monthly and annual farm and cooperative prices of raw milk and  on the average monthly and annual wholesale and retail prices for a gallon  of whole, 2 percent, 1 percent, and skim milk.  Tables 11 through 25 provide  these data for 15 selected markets over the period October 2000 through  May 2004.
section_title: Factors That Influence the Price of Milk as It Moves from the Farm to the Consumer
paragraphs: The prices that farmers, cooperatives, wholesale processors, and retailers  receive are determined by the interaction of many factors, such as forces  affecting the supply of raw milk and manufactured and fluid milk products,  consumer demand for manufactured and fluid milk products, federal and  state dairy programs, the level of services provided by dairy cooperatives,  market structure at various levels of the marketing chain, and other input  costs of processing and retailing. Dairy farmers receive a price for raw  milk, and each entity involved in the processing and marketing of fluid milk  adds value to the product and retains a portion of the difference between  the farm and retail prices. (This difference is known as the price spread.)  This appendix examines the key factors that influence milk prices at the  different levels of the marketing chain.
subsections: section_title: Market Forces, in Addition to Federal and State Policies, Influence Milk Prices at the Farm Level
paragraphs: Supply and demand forces, which in turn are influenced by federal and  state dairy programs, determine farm prices for the raw milk that is sold for  use in fluid milk and other dairy products. For example, in recent months,  a variety of supply and demand forces have come together to significantly  increase farm milk prices. On the supply side, the available supply of raw  milk has been reduced by farmers cutting back production due to a  previous period of low prices and by the closing of the Canadian border to  replacement cows as a result of concerns about mad cow disease. On the  demand side, consumer demand for nonfluid dairy products has increased  as consumers resumed eating out following the attacks of September 11,  2001, and as dietary trends, such as the rising popularity of low- carbohydrate diets, have changed. While these forces have been driving  recent price trends, federal and state dairy programs continue to influence  milk prices. For example, major domestic programs such as federal milk  marketing orders (FMMOs) and price supports help individual farmers who  lack market power compared to other entities such as wholesale  processors and retailers and help to ensure that farm prices do not fall  below a minimum level. At the same time, U.S. import restrictions maintain  domestic dairy prices at levels higher than average international market  prices by limiting the quantities of milk products that are imported into the  country.
subsections: section_title: Supply and Demand Forces Affect Farm Milk Prices
paragraphs: The quantity of raw milk that dairy farmers supply (production) is  determined by the operating costs of producing that milk, such as feed and  fuel, ownership costs for dairying equipment, land costs, and labor costs,  as well as the price that farmers expect to receive for milk (as based on  demand). Of these costs, the 2002 annual report on the costs of milk  production in California, the largest milk producing state, showed that the  highest cost is feed, at 44 percent of milk production costs. Other major  costs include replacement cows (14 percent), other operating expenses (13  percent), and labor (11 percent). Milk production can also vary seasonally,  according to weather, and is affected by farmers’ management practices.
In February 2004, the U.S. Department of Agriculture (USDA) published a  report on the characteristics and costs of milk production in the United  States, which found that dairy farmers in the West had a cost advantage  over farmers in other regions because western operations were appreciably  larger. Farms with 500 or more milk cows had substantially lower total  operating and ownership costs, averaging $11.60 per hundredweight of  milk sold. This cost advantage arises because as herd size increases,  associated increases in fixed costs, such as capital investments, are spread  proportionally over a larger amount of production, thereby lowering the  fixed costs per hundredweight of milk produced. USDA found that the  average herd size of low-cost operations was more than three times the size  of high-cost operations. Table 26 shows the average ownership and  operating costs by region and herd size in 2000.
The USDA study also reported that while milk is produced in all 50 states,  the top 5 milk-producing states in 2000—California, Wisconsin, New York,  Pennsylvania, and Minnesota—accounted for 53 percent of total milk  produced. Growth in the importance of western regions as major sources  of milk over the past 25 years is a significant feature of the United States  dairy industry. For example, in 1975, midwestern states such as Iowa, Ohio,  and Missouri were prominent among the top 10 dairy producing states. By  2000, production in Idaho, New Mexico, and Washington State surpassed  production in these traditional dairy states. Milk production is  consolidating so that farms with larger numbers of cows account for a  growing share of production. In 1993, farms with 100 or more cows  accounted for 14 percent of all U.S. dairy farms, over half of all cows, and  over 55 percent of the milk produced. As of 2000, these numbers had grown  to 20 percent of all dairy farms, 66 percent of all cows, and more than 70  percent of milk produced. Significantly, farms with 500 or more cows  accounted for 3 percent of all dairy farms, but 35 percent of cows and 31  percent of milk produced in 2000.
The production of milk has unique characteristics that distinguish it from  other agricultural products and that cause relatively small changes in  supply or demand to result in relatively large changes in price, particularly  at the farm level. Farmers employ specialized assets or equipment to  produce milk, and they have limited ability to use their farms, cows, and  equipment for other purposes during periods of low prices. This limited  flexibility creates a relatively inelastic supply of milk with respect to price.
Demand for raw milk is mainly derived from consumer demand for fluid  milk and manufactured milk products. Consumer demand for different  fluid or manufactured milk products affects the price of raw milk used for  other products because increased consumer demand for one particular  product–causing more of that product to be produced--reduces the supply  of raw milk available for other products, thus increasing the price that  manufacturers of other products must pay to acquire raw milk. Over the  long term, per capita demand for fluid milk products has been steadily  declining, in large part because consumers have substituted carbonated  soft drinks and other beverages for fluid milk. On the other hand, consumer  demand for milk products has varied based on dietary considerations, such  as the rising popularity of low-carbohydrate diets and changes in food  consumption patterns, such as an increase in the amount of food consumed  away from the home. Despite some evidence that consumer demand for  fluid milk has become more price elastic, it remains relatively price  inelastic compared to the demand for many other products.
Given the relative inelasticities of milk supply and demand with respect to  price, a number of sources indicated that recent changes in the amount of  raw milk produced, when combined with changes in demand, have affected  farm prices. After late 1999, farm prices began falling in response to the  production surplus that existed at that time. In addition, a number of dairy  experts indicated that following the terrorist attacks of September 11, 2001,  prices began to fall even further as people stopped eating out as much,  thereby reducing the demand for manufactured milk products such as  cheese. This reduced consumption compounded the long-term decline in  demand for fluid milk products. USDA reported that the combination of  these supply and demand factors was responsible for the low farm prices  that occurred during 2002 and 2003.
More recently, however, supply and demand conditions have changed to  produce record high farm prices in 2004. For example, in response to low  prices during 2002 and 2003, some farmers began to cut back on production  by reducing the sizes of their herds. However, with the relative price  inelasticity of milk supplies, one academic expert noted that it can take 12  to 18 months to achieve a supply response to low prices. During this time,  the identification of a cow infected with mad cow disease in Alberta,  Canada, in May 2003, led to a temporary U.S. ban on imports of Canadian  beef and cattle. This ban included live animals, some of which would have  been used as replacement cows in U.S. dairy herds. While some beef  imports have resumed, USDA has not lifted restrictions on imports of live  cattle. Consequently, in June 2004, a report by USDA’s Economic Research  Service noted that with relatively few expansions in late 2003 and the tight  supplies of replacement cows, few dairy farmers could increase production  in response to rising milk prices, a response that usually limits price  increases.
Another factor in reducing milk production has been the lower amount of  bST—a hormone used in milk production—available to U.S. farmers.  USDA reported that about 2 percent of the U.S. milk supply can be  attributed to the use of bST. However, in January 2004, Monsanto, the  maker of the hormone, announced that its customers would receive only  half their normal supply. This reduced availability began March 1 and is  expected to continue through the end of 2004. Additionally, drought  conditions in recent years have led to higher feed costs and have negatively  affected the quality of the feed. Finally, some sources identified the  National Milk Producers Federation’s Cooperatives Working Together  program as another factor leading to reduced raw milk supplies. Since the  program began in July 2003, cooperatives have tried to reduce raw milk  supplies by eliminating some dairy herds, decreasing production, and  increasing exports. USDA estimates indicate that from January through  June 2004, milk production in the top 20 dairy producing states averaged  about 1 percent below production levels during the same period in 2003.
While these factors combined to reduce the available supply of raw milk,  dairy experts indicated that demand for manufactured milk products has  recovered during 2004. In part, they cited a general economic recovery as  contributing to this increased demand. They also indicated that people  have returned to consuming more food away from home, as they did prior  to September 11, 2001. This recovery in demand, coming at a time of  reduced milk supplies, pushed farm prices to record high levels in April and  May of 2004. For example, USDA’s market-based announced minimum  price for milk to be used in manufactured products, such as cheese, was  $19.66 and $20.58 per hundredweight in April and May of 2004, respectively.  These prices compare with $9.41 and $9.71 per hundredweight for April and  May of 2003. More recently, these high prices have started to moderate; the  comparable announced minimum price for June 2004 was $17.68. However,  USDA has estimated that average 2004 farm-level prices will be more than  $3 per hundredweight higher than they were in 2003.
section_title: Federal and State Dairy Programs and Policies Influence Farm Prices
paragraphs: A complex system of programs and policies influences the price of raw  milk used to produce fluid milk and manufactured products. USDA’s milk  marketing orders, as well as some states’ dairy programs, attempt to  stabilize milk marketing conditions by establishing minimum raw milk  prices and other marketing rules, thus, these programs assist individual  farmers and dairy cooperatives, which lack the market power of other  entities such as wholesale milk processors. USDA’s price support program  attempts to ensure that farm prices do not fall below a minimum level, and,  together with the Milk Income Loss Contract (MILC) program, provides a  safety net for individual farmers during periods of low prices. These  programs and other federal dairy policies operate in a broader context of  trade restrictions, which can limit competition from imported dairy  products and maintain U.S. prices above average international market  prices.
subsections: section_title: Federal and State Milk Marketing Orders
paragraphs: In 2003, the price of about 67 percent of the fluid grade milk marketed by  dairy farmers in the United States was regulated under the FMMO program,  created in 1933 and administered by USDA. Under this program, USDA  uses national dairy market price information to set the minimum prices  that must be paid by processors for raw fluid grade milk in specified  marketing areas, or orders. Figure 32 shows a map of the current 10  FMMOs.
Under the FMMO program, USDA has a classified pricing system for setting  minimum prices for milk on a monthly basis, based upon the intended use  of the milk, as shown in table 27. While there is some variation among the  methods used for setting prices in different orders, in general, FMMO class  prices are determined by formulas with milk component values derived  from wholesale dairy product prices. For example, Class III formulas use  weekly average butter, cheese, and dry whey prices to determine values on  a monthly basis for butterfat, protein, and nonfat solids. The Class IV  formulas use weekly average butter and nonfat dry milk prices to  determine values on a monthly basis for butterfat and nonfat solids,  respectively. The Class II price is determined by adding a fixed amount—a  Class II differential of $0.70 per hundredweight—to the advanced Class IV  skim milk value, while the Class I price is determined by adding a Class I  differential to the higher of the advanced Class III or IV skim milk values.  The Class I differentials vary by order. These differentials were, and to  some extent remain, designed to represent the cost of transporting milk  from areas with a surplus—traditionally the Upper Midwest region—to  areas with a deficit, when necessary to meet the demands for fluid milk  products. Because these differentials vary among orders, Class I prices  differ from one marketing order to another.
Dairy farmers selling raw milk to manufactured or fluid milk processors  regulated by an FMMO receive an average, or “blend,” price that is the  weighted average of the prices of Class I through IV milk. The weights are  determined by the amount of milk sold in each class in the marketing order.
The average price farmers receive, therefore, depends in part on the extent  to which the total raw milk supply in a specific order is used to make fluid  milk, as opposed to the three classes of manufactured products. Dairy  farmers located in a milk marketing order sometimes ship their milk to  another order to obtain a higher price. If the farmer meets the receiving  milk marketing order’s shipping requirements, all of that farmer’s milk, not  only the shipped milk, can qualify for that order’s blend price. However,  farmers must consider whether the benefit of receiving a higher blend price  outweighs the cost of transporting a sufficient amount of milk to qualify for  the receiving order’s blend price.
To generate the money paid to farmers, processors pay into, or draw from,  a federal order “pool” based on the value of the use for which they are  buying the raw milk. Fluid milk processors are required to participate in  the federal order pool if they are covered by one of the federal milk  marketing orders. Processors of manufactured products are not required to  participate in the pool. Under the classified pricing system, raw milk used  in fluid products is valued more highly. Therefore, the fluid milk processors  typically pay money to the pool, while those producing other products  typically draw money from the pool. This draw represents a benefit to  processors of manufactured milk products for serving as a reserve supply  plant for that order’s Class I market. In part, a processor’s payment or draw  depends on the producer price differential, a measure of the difference  between the value of that processor’s use of raw milk as determined by the  market and the value if all of that processor’s raw milk were used in Class  III products. In times of significant price volatility, it is possible for the  producer price differential to be negative, so that some processors of  manufactured products would have to pay into the pool. In such cases,  some of these processors choose not to participate in the pool, or de-pool  their milk, because they would be required to pay into the pool instead of  receiving a draw.
Some states, such as California, Maine, Nevada, New York, Pennsylvania,  and Virginia, have established their own minimum farm-level milk pricing  programs that cover all or portions of their states. These states have  established commissions or boards to perform functions similar to those of  USDA. For example, Virginia’s milk commission, created in 1934,  establishes monthly farm prices to ensure dairy farmers an adequate return  on their investment and to preserve market stability. Similarly, Nevada’s  dairy commission, established in 1955, sets minimum prices for raw milk  sold to processing facilities located within that state.
section_title: Dairy Price Support Program
paragraphs: The dairy price support program, established in 1949, supports farm prices  by providing a standing offer from USDA’s Commodity Credit Corporation  (CCC) to purchase butter, cheese, and nonfat dry milk at specified prices.  The prices offered for these dairy products are intended to provide  sufficient revenue so that processors of these products can pay farmers, on  average, a legislatively set support price for raw milk. Since 1999, the  support price has been set at $9.90 per hundredweight.
By offering to purchase as much butter, cheese, and nonfat dry milk as  processors offer to sell at specified prices, the price support program sets a  floor on the price of these commodities and, thus, indirectly on the raw  milk used to produce them. Because processors are not required to sell to  the CCC and milk processing costs vary, farmers may receive prices that  are either above or below the support price. However, manufactured  product prices generally will not fall below the floor for very long. Also,  because the price for raw milk used for fluid purposes under the FMMO  program is based in part on the price of raw milk used for manufacturing  purposes, the price support program indirectly influences the price that  farmers receive for raw milk used for fluid purposes as well.
The Secretary of Agriculture can adjust—or tilt—the related CCC purchase  prices for butter and nonfat dry milk and still achieve the target support  price for raw milk used in manufactured products. These products are  considered joint products manufactured from the same 100 pounds of  milk. Therefore, by increasing the support price of butter while lowering  the support price of nonfat dry milk, or vice versa, USDA is able to adjust  the CCC purchase prices, while maintaining the overall support price. The  ability to adjust the relative purchase prices of these products is important  for correcting imbalances in the CCC’s purchases of milkfat (butter) and  nonfat solids (nonfat dry milk). Failure to correct for such imbalances can  create an incentive for farmers to expand production and may alter the  flow of milk to alternative uses. The 1990 Farm Bill authorized the  Secretary of Agriculture to adjust the tilt twice annually to limit the  accumulation of significant government stocks of certain commodities.
As market prices rise, the support program allows the CCC to release its  commodity stocks if the market price for a particular commodity exceeds  that commodity’s purchase price. In this respect, the program helps to  decrease volatility in milk prices with regard to high-price periods as well  as low-price periods.
section_title: Milk Income Loss Contract Program
paragraphs: In 2002, the MILC program began to provide countercyclical payments  directly to farmers during periods of low prices. The MILC program  provides support to farmers when the price of Class I milk in Boston falls  below $16.94. MILC payments are equal to 45 percent of the difference  between $16.94 and the lower Boston Class I price. Farmers in all regions  of the country have access to payments under this program, but only 2.4  million pounds of milk per farm are eligible for payments during each  federal fiscal year. Farmers may choose the month that they begin  accepting their payments. This discretion may enable farmers producing  more than 2.4 million pounds of milk per year to target their MILC  payments during the lowest-price periods of the year to maximize the MILC  payments they receive before reaching the cap on eligible production.
section_title: Trade Restrictions and Export Incentives for Dairy Products
paragraphs: According to some government and academic experts, trade restrictions  have the greatest effect of any federal policy on farm milk prices. Trade  restrictions maintain U.S. prices above average international market prices  by restricting the amount of imports, particularly of manufactured dairy  products, that enter the country. In other countries, costs of production  may be lower, or exports may be more heavily subsidized, possibly  allowing these countries to export products to the United States at  competitive prices. Thus, without trade restrictions, manufactured  products from these other countries might enter the United States in  greater quantities. This increased supply of manufactured products would  be expected to decrease the demand for domestic raw milk and lead to  lower farm prices. Without these trade restrictions, other dairy programs,  such as the price support program, might not be feasible because lower  manufactured product prices resulting from international competition  could trigger an increase in purchases by the CCC, which could render the  program prohibitively expensive.
The primary U.S. international trade restriction is the tariff-rate quota,  which is the primary international trade restriction allowed under current  international agreements. USDA’s Foreign Agricultural Service uses  licensing to administer a tariff-rate quota system for most dairy products.  Under tariff-rate quotas, a low tariff rate applies to imports up to a  specified quantity, and a higher tariff rate applies to any imports exceeding  that amount. These higher over-quota tariff rates generally limit trade to  within quota levels. Quota rates and quantities vary by product.
Another aspect of U.S. trade policy that affects farm prices is the Dairy  Export Incentive Program (DEIP), an initiative that aims to help exporters  of certain U.S. dairy products–specifically, nonfat dry milk, butterfat, and  various cheeses–meet prevailing world prices for targeted dairy products  and destinations. A major objective of the program is to develop export  markets for dairy products where U.S. products are not currently  competitive. Under the program, the Foreign Agricultural Service pays cash  to exporters as bonuses, allowing them to buy dairy products at U.S. prices  and then sell them abroad at lower international prices. DEIP could affect  farm prices primarily by increasing demand for dairy products through  export subsidies. According to a 2002 report by the Congressional  Research Service, past studies have indicated that DEIP subsidies have at  times enhanced farm prices; for example, these studies indicated that DEIP  subsidies enhanced farm prices by $0.30 to $0.50 per hundredweight in  1992. Additionally, in May 2003, the National Milk Producers Federation  testified that the subsidies for 5,000 metric tons of butterfat provided by  DEIP in March 2003 increased wholesale butter prices by an estimated  $0.06 per pound. This price increase boosted farm income by between $20  million and $30 million. DEIP can also help lower government costs by  reducing the amount of product purchased under the price support  program to the extent that savings in the price support program exceed the  costs of subsidies. Given recent market conditions, DEIP has primarily  been used to encourage exports of nonfat dry milk and cheese, and for the  most part, from 1998 through 2002 the program supported exports of these  products to the maximum extent allowable under international trade  commitment limits.
section_title: Services Provided by Cooperatives, Market Structure, and Collective Action Can Influence the Price of Milk at the Cooperative Level
paragraphs: Milk reaches the consumer through a variety of pathways; however, most  milk produced by dairy farmers in the United States is marketed through  dairy cooperatives. Dairy cooperatives can either sell, or arrange the sale  of, raw milk purchased from farmers to wholesale milk processors, or they  can process it into fluid and manufactured milk products and distribute  them to retail outlets. As part of sales to wholesale milk processors,  cooperatives negotiate with the processors for over-order premiums, which  represent the difference between the prices charged to the wholesalers and  regulated minimum prices, in areas with federal or state marketing orders  or regulations. The difference between the price at which cooperatives sell  raw milk to wholesale fluid milk processors and the farm price for fluid  milk is influenced by the costs of services that cooperatives provide to their  members and to their buyers, the relative market power of cooperatives  and fluid milk processors, and the effects of collective action taken by  dairy cooperatives in marketing their members’ milk.
subsections: section_title: Costs of Services Provided by Cooperatives Influence Milk Prices
paragraphs: Over-order premiums, in part, compensate cooperatives for the services  they provide to their members and on behalf of their members to  wholesalers. Some distinctive features of cooperatives include member  ownership and control, at-cost services for members, and distribution of  income to members on the basis of patronage. Farmers join dairy  cooperatives to guarantee a market outlet for their milk, to gain bargaining  power to obtain the best price in the market, to have their milk marketed  efficiently, with the assurance that their milk will be accurately weighed  and tested, and to be effectively represented in legislative, regulatory, and  public relations matters. Most dairy cooperatives require farmers to sign a  1-year membership agreement that commits them to market all their milk  through the cooperative.
Cooperatives operate like corporate businesses to perform services for  their members. For example, Dairy Farmers of America, the largest dairy  cooperative in the country, serves almost 23,000 members, producing about  21 percent and marketing about 33 percent of the milk in the United States.  According to the cooperative’s Web site, the cooperative provides a variety  of services to its members, including the following:  insurance—medical programs, dental/vision plans, and life insurance  available to members via a milk check deduction;  direct deposit—direct deposit of members’ milk checks, ensuring that  farmers’ pay checks will be available within 24 hours of the pay date;  forward contracting—a marketing service that allows members to  protect themselves against price volatility by locking in the future sale  price of their milk several months before it is produced; and  financing services—loan packages for cattle, equipment, and operating  expenses.
In some cases, dairy farmers pay on a per-use basis for the services they  receive. However, cooperatives may also try to offset the costs of their  services through negotiations with wholesale milk processors for over- order premiums.
Over-order premiums also compensate dairy cooperatives for a number of  services that they provide to fluid milk processors on behalf of their  members. Generally, these services include (1) transporting milk from  different milk-producing areas, (2) scheduling—or balancing—milk  deliveries to coincide with demand, and (3) standardizing the component  content of milk deliveries. Different cooperatives also provide additional  services for fluid milk processors. For example, one cooperative we  contacted noted the rigorous quality control procedures it performs on its  members’ milk. According to the cooperative official, these efforts allow  the cooperative to market its members’ milk as better quality, potentially  helping the cooperative negotiate higher over-order premiums. Officials  from another cooperative said that a major component of the costs of  services provided by cooperatives is balancing the delivery of raw milk  supplies to processors’ plants. At certain times processors’ plants have  surging demand for raw milk, while at other times the plants are empty. In  addition, supply disruptions, such as labor strikes, create significant  balancing disruptions. In this environment, few, if any, fluid milk  processing firms have the capital (plants to make cheese and other  products during periods of low fluid demand) to assume the risks inherent  in balancing, and so in most cases this responsibility is met by the  cooperatives.
section_title: Relative Market Power of Cooperatives and Processors Influences Milk Prices
paragraphs: Historically, farmers produced and distributed fluid milk as well as some  manufactured products. Milk is a highly perishable product that is bulky to  transport. Traditionally, this left farmers dependent on local markets for  the sale of their milk. The role of dairy cooperatives developed as farmers  faced greater demand for fluid milk and dairy products and the number of  farmers who processed and distributed their own milk products declined.  Instead, specialized firms began taking on the role of processing fluid and  manufactured milk products and marketing them for sale to consumers.  However, in this environment, there were many more farmers than  processors, so processors had the opportunity to bargain with different  farmers to obtain a lower price for their raw milk supplies. In this situation,  farmers were at a disadvantage. Consequently, cooperatives took on the  role of collecting raw milk from farmers and distributing it to processors.  By doing so, cooperatives helped to balance the bargaining power between  farmers and processors. The 1922 Capper-Volstead Act provides limited  antitrust immunity to cooperatives that meet certain requirements under  certain conditions and gives farmers an opportunity to work together in  setting raw milk prices, including bargaining for market premiums. Thus,  over-order premiums, in part, reflect market power acquired by  cooperatives relative to processors.
Since our June 2001 report, the concentration of dairy cooperatives has  increased, with the potential effect of enhancing their market power in  negotiations with processors. In 2001, we reported that 83 percent of the  milk produced in the United States was marketed by cooperatives.  However, USDA recently reported that in 2002, the share of milk sold to  processors and other distributors by cooperatives reached 86 percent of all  the milk produced in the United States. Cooperatives attained this market  share despite a 13 percent decrease in the number of dairy cooperatives  between 1997 and 2002. During this time the amount of member-produced  milk marketed by the eight largest dairy cooperatives grew from 52 to 63  percent of the total volume of milk marketed by cooperatives. This  translated into an increase from 42 to 52 percent of the total volume of milk  produced in the United States.
A number of dairy experts cited the need to offset gains in market power  made by increasingly concentrated firms at the wholesale processor and  retail levels of the milk marketing chain as a key factor in the continued  concentration of cooperatives. The greater the percentage of the milk  supply that a cooperative markets, the greater its ability might be to obtain  higher over-order premiums in negotiations with wholesale processors. On  the other hand, one academic source questioned the extent to which  increased concentration is enhancing the market power of dairy  cooperatives, particularly over the long term. He noted that although Dairy  Farmers of America has been consolidating its control over milk supplies in  some regions, farmers and cooperatives have been able to command larger  over-order premiums in the East and Upper Midwest regions—where the  cooperative’s presence is not as strong—than in the West, where milk  supplies have been increasing. Other sources noted that competition still  exists among cooperatives and independent dairy farmers and that this  competition prevents even larger cooperatives from obtaining excessively  high over-order premiums.
section_title: Collective Action by Cooperatives Influences Milk Prices
paragraphs: Another factor in determining the over-order premiums received by  cooperatives for raw milk is collective action taken by cooperatives.  Cooperatives work together to try to set prices by coordination allowed  under the protection afforded by the Capper-Volstead Act. For example,  officials with Dairy Farmers of America said that a major factor in the price  of milk at the cooperative level is the action of marketing agencies  composed of cooperatives. Marketing agencies behave like cartels and  announce prices for their cooperative members. In most cases these  agencies set prices for raw milk used in fluid milk and other products. Most  of the prices announced by the marketing agencies represent the minimum  federal order prices; additional charges may be added representing the  costs of services provided by the cooperatives to the processors.
Representatives of Dairy Farmers of America said that there are marketing  agency agreements in most major markets except in the Pacific Northwest  and that for the most part, cooperatives participate in marketing agencies.  They further stated that the use of marketing agencies has become more  common in recent years. The marketing agencies may also market milk for  independent farmers. The officials noted that while cooperatives and  independent farmers can choose not to participate in the marketing  agencies, experience has shown that as more producers choose to market  milk outside the system, the marketing agencies face significant  competition and prices fall. Eventually, if the prices get low enough, the  producers have an incentive to work together again.
In an alternative type of collective action, three cooperatives—the Dairylea  Cooperative, Dairy Farmers of America, and St. Albans Cooperative  Creamery—established a milk marketing organization called Dairy  Marketing Services. According to a Dairy Marketing Services official, the  organization was formed because the cooperatives realized that they  needed more market power to compete with increasingly concentrated  processors and retailers. Cooperatives such as Dairylea, or individual  farmers, establish contracts with Dairy Marketing Services to market their  milk. Dairy Marketing Services markets about 16 billion pounds of milk  annually for farmers in the Northeast area that extends from Maine to  Maryland, and includes a small area in Ohio. The official estimated that this  quantity represents about 45 percent of the milk marketed in the Northeast  and is produced by some 10,000 to 11,000 farmers.
The Dairy Marketing Services official stated that the organization has been  able to carve a niche for itself in the milk marketing chain by convincing  processors that it is more efficient for them to have Dairy Marketing  Services arrange to have raw milk transported from the farm to the plant  and allow the processors to focus on processing milk. As a result, Dairy  Marketing Services has been able to obtain contracts from a number of  major processors in the Northeast, including Dean Foods, Crowley Foods,  and Kraft, to ensure an adequate supply of milk for their plants.  Additionally, Dairy Marketing Services provides specialized services for  farmers such as health insurance and workmen’s compensation, a livestock  purchasing service, and risk management operations for farmers engaged  in forward contracting. Although we were unable to confirm the effects  that Dairy Marketing Services’ efforts have had, the official stated that the  organization has provided higher over-order premiums and lower  transportation charges for its participating cooperatives and farmers than  would have otherwise been the case.
section_title: Input Costs, Service Levels, Innovations, and Market Structure Influence Wholesale Fluid Milk Prices
paragraphs: The difference between the price at which wholesale fluid milk processors  sell fluid milk products to retail firms and the price they pay for raw milk is  influenced by changes in input costs, such as fuel, labor, packaging,  transportation, and capital expenses. These costs, in turn, are affected by  recent innovations that have increased efficiency and lowered costs of fluid  milk processing, as well as by the level of service that fluid milk processors  provide to retailers. For example, in addition to shipping the products to  retailers, some wholesalers provide in-store services, including unloading  the milk on the store dock, restocking the dairy case, and removing  outdated or leaking containers. The difference between what fluid milk  processors pay for raw milk and the wholesale price they charge their retail  customers is also influenced by continued structural change in the fluid  milk processing industry, including a steady increase in firm consolidation  and the market share of some firms. While there have been many reasons  for these trends, the effects on the market and fluid milk prices at this level  are unclear.
subsections: section_title: Input Costs, Service Levels, and Innovations Influence Wholesale Fluid Milk Prices
paragraphs: Several fluid milk processors stated that the cost of raw milk, and, in  particular, the federal order minimum price, was the single most important  influence on wholesale milk prices. We estimate that the price of raw milk  ranges from about 60 to 70 percent of the wholesale price of 2 percent milk.  As such, the wholesale price that processors charge would be directly  linked to the Class I federal order price on a year-to-year basis, with  adjustments for over-order premiums and other inputs. However, a variety  of other input costs can also affect the price at which fluid milk processors  sell fluid milk products to retailers. Some sources indicated that costs of  inputs other than raw milk have been increasing in recent years. As one  executive of a milk-processing firm explained, the primary input costs,  apart from raw milk, include labor and energy. A 2002 study examining  changes in fluid milk processing plants located in the state of Maine found  that total processing costs rose at an annual rate of about 2.4 percent  (adjusted for inflation) from 1993 through 2000. The study indicated that  economywide wage inflation plus a dramatic increase in health care  premiums paid by employers drove labor costs above the costs of other  inputs, such as land and building expenses and plant supplies. Equipment  costs increased 10.9 percent per year with investments in plant automation  and greater reliance on information technologies. Also, fuel costs increased  by 4.6 percent per year, reflecting economywide trends in energy costs.  Moreover, while the cost of operating capital constituted only 1.0 percent  of processing costs, it increased substantially during this period due to an  increase in the short-term lending rate. Table 28 displays the percentage  change in fluid milk processing costs in Maine reported in this study for  each cost category from 1993 through 2000.
Changes in the level of service that some fluid milk processors provide  their retail customers have increased the efficiency of the dairy supply  chain, thus potentially influencing wholesale milk prices. For example,  some fluid milk processors have begun to undertake supply-chain  management for their retail customers. According to a number of retailers  and processors, supply-chain management commonly involves shared  computer systems, which, in the vertical marketing chain, allow processors  to more efficiently manage the processing and transporting of fluid milk  products. One processor indicated that it uses an electronic data transfer  system to manage supplies for certain retailers. In particular, this system  allows the processor to contract for a certain number of loads of milk per  day. Further, according to a recent presentation given by company officials,  Dean Foods’ national, refrigerated, direct-store-delivery system allows it to  deliver fluid milk to its customers with increased route network efficiency  and without customer disruption. Dean Foods operates 129 fluid  processing plants in 39 states, servicing more than 150,000 customers coast  to coast via its direct-store-delivery system of more than 6,000 routes.
By allowing fluid milk products to move more efficiently from the  processor to the retailer, these kinds of services help to ensure quality and  reduce waste and costs along the supply chain. To the extent that  processors benefit from the reduced costs of supplying retailers with fluid  milk products, the provision of these services could have a downward  effect on wholesale prices. On the other hand, these services could provide  value to retailers for which they might be willing to pay a higher price when  acquiring fluid milk products. Therefore, the net effect on wholesale prices  of the level of service that processors provide to retailers is uncertain.
Additionally, innovations in technology can affect prices at the wholesale  milk processing level. For example, changes in processing technology, such  as more automated equipment, can improve the efficiency of processing  operations and, to the extent that processing firms are successful at  reducing their costs through innovative practices, they may be able to  reduce their prices. A representative of one fluid milk processor explained  that improvements in processing and packaging technology have doubled  and tripled output. Also, a representative of one firm that processes milk  for sale in its own retail stores stated that the firm has dedicated a large  contingent of people toward the goal of reducing milk losses at its  processing plants and has been successful at cutting these losses in half. He  noted that a driving force behind these efforts is to try to alleviate increases  in other input costs, such as labor.
With innovations in technology, the fluid milk processing industry has also  invested in innovative new products. By developing products with  extended shelf lives, processors can potentially save shipping costs,  leading to lower wholesale prices. For instance, the dairy processing  industry’s collective investment in extended shelf life, ultra high  temperature, and aseptic packaging technology allows fluid milk products  to reach the end user more efficiently while maintaining quality. The  benefits to processors and their retailers include the ability to ship these  products longer distances because they are able to endure more stress than  traditionally processed milk.
section_title: Market Structure in the Fluid Milk Processing Industry Can Influence Wholesale Prices
paragraphs: Since the 1960s, there has been long-term structural change in the  wholesale fluid milk processing industry as a continuously declining  number of firms have processed an increasing average volume of milk.  Structural change in the processing industry has been driven by economies  of size, technological changes, high concentration at other levels of the  milk marketing chain, and rapid consolidation into fewer and fewer firms.  While structural change can lead to lower prices due to cost reduction from  greater efficiency in production, it can also lead to higher market  concentration, particularly in individual markets. In general, high and  increasing market concentration can result in greater market power,  potentially allowing firms to increase prices above competitive levels.  Accordingly, the net impact of increased market concentration on  wholesale prices can be either positive or negative.
In recent years, through aggressive acquisitions of independent dairy  processing plants, a handful of fluid milk processing firms have changed  the market structure of the dairy industry at the wholesale level. These  companies have generally pursued the business strategy of acquiring strong  regional dairy processing plants so that they can strengthen their presence  in existing markets, while expanding their geographic coverage to a  national level. The acquisition and consolidation trend at the wholesale  level has affected market structure by leading to higher market  concentration for fluid milk processors in some markets. One common  measure of market concentration is the four-firm concentration ratio–the  percentage of sales by the top four firms in a market. According to the 1997  Census of Manufacturers, the market share for the top four fluid milk  processors in the nation was about 21 percent. However, the market share  for top fluid milk processors at the local level was significantly higher. For  example, in our June 2001 report, we found that in Boston, Massachusetts,  the market share of the top four fluid milk processors increased from 66  percent in December 1997 to 88 percent in December 1999.
Since our last report in 2001 on fluid milk prices, this trend has continued,  and there have been several significant mergers, acquisitions, and joint  ventures that have further consolidated the industry. For example, in late  2001, Dean Foods merged with Suiza, Inc., bringing together the number  one and two firms in terms of market share in the processing industry.  Then, in July 2002, the Land O’ Lakes dairy cooperative sold its fluid milk  operations to Dean Foods. We estimate that these acquisitions and mergers  gave Dean Foods about a 27 percent market share nationally in fluid milk  products in 2002. Others have estimated that Dean Foods’ market share is  about 35 percent nationally and approximately 70 percent in New  England. As of 2002, we estimate that the market share of the top four  fluid milk processors has increased to approximately 47 percent. As seen  in figure 33, with increased concentration, the number of fluid milk  processing plants has gone from 1,066 plants producing an average of 50.1  million pounds of milk per year in 1980 to 385 plants producing an average  of 154.2 million pounds per year in 2002.
Such increased concentration of fluid milk processing firms, particularly in  individual markets, can increase the price at which fluid milk is sold to  retailers because market concentration can provide these firms greater  market power. Thus, some analysts viewed the trend toward greater  concentration in the wholesale market as a means toward greater  dominance and market power in selling fluid milk to retailers. Further, they  noted that increased market power can also benefit processors in their  negotiations for raw milk supplies from cooperatives and independent  farmers. For example, the exercise of market power could allow  processors to negotiate more favorable supply contracts, which could drive  down input prices and increase the spread between wholesale and retail  prices. Other economists who study the causes of market concentration  described a phenomenon called the “replication hypothesis”—as  concentration grows at one marketing level, it is likely to be replicated at  other marketing levels. For instance, high market concentration at the  retail level can lead to greater concentration at the fluid milk processor  level, and higher concentration in fluid milk processing can, in turn, lead to  higher concentration at the cooperative level. One fluid milk processor that  we spoke with stated that retail concentration has resulted in retailers  preferring only one supplier, requiring a processor to have multiple plants  in order to supply a retailer who serves many markets.
On the other hand, increasing concentration can lead to cost savings  through efficiency gains, which may be passed on to retailers in the form of  lower wholesale prices. For example, some economists viewed  consolidation of processing firms as a result of increasing economies of  scale and excess plant capacity. That is, processors decrease their costs per  gallon for items like packaging or processing costs, as they increase the  amount of milk they process. One dairy analyst reported that in plants  ranging from a monthly volume of 90,000 pounds per month to 30 million  pounds per month processing costs decreased from about $1 per gallon to  about $0.50 per gallon. In the end, the impact of market concentration on  wholesale prices, either positive or negative, depends on whether market  power or efficiency dominates.
section_title: Retailing Costs, Consumer Demand, and Market Structure Changes Affect Retail Prices for Fluid Milk
paragraphs: Three key factors that influence fluid milk prices at the retail level are  retailing costs, consumer demand, and market structure. Recent increases  in input costs such as labor and energy have been substantial. In an effort  to hold down their retailing costs and remain competitive, some retailers  are implementing supply-chain management and other innovations that  increase efficiency. At the same time, consumers are purchasing a declining  amount of traditional fluid milk and are increasing consumption of other  beverages, such as soft drinks and bottled water. Market structure changes  include continued consolidation in recent years through mergers and  acquisitions among large food retailers at the national level and in many  local markets, along with an increasing number of outlets that are  competing with traditional supermarkets to sell fluid milk.
subsections: section_title: Costs of Retailing Influence the Price of Fluid Milk
paragraphs: Representatives of the Food Marketing Institute stated that after the  wholesale costs of the milk, the primary costs that influence the retail price  of fluid milk are related to labor and energy. They added that all of these  costs have been rising recently. According to the Bureau of Labor Statistics,  the average hourly earnings for nonsupervisory food store employees went  from $7.56 per hour in 1992 to $10.20 per hour in 2002. These payroll costs  are the largest percentage of retail operating costs, followed by the second  largest single category, employee benefits such as health insurance. Table  29 shows the breakdown of supermarket operating costs in 2003 as a  percentage of total sales and gross margin.
Table 30 displays the sales and expense growth as a percentage of sales for  the supermarket industry during the last decade, from 1993 through 2003.  During this time, total employment costs increased by 12.0 percent,  including a 10.7 percent increase in payroll expenses; the cost of supplies  also increased by 10.0 percent.
A 2003 study that was more specific to retailer costs related to fluid milk  sales noted that these costs include both direct and indirect costs. Direct  costs are those for electricity, labor, store equipment, and fluid milk.  Indirect costs include corporate, division, and store overhead. While the  study found variation in the indirect costs, such as store overhead, there  was less variation across retail stores in direct costs.
Increasing per unit costs have led some retailers to try to improve  efficiency and reduce total costs. As mentioned in the discussion of factors  influencing fluid milk prices at the wholesale level, some retailers are  reducing costs by working with their wholesale suppliers to achieve  supply-chain management. For example, officials with Wal-Mart noted that  the firm has tried to reduce its costs and maintain its everyday-low-pricing  strategy for consumers through  a computerized system called Collaborative Planning Forecast  Replenishment that allows processors to track stock levels at Wal-Mart  locations and schedule deliveries to specific locations;  direct-store-delivery of the majority of its fluid milk products to increase  the efficiency of its supply chain; and  changes to its shipping practices, such as not putting labels on its cases,  that have allowed Wal-Mart to save time and money.
Another retailer indicated that it is trying to improve the way it stocks its  shelves to cut costs. A representative indicated that the retailer has  invested in retrofitting its stores to use a device called a “bossy cart,” which  allows store employees to move 80 gallons of milk into the milk case in one  shelf-stocking.
section_title: Consumer Demand Influences Retail Fluid Milk Pricing
paragraphs: Consumer demand, driven by factors such as taste, convenience, and  health, influences the retail price of milk. Moreover, since fluid milk  represents approximately 3 percent of total supermarket sales, it is an  important category for store performance, and retailers have an incentive  to price their products competitively. However, over time, fluid milk  consumption has gradually declined, with per capita demand for milk  trending downward at a rate of 2 to 3 percent per year. This downward  trend stems from several key factors including increasing consumption of  substitute drinks such as carbonated soft drinks, juice drinks, coffee, teas,  soy products, and bottled water. Also, there has been an increasing trend  toward more eating outside the home, reducing the demand for fluid milk  sold in food stores. Within the fluid milk category, whole milk has gone  from being 92 percent of fluid milk consumed in 1960 to about 35 percent in  2001. Private labels represent the largest portion of the market, about 60  percent. More recently, however, there has been growth in the  development of innovative value-added dairy products. These new  innovations include dairy products for medicine/health (such as low- carbohydrate products), multipack drinks such as single-serve and vending  drinks, and organic dairy products.
In response to trends in consumer demand for fluid milk products, retailers  from high-end supermarkets to mass merchandisers use diverse pricing  strategies, and no single approach applies to any group. However,  according to some retail executives, one method that retailers are currently  using is category management. Using this strategy, a retailer would not  focus on how much 1 percent, 2 percent, or whole milk it sells, but rather  on how much is sold from the entire dairy case. Accordingly, category  managers would view product assortment strategically, evaluating the  performance of entire groups of related dairy products. The goal is to  maximize the sales for the entire category, which requires continual  adjustment to match consumer demand. To accomplish this goal, managers  may feed scanner data and other market information into computer models  that make product assortment decisions.
A related issue influencing the retail price of fluid milk is the price elasticity  of demand, that is, the sensitivity of fluid milk consumption to changes in  price. For many years, empirical studies have indicated that milk prices  were very price inelastic, meaning that there was little change in demand in  response to a change in price. Most studies suggest that overall, the  demand for milk is still price inelastic. However, some recent studies  suggest that the demand for milk is not as price inelastic as it was  previously.
Moreover, some researchers have found that for many fluid milk products,  demand is elastic, or that there is a greater change in demand relative to a  change in price for certain types of milk. One study reported that price  elasticities varied considerably by container size, type (such as white or  flavored), and fat content of the milk. For instance, the study found that  the demand for whole milk, skim milk, and low fat milk in half-gallon  containers was price elastic. This research also suggested that carbonated  soft drinks are the chief substitute or competitor for fluid milk products,  while water is a complement in consumption. In another study,  researchers found that the elasticities of demand for skim/low fat and  whole milk brands are different. Demand for skim/low fat milk was found  to be more price elastic than demand for whole milk, suggesting that  retailers could increase overall fluid milk sales by lowering the prices of  skim/low fat milk relative to prices for whole milk.
section_title: Retail Market Structure Can Influence Fluid Milk Prices
paragraphs: As with the fluid milk processing industry, there have been trends of  increasing consolidation and concentration at the retail level during recent  years, especially among retail firms in some individual markets. Structural  change and increased consolidation at the retail level of the milk marketing  chain could lead to lower retail prices as individual retailers experience  increased efficiencies in their operations. On the other hand, high levels of  concentration can result in greater market power, potentially allowing  firms to increase market prices above competitive levels. Also, greater  market concentration at this level could increase a retailer’s buying power  with fluid milk processors, potentially lowering costs. Depending upon  whether these lower costs are passed on to consumers, this can either  lower retail milk prices or increase the spread between wholesale and  retail prices.
According to USDA, since 1996, almost 4,700 supermarkets, representing  $75.5 billion in sales, were acquired by other firms. Major mergers and  acquisitions that have occurred in the retail food market in recent years  include the following:  In 1998, Kroger, the nation’s largest supermarket chain, acquired Fred  Meyer, and Albertsons acquired American Stores, the second-largest at  that time.
In 2000, Delhaize America, operator of the Food Lion chain of stores,  purchased Hannaford Brother’s Shop ’n Save supermarkets in New  England to become the eighth-largest food retailer at that time.
In 2001, Kroger purchased supermarkets in Oklahoma and Texas from  Winn-Dixie.
In 2001, Safeway made several acquisitions including Genuardi’s Family  Market stores (Pennsylvania, New Jersey, and Delaware), Randall’s food  markets (Houston, Texas), and Dominick’s supermarkets (Chicago  metropolitan area).
In 2004, Albertsons, the third-largest U.S. food retailer, purchased  Shaw’s, the eleventh-largest at the time.
In June 2001, we reported that, for the 100 largest U.S. cities, the combined  average market share of the top four firms increased from 69 percent in  1992 to 72 percent in 1998, with some variation depending upon the  particular market area. An official of one large supermarket chain noted  that because of Wal-Mart’s large presence in the market, other companies’  slices of the “demand pie” got thinner, providing an incentive to expand and  buy out other companies. According to USDA data, the top four firms  among all food retailers in 2003 were Kroger, Wal-Mart, Albertsons, and  Safeway.
Consolidation in food retail chains has led to high levels of concentration in  individual metropolitan markets. Table 31 displays market concentration,  as measured by the four-firm concentration ratio, in the 15 markets that we  used in this report to analyze the spread between retail and farm milk  prices. While this threshold varies, some economists have characterized a  market with a four-firm concentration ratio of 60 percent or greater as a  “tight oligopoly” or highly concentrated. In 2003, the levels of  concentration varied by metropolitan market, with the percentage of the  market held by the four largest firms ranging from 62.8 percent in the  Minneapolis/St. Paul area to 84.9 percent in Denver, with an overall  unweighted average of 73.9 percent. Moreover, for the 15 markets that we  analyzed, the overall average four-firm concentration ratio for 1998 that we  reported in 2001—74 percent—is comparable to the 2003 average.
At the same time, the traditional dominance of supermarkets in food sales  has been challenged by competition from new mass merchandisers and  super centers such as Wal-Mart, K-Mart, and Target. These retailers tend to  offer lower prices and often purchase their inventories in large quantities to  pass on low prices to consumers. According to a recent USDA report, even  the larger conventional food stores do not have the same buying power as  these large general merchandisers. They also tend to grow by new  investment in stores rather than through mergers and acquisitions, in  contrast to traditional supermarkets. Figure 34 displays the change in food  sales by market segment of food retailers between 1993 and 2003. Sales  from supermarkets decreased from 63 percent to 58.3 percent during this  time period. However, sales from warehouse clubs and super centers  increased from 3.6 percent to 9 percent, while those of convenience stores  and drug stores also increased—from 11.9 percent to 13.6 percent. Overall,  sales from nontraditional food retailers—warehouse clubs and super  centers, mass merchandisers, and convenience and drugstores—went from  17.2 percent in 1993 to 24.4 percent in 2003.
Within the fastest-growing segment, warehouse clubs and super centers,  the largest food retailer is Wal-Mart, followed by Target and Meijer’s, while  the second fastest growing segment includes the major drug chains, such  as Walgreen’s and CVS. As of 2003, Wal-Mart super center sales reached  $103.2 billion, with estimated grocery sales of $41.3 billion. According to a  recent ACNielsen study, while all U.S. households still shop in traditional  grocery stores, the annual number of trips to such stores continues to  decline. In contrast, super centers have shown strong gains in household  penetration as well as gains in the number of trips per year. In dairy,  however, conventional food stores still offer a larger selection of milk  products. A recent study by researchers at Cornell and Oklahoma State  Universities on dairy case management found that the number of milk  products offered was highest in supermarkets (74) and lowest in drug  stores (16). While the volume of milk products was highest for mass  merchandisers, the number of products (24) was similar to convenience  stores (22). The authors explained that historically, mass merchandisers  concentrated on moving a large volume of product with a limited variety.
section_title: Economic Studies of Price Transmission in the U.S. Fluid Milk Market
paragraphs: This appendix summarizes the findings of 14 economic studies of price  transmission in U.S. fluid milk markets. These studies estimated the extent  to which price changes at one level, such as the farm level, are transmitted  to other levels, such as the retail level, and the time in which these price  changes are transmitted. Many of the studies found a difference, or  asymmetry, in either the extent or speed of price transmission, depending  on whether the initial price change was an increase or a decrease (see table  32). Some of the studies analyzed possible causes for price asymmetry and  often identified the presence of noncompetitive markets as a contributing  factor. Although most studies estimated how prices are transmitted from  the farm to the retail level, a few also estimated how price changes are  transmitted from the retail level back to the farm level.
How prices are transmitted within the milk marketing chain is important to  policy makers because it affects both farmers and consumers. Farmers  may be concerned with price transmission because they may believe  increases in retail prices are not fully passed back to the farm level, while  decreases are passed on. Consumers and farmers may believe that  decreases in farm prices are not fully passed along to the retail level, while  increases are passed on. Figure 35 illustrates price transmission through  the vertical milk marketing chain; the arrows show how price signals are  transmitted in both directions between marketing levels.
The first section of this appendix is a detailed table summarizing the  models, data, and key assumptions used in each study, and each study’s  results. The second and third sections discuss the farm-to-retail results,  including evidence of price asymmetry, with respect to the extent of price  transmission and the speed of price transmission. The fourth section  discusses the retail-to-farm results on price transmission. The last section  discusses the studies’ findings regarding factors that might cause price  asymmetry.
subsections: section_title: Summary of Recent Economic Studies of Price Transmission in the U.S. Fluid Milk Market
paragraphs: While most of the studies summarized in table 33 use, as a basis for their  models, the standard Houck (1977) and Kinnucan and Forker (1987)  models to identify price asymmetry, others use newer methods such as the  error correction model, which some researchers believe provides a more  appropriate specification for examining asymmetric price transmission.  Most of the studies estimated only “forward” price transmission, or price  transmission from the farm to the retail level, but we also report on one  study that estimated “backward” price transmission, from the retail level to  the farm. The studies also differed in whether they estimated short-run or  long-run price transmission asymmetry or both. We take all of these  differences into account in interpreting the studies’ overall conclusions and  discussing their results.
section_title: Results on the Extent of Farm-to-Retail Price Transmission and Price Transmission Asymmetry
paragraphs: On both national and regional or citywide levels, the majority of the fluid  milk studies that we identified found evidence of farm-to-retail price  transmission asymmetry in price levels. While the studies estimated a wide  range of price transmission levels, in general, the estimates of price  transmission for initial farm price increases were greater than for farm  price decreases.
subsections: section_title: National Level Results
paragraphs: The fluid milk price transmission studies that we identified using national  aggregate data estimated a wide range of price transmission levels and  generally found evidence indicating asymmetric price transmission—farm  price increases were more fully transmitted to retail prices than farm price  decreases. Using national average farm and retail prices for whole milk,  Emerick (1994) and Wang (2003) developed two similar studies that  identified the degree of price transmission nationally. While both studies  used similar models, the Wang study used somewhat more recent data.  Taken together, both studies’ short-run results suggest that about 45  percent to 94 percent of farm price increases were passed along to the  retail level, while only 31 percent to 41 percent of farm price decreases  were similarly passed along. These studies estimated that in the long run,  transmission levels for price increases ranged from 83 percent to 107  percent, while transmission levels for price decreases ranged from 55  percent to 64 percent. Both researchers found price asymmetry in the long  run, but Wang also found price asymmetry in the short run. In his study of  seven metropolitan markets across the country using data from 1994 to  2003, Capps Jr. (2004) also identified price asymmetry in a majority of  selected fluid milk markets for whole and 2 percent milk. Measuring the  level of price transmission by using the elasticity of price transmission, he  estimated elasticities for farm price increases ranging from 0.23 to 0.58 for  whole milk and 0.11 to 0.46 for 2 percent milk. For farm price decreases,  these elasticities were much lower, ranging from –0.02 to 0.12 for whole  and –0.06 to 0.25 for 2 percent, respectively.7, 8 Similarly, in Linkow et al.  (2004), using an asymmetric friction model of 10 metropolitan markets  across the country, the authors found evidence of price asymmetry—retail  prices were more responsive to cooperative farm price increases than  decreases.
section_title: Regional and City-Level Results
paragraphs: Many studies that used regional or city-level data also estimated a wide  range of price transmission levels as well as asymmetric price  transmission. In an econometric model for whole, skim, 1 percent, and 2  percent milk, Carman and Sexton (forthcoming 2005) estimated farm-to- retail price transmission for nine metropolitan markets in the Western  United States. Estimated levels of price transmission for all types of fluid  milk combined for the California markets ranged from 56 percent in San  Diego to 122 percent in Sacramento for price increases, and from 49  percent in San Francisco to 110 percent in San Diego for price decreases.  For the non-California markets, for both increases and decreases, the  estimated levels of price transmission were much lower, ranging from 3  percent in Portland to 72 percent in Seattle for price increases and 6  percent in Phoenix to 83 percent in Salt Lake City for price decreases. The  authors also noted that none of their price transmission parameters for all  types of fluid milk for Portland was statistically different from zero,  indicating no evidence that retail prices responded to farm price changes in  this market.
The elasticity of price transmission from the farm to retail level is the percentage change in  the retail price of a product due to a 1 percent change in the corresponding farm price.
While these elasticity estimates are ones obtained from using the Houck method, the author  found similar results, although smaller, using a time-series, cointegration approach: the  error correction model (see table 33). transmission of 68 percent for farm price increases for the Boston market.  Within the same study, the authors also note that Cotterill (2003), in other  research for Boston, estimated a pass-through rate of between 20 and 26  percent for price decreases, suggesting price asymmetry in this market. In  another study of the Boston market, using a two-stage market channel  model, Dhar and Cotterill (2002) found that the firm-specific price pass  through rate was 32 to 47 percent, while industrywide pass through was 88  to 100 percent for price increases.
In yet another study of the Northeast market, Romain et al. looked at price  asymmetry before and after the imposition of the New York price-gouging  law in 1991 and tested for price asymmetry using the elasticity of price  transmission. Before the price-gouging law, they found that a 1 percent  increase in the farm price translated into a 0.70 percent and 0.62 percent  increase in retail prices in New York City and Upstate New York,  respectively, while a 1 percent decrease translated into a 0.30 percent and  0.49 percent decrease in these markets. After the law went into effect, they  found that a 1 percent increase in the farm price translated into a 0.52  percent increase in retail prices in both New York City and Upstate New  York, while a 1 percent decrease translated into a 0.43 percent and 0.51  percent decrease in these markets, respectively. Therefore, long-run price  asymmetry was significant in both regions prior to the price-gouging law,  but remained statistically significant only in New York City afterwards,  though at a much lower level.
section_title: Results on Farm-to- Retail Speed of Adjustment and Price Transmission Asymmetry
paragraphs: We identified fewer studies that examined the speed of adjustment and  related price asymmetry, or differences in the time required for farm and  wholesale level price increases and decreases to be passed through to the  retail level. Hansen et al. (1994), using national aggregate price data for  whole milk, estimated that it took 3 months after the wholesale price  increased for the retail milk price to increase, but that it took 30 months for  the retail price to adjust to wholesale price decreases. In another study  using national data, Wang (2003), using a structural model, found that, for  farm price increases, retail prices adjusted more quickly in the first month  after the increase and more slowly in subsequent periods. Conversely, for  farm price decreases, the speed of price adjustment was slower in the  initial month and increased in the following months, implying speed of  adjustment asymmetry.
Nearly all of the studies of regional or metropolitan price transmission  found asymmetry in timing—the price adjustment process for price  decreases much exceeded that for farm price increases. Carman (1998)  found a 1-month lag for price decreases and no lag for price increases in the  California markets. In a later study, Carman and Sexton (forthcoming 2005)  found that for the majority of cities they analyzed, the time lags estimated  for price decreases generally exceeded those for price increases. For the  four types of fluid milk, Carman and Sexton found that farm price  decreases generally took from 1 to 3 months to be transmitted to the retail  level, while price increases took no more than 1 month. In the California  markets, the authors found that, in general, retail prices responded more  quickly to farm price increases than to decreases. Lass et al. (2001) found  that for the Boston and Hartford markets, retail price adjustments to rising  farm prices were much more rapid than similar adjustments to falling farm  prices. Lass (2004) also found evidence of slower price transmission to the  retail level when farm prices were falling. For markets in the Northeast,  Frigon et al. (1999) reported short-run asymmetry in price adjustment for  several markets: price adjustment was complete in Upstate New York after  2 months and in New York City and the Northeast United States after 3  months. The authors concluded that short-run asymmetry seemed to be  milder in Upstate New York, because it lasted for only 2 months. In the long  run, after 4 months, the Northeast United States, Upstate New York, and  New York City (after enactment of the gouging law) markets had fully  adjusted, with only the New York City (before enactment of the gouging  law) market not fully adjusting.
section_title: Results for Retail-to- Farm Price Transmission and Price Transmission Asymmetry
paragraphs: Using data from 1971 through 1991, Emerick (1994) tested for causality in  fluid milk pricing between the farm and retail levels and found that it was  bidirectional. That is, the author found that for these data, in addition to  farm price changes affecting retail prices, retail price changes also affect  prices at the farm level. However, this specification resulted in some  parameter values for retail-to-farm price transmission that were  inconsistent with economic expectations. In a later study, Wang (2003)  estimated results for retail-to-farm price transmission. In the short run,  which was estimated to be 1 month, the author found that price increases  were immediately passed on to the farm level with a level of transmission  of 94 percent, while price decreases were passed on at a level of 2 percent.  However, in the longer run, which was estimated as 3 months, price  increases were passed through at a level of 40 percent, while price  decreases were passed through at a level of 34 percent. In the long-run  specification, neither increases nor decreases in price were fully passed  through. Thus, while the author found price asymmetry in the short run,  she found price symmetry in the long run for retail-to-farm level price  changes. As in Wang’s farm-to-retail analysis, increases in the retail price  were passed through nearly fully in the initial month, and then decreased  substantially. However, although decreases in the retail price were not  passed on initially, they were passed on at an increasing rate in the  following months.
section_title: Possible Causes of Asymmetry in the Extent and Speed of Price Transmission
paragraphs: Even fewer economic studies have provided evidence on what causes price  transmission and price transmission asymmetry. For the U.S. fluid milk  market in particular, we found few studies that examined factors affecting  the extent of price transmission and price transmission asymmetry. While  two major explanations are cited in the economic literature as central to  explaining price transmission and transmission asymmetry— noncompetitive markets and adjustment costs—there are several others  cited, including the role of government policies, spatial market  competition, substitution in processing technology, asymmetric  information, economies of scale, and differentiated products. However,  only the presence of noncompetitive markets and the effects of  government policies were examined in the studies of price transmission  that we identified.
subsections: section_title: Noncompetitive Markets
paragraphs: In general, economic research has found that a higher degree of market  power can reduce the degree of price transmission. Particularly relevant  to the fluid milk market, researchers have also shown that the number of  vertical stages and the extent to which a market varies from the  competitive norm both influence the degree of price pass through. Of the  14 studies that we examined, only 5 explored the role of competition in  combination with the degree of price transmission and price transmission  asymmetry in the milk marketing chain. In particular, 2 of these studies  examined market power stemming from product differentiation of different  milk types. The evidence from these studies is somewhat mixed. While 1  study did not find a linkage between market concentration and price  transmission, other studies using a variety of methods did find evidence of  either a lack of price transmission or price transmission asymmetry in  markets that also possessed a degree of market power.
Carman and Sexton (forthcoming 2005), using multiple analytical  techniques, found that fluid milk markets in the Western United States that  displayed noncompetitive pricing also tended to lack price transmission  and show price asymmetry. Using monthly data from 1999 through 2003,  the authors (1) analyzed the effects of horizontal differentiation among  fluid milk types by ranking milk with different fat contents for different  markets based on the costs that would be predicted under perfect  competition, (2) performed correlation analysis between changes in the  monthly farm and retail prices of milk with different fat contents, with a  lack of correlation indicating the exercise of market power, and (3)  analyzed price transmission, along with the estimated price transmission  coefficients, to determine competition in the market.
In the first analysis, rank values for all milk types did not conform with  price expectations, with the exception of whole milk for all the months in  Seattle. Moreover, except in Portland, they found that the rankings of retail  milk prices for whole, skim, 1 percent, and 2 percent milk provided  evidence of not being based on costs, as would be expected in perfect  competition. For the price correlations, the results indicated that only a  few product pairs in the nine markets have a high degree of  interdependence, as one would expect for close substitutes. Low  correlations ranging from nearly complete independence to moderate  independence for at least one pair of products were evident in each market.  For instance, retail price changes for skim milk appeared independent of  other milk prices in Sacramento, Seattle, Portland, Salt Lake City, and  Denver. The authors explained that these correlations all indicated pricing  that was inconsistent with competitive pricing.
For the price transmission analysis, the estimated results differed among  the California markets, depending on the city and type of milk. For  instance, in certain California markets, such as Los Angeles and San Diego,  farm price decreases lagged farm price increases by 2 to 3 months,  depending on the product, indicating price asymmetry in timing. Some of  these price coefficients were consistent with competitive pricing and  others were not. However, price transmission estimates for other  metropolitan regions in the West (Seattle, Portland, Phoenix, Salt Lake City,  and Denver) provided stronger evidence of noncompetitive pricing, and  some also indicated price adjustment asymmetry, such as Salt Lake City  and Phoenix. For these markets, only 3 of the 40 estimated price  transmission coefficients were consistent with perfect competition.
Using another model of horizontal product differentiation, a subsequent  study by Sexton, Xia, and Carman (2004) econometrically estimated the  timing of fluid milk price transmission and tested for market power for four  California and five non-California cities from 1999 to 2003. While the results  were somewhat mixed, hypothesis tests for the cities indicating oligopoly  or monopoly scenarios also displayed more gradual price transmission  results than those indicating more competitive scenarios, suggesting a link  between noncompetitive market structures and a lack of price  transmission.
Chidmi et al. (2004) estimated price transmission and market power for the  Boston fluid milk market using the New Empirical Industrial Organization  approach and data from 1996 through 2000. The empirical results of the  model, in particular the conjectural variation elasticity, suggest that  participants in this market may possess market power and that  supermarkets do not ignore each other’s actions. Although the model did  not account for speed of adjustment, the authors estimated a price  transmission level of 68 percent, suggesting that market power is  associated with incomplete price transmission. A study by Frigon et al.  (1999) includes a measure of market power, the four-firm concentration  ratio, in its model of price transmission for Upstate New York and New  York City. However, this variable did not prove to be significant. Later, in a  similar study (Romain et al., 2002), the authors explain that their results of  price asymmetry prior to 1991 in New York City were evidence that  middlemen in the fluid milk market were exercising market power prior to  the price-gouging law. The authors found that price asymmetry decreased  after the law went into effect. They acknowledged, however, that to  rigorously address the issue of a noncompetitive market, an alternative  market power model would have to be developed.
section_title: Government Policies
paragraphs: Two studies looked at the effects of national government intervention on  price transmission. Emerick (1994) and Wang (2003) both examined the  question of whether changes in dairy policy, especially the reduction in the  dairy price support level that began in the mid-1980s, had changed the  nature of price transmission for dairy products. Both authors basically  came to the same conclusions. Emerick noted that asymmetry is more  likely to have occurred since 1988, adding that the greater price volatility  may have caused some difficulties for retailers and wholesalers in  determining the “appropriate” price. Wang, using additional data through  1997, found that reductions in the price support level tend to have a large  impact on the fluid milk and nonfat dry milk price transmission  relationships. In the fluid milk market, the farm-to-retail price transmission  process became asymmetric, with the greater price volatility in the post- 1988 period. While the degree of price transmission increased for both  increases and decreases in price, it increased proportionately more for  increases than for decreases.
Six of the studies examined price transmission in conjunction with other  state and federal policies and programs, such as the New York price- gouging law and the Northeast Interstate Dairy Compact. Four studies,  Lass et al. (2001), Lass (2004), Chidmi et al. (2004), and Dhar and Cotterill  (2002), estimated price transmission while the Northeast Interstate Dairy  Compact was in effect. Lass et al. found that processors and/or retailers did  not fully pass through their price increases and, in fact, may have absorbed  part of the cost of the Compact’s over-order premium. In his 2004 study,  Lass explained that the greater variation in farm prices that occurs without  the Compact would actually lead to higher retail prices because of the  larger estimated impacts on retail prices of increasing farm prices than  decreasing farm prices. Dhar and Cotterill disagreed and contended in their  study that the risk reduction benefit from the Compact was completely  overpowered by a shift toward tacit collusion in the post-Compact period.  In the studies of New York markets (Frigon et al., 1999, and Romain et al.,  2002) that looked at the effect of the price-gouging law, researchers found  that after the law took effect, price asymmetry was not present or was  present at much lower levels.
section_title: Effects of Recent Federal Dairy Program Changes and Alternative Policy Options
paragraphs: Recent changes in federal dairy programs vary in their effects on policy  considerations that we identified, such as farm income, milk production,  federal costs, price volatility, economic efficiency, and consumer prices. A  number of options have been proposed or discussed to further modify  existing programs or introduce alternative policies, all of which could  affect these policy considerations in different ways. The likely effects of  these program modifications or alternative policies are influenced by  prevailing conditions, such as high and low dairy prices, and may be  different in the short and long terms.
subsections: section_title: Recent Changes in Federal Dairy Programs Vary in Their Effects on Policy Considerations We Identified
paragraphs: Since 2000, three major changes have taken place in federal dairy  programs. First, in response to legislative requirements, the U.S.  Department of Agriculture (USDA) reformed the federal milk marketing  order (FMMO) system. Second, USDA adjusted the relative purchase prices  of butter and nonfat dry milk under the price support program. Finally,  Congress authorized and USDA established the Milk Income Loss Contract  (MILC) program. These changes had mixed effects on the policy  considerations included in our analysis. Reforms to the FMMO system had  mixed effects on farm income, depending on the geographic location of the  farmer, while the overall effects on all farmers are less clear. Because of  their effect on fluid milk prices, changes in the price support program  tended to reduce the level of support for farm income and reduce federal  costs, but increase economic efficiency. Introduction of the MILC program  typically had the opposite effects, while maintaining production.
subsections: section_title: Federal Milk Marketing Order Reforms
paragraphs: In carrying out requirements in the Federal Agriculture Improvement and  Reform Act of 1996 to reform FMMOs, USDA conducted extensive research  and held public hearings. Agricultural Marketing Service (AMS) officials  indicated that as a result of this process USDA implemented reforms to the  FMMO system in January 2000 that were consistent with the findings of its  research. Its major reforms included  consolidating the number of marketing orders from more than 30 to 11; changing the classified pricing structure by creating a new class for  manufactured milk products, Class IV, with the “higher of” the  advanced Class III or Class IV skim milk values as the basis—or  mover—for Class I prices; reducing the lag between the Class I and  Class III and IV price announcements; and establishing a fixed  differential of $0.70 per hundredweight to be added to the advanced  Class IV skim milk value in determining the price to be paid for milk  used in Class II products;  introducing a new product formula pricing system; and  relaxing restrictions on pooling milk in some marketing orders.
USDA implemented additional reforms to the classified pricing system in  April 2003 that modified aspects of the Class III and IV pricing formulas.
subsections: section_title: Federal Order Consolidation
paragraphs: In response to the legislative requirement, USDA reduced the number of  FMMOs to 11, which were typically combinations of pre-existing orders.  For example, the Central Order is a combination of several smaller  marketing orders in the central part of the United States. According to  USDA’s final regulatory impact analysis for the order reforms, these  consolidation decisions were based on structural factors such as milk  movement, the number of market participants, and natural boundaries.
USDA officials and other dairy experts told us that nationally, the prices  received by farmers for their raw milk did not change much as a result of  FMMO consolidation. One academic study reported that order  consolidation probably increased the economic efficiency of the FMMO  system by more closely aligning areas where raw milk is marketed by dairy  farmers with areas where it is distributed as fluid milk products.  Additionally, the study noted that consolidation helped to reduce the  amount of market distortion created by order regulation.
However, the magnitude of the effects on farm income varied among orders  because, in some cases, the consolidation combined orders that had  substantially different raw milk utilization rates for the manufactured and  fluid products in the various milk classes, particularly Class I (fluid milk).  As a result, some dairy farmers experienced higher or lower utilization of  their raw milk in Class I products than they had in the past. Changes in  utilization rates are significant because farmers receive a blend price for  their milk based on the utilization rates for the different milk classes within  an order; thus, farmers in orders where Class I utilization rates increased  generally saw their incomes increase, while farmers in orders where the  Class I utilization rates decreased generally had their incomes reduced.
The changes in utilization rates associated with FMMO consolidation were  particularly evident in the Western Order. When USDA created the Western  Order, it combined the Great Basin and the Southwestern Idaho–Eastern  Oregon Orders. These orders had substantially different Class I utilization  rates. In 1999, the Great Basin Order had a Class I utilization rate of 51  percent, while the Southwestern Idaho–Eastern Oregon Order had a Class I  utilization rate of 8 percent. When these orders were combined into the  Western Order, the resulting Class I utilization rate was estimated to be  about 23 percent, lowering income for the farmers in the Great Basin Order  who had previously received much higher blend prices. To address this and  other concerns, Dairy Farmers of America, a cooperative representing a  number of farmers in the Western Order, requested that USDA hold a  hearing to reform the order’s provisions. USDA made some changes based  on the concerns presented at the hearing; however, the revised order  provisions did not receive the two-thirds approval necessary to be adopted,  and USDA terminated the order as of April 1, 2004, stating that the  continuation of the existing Western Order would not be in conformance  with declared policy.
Elimination of the Western Order has raised concerns that increased  amounts of Idaho milk, which had been pooled on the Western Order,  would be pooled on the Upper Midwest Order. Based on past experience,  this would reduce the Class I utilization rate and lower the blend price for  Upper Midwest farmers. However, dairy experts had mixed views on  whether additional orders would be terminated. In particular, one industry  expert noted that it remains unclear whether farmers in the former Western  Order will be able to receive higher prices for their milk without their  order. Some of these farmers, particularly those that had been in the Great  Basin Order, could benefit by not having to pool their Class I milk. On the  other hand, one source stated that these farmers could face increased  shipping requirements to pool their milk on a remaining order. Additionally,  some experts stated that without FMMOs farmers and cooperatives do not  have the market power to obtain high prices for their raw milk in  negotiations with processors.
section_title: Classified Pricing Structure Changes
paragraphs: FMMO reform changed the structure of the classified pricing system by  creating a new Class IV, representing the minimum price that processors  pay for raw milk used in butter, nonfat dry milk, and other dry milk  powders. Additionally, the new mover of Class I prices became the  “higher of” the advanced Class III or Class IV skim milk values. Use of the  “higher of” mover was intended to enable fluid milk processors to attract  milk from butter, nonfat dry milk, and cheese processors by helping to  ensure that the blend price would exceed both the Class III and IV prices.  USDA also reduced the lag period—the time between when the Class I  price is announced and the Class III and IV prices are announced—from  approximately 8 weeks, to 6 weeks. Class I prices are announced in the  month preceding the month to which they apply, based on the “higher of”  the advanced Class III and IV skim milk values. However, the Class III and  IV prices that determine the price of raw milk used to manufacture these  products are not announced until the Friday on or before the 5th of the  month following the month to which they apply. Consequently, there is a 6- week lag between these two price announcements. Further, USDA  established that the minimum prices paid for skim milk used in Class II  products would be the advanced Class IV skim milk and butterfat values,  plus a fixed differential of $0.70 per hundredweight. In its March 1999  regulatory impact analysis, USDA concluded that these changes would help  to eliminate situations in which prices of milk used in manufactured  products rise above the price of milk used in fluid milk products and thus  make the Class I mover more representative of current market conditions.
Academic researchers and an industry official indicated that the creation of  Class IV continued disincentives that were present prior to the 2000  reforms to shift milk to its highest-valued use. Previously, separate  minimum prices were established for raw milk used in manufactured  products that are now included in the new Class IV. Raw milk used in the  production of butter was priced under Class III, which also included cheese  and other products. However, nonfat dry milk was priced in a separate  Class III-A. According to AMS officials, the development of Class III-A was  necessary because manufacturers were unable to sell nonfat dry milk at  market prices that would allow them to pay the Class III minimum price for  their raw milk. They noted that for a classified pricing system to work, the  minimum class prices must be below the market clearing prices for  products produced with that raw milk (taking into account the cost of  other inputs to these products). However, one study found that the creation  of Class IV institutionalized separate pricing for nonfat dry milk. By  separating out the price for nonfat dry milk (the lowest-valued use), the  classified pricing system might maintain production of nonfat dry milk  even when market signals indicate that raw milk should be used to  manufacture cheese as the higher-valued use.
Additionally, a 2004 study sponsored by the American Farm Bureau  Foundation for Agriculture (American Farm Bureau) reported that creating  a separate Class IV and then basing Class I prices on the “higher of” the  advanced Class III or IV skim milk values, has reduced the influence that  cheese prices traditionally had over other prices in the FMMO system, and  thus partially isolated Class I prices from market forces. For example, in  every month from January 2000 through July 2001, advanced Class IV skim  milk values were higher than advanced Class III skim milk values.  However, as of 2000, utilization of milk for Class IV products across all  federal orders averaged 7 to 8 percent, while Class III products accounted  for about 45 percent of milk utilization. According to the American Farm  Bureau study, without the advanced Class III skim milk value as the mover  for Class I prices, when the Class IV price exceeds the Class III price,  similar price signals are no longer received by farmers in relatively high  Class I utilization markets and in high Class III utilization markets. This  difference occurs because during these times farmers in high Class I  utilization markets are receiving their price signals based on the high Class  IV prices, which are heavily influenced by the price support program during  periods of excess production and low manufacturing product prices.  Therefore, farmers in high Class I utilization areas receive higher farm  prices than would otherwise be the case, and higher prices encourage  increased production by these farmers. However, the higher production  levels of these farmers puts downward pressure on the Class III prices and  causes regional inequities in farm income.
Furthermore, because Class I prices are now more closely related to the  level at which the price support program sustains nonfat dry milk prices,  proposed changes to the price support program have become much more  controversial. Prior to the 2000 FMMO reforms, Class I prices were based  on the Class III price, which, as noted previously, did not include nonfat dry  milk. However, with the 2000 reforms, the level of support provided by the  price support program for nonfat dry milk prices directly influences the  Class IV price. During periods when the Class IV price is higher than the  Class III price, changing the price support program in such a way that Class  IV prices are reduced will cause the Class I price to similarly fall, thus  having a greater impact on the overall blend prices received by farmers.
section_title: Introduction of a New Product Formula Pricing System
paragraphs: As part of FMMO reform, USDA introduced a new product formula pricing  system that established minimum prices for raw milk based on milk  component values for butterfat, protein, nonfat solids, and other solids.  These values are derived from the wholesale prices of cheddar cheese,  butter, nonfat dry milk, and dry whey as announced in weekly surveys  conducted by the National Agricultural Statistics Service. The minimum  prices also factor in allowances based on estimates of manufacturing costs  for these products and product yield factors representing the amount of a  particular product that can be manufactured from specified quantities of  the underlying components. Seven of the 11 orders (primarily the Northern  orders) adopted the new product formula pricing system, while the other  four orders (primarily the Southern orders) use a pricing system that bases  milk prices on skim milk and butterfat.
During much of the time that classified pricing has been part of the federal  order system, the formulas used to set minimum prices paid to farmers  were based on competitive pay prices. The pay price was known as the  Minnesota–Wisconsin price, and it represented the results of state surveys  of competitive market prices for Grade B milk paid by manufacturing  plants in Minnesota and Wisconsin. However, with a reduction in Grade B  milk production, this milk was very thinly traded and the pricing series  became less representative of the value of Grade A milk used for  manufacturing.
According to a number of dairy experts, the change from a competitive pay  to a product formula pricing system that incorporates fixed manufacturing  allowances has enhanced the effects of price volatility on dairy farmers.  As noted in appendix V, there are a variety of input costs to the  manufacturing process, including labor, energy, and capital. With product  formula pricing, manufacturing allowances, which are supposed to  compensate for these other input costs, and product yield factors are fixed.  To the extent that changes in these other input prices are reflected in the  prices at which manufacturers sell their products, fixed manufacturing  allowances will allow changes in other input costs to more readily affect  the minimum raw milk prices paid to farmers.
Dairy experts also indicated that the fixed manufacturing allowances in the  product pricing formulas reduced economic efficiency by reflecting raw  milk supply and demand conditions less clearly. Moreover, one large  processor stated that the manufacturing allowances in the pricing formulas  are too low and do not adequately represent the costs of manufacturing.  Regardless of the market price of cheese, butter, or nonfat dry milk, the  fixed manufacturing allowances provide manufacturing plants with the  same net returns from 100 pounds of raw milk. Therefore, when market  conditions reflect higher prices for one of these products, relative to the  others, manufacturers have less of an incentive to shift production to the  higher-valued use because any gains they might have realized from selling a  higher-priced product would be negated by the fact that their  manufacturing allowance is fixed. The 2004 American Farm Bureau study  noted that prior to the introduction of the new product formula pricing  system, manufacturers that produced butter, cheese, and nonfat dry milk  competed more aggressively for raw milk. The study found that if the  prices of nonfat dry milk and butter, for example, were depressed relative  to cheese prices, cheese manufacturers would attract milk away from the  manufacturers of these other products. Therefore, raw milk would more  readily move to its highest-valued use.
Further, some dairy experts noted that the additional volatility introduced  by the fixed manufacturing allowances in the new product formula pricing  system, when combined with the disincentives these allowances and  separate manufacturing classes create against shifting milk to its highest- valued use, might have contributed to negative producer price  differentials and de-pooling. Negative producer price differentials can  occur because with the 6-week lag between the Class I and Class III and IV  price announcements, rapid increases in the manufactured product prices  from which Class III and IV prices are derived can raise these prices above  the Class I price. USDA officials noted that the change to a “higher of”  mover for Class I prices and the reduction of the lag period were designed  to reduce the frequency of negative producer price differentials. However,  to the extent that the fixed manufacturing allowances have introduced  additional volatility into the pricing system, and the disincentives created  by these fixed manufacturing allowances and separate manufacturing  classes have prevented raw milk supplies from moving to their highest- valued use, negative producer price differentials and de-pooling have  continued.
During times when the producer price differential is negative, some  processors of manufactured products who normally receive a draw from  their federal order pool to pay farmers instead have to pay into the pool. In  such circumstances, many of these processors choose to de-pool because  by doing so, they gain a competitive advantage over those that remain and  have to pay into the pool. One study on FMMO pooling issues reported  that since June 2003, negative producer price differentials and de-pooling  have become more common. The study noted that the producer price  differential in the Upper Midwest Order was negative from July through  November 2003 and reached a record low level in April 2004 of $4.11 per  hundredweight. For example, cheese prices in the Upper Midwest Order  began to rise sharply in mid-July 2003; thus the advanced Class III skim  milk value that served as the Class I mover for August did not include these  higher prices. However, the Class III price that was announced in August  did include these higher prices, creating a negative producer price  differential. As a result, a number of cheese processors de-pooled in  August, reducing the order’s Class III utilization, which is usually around 75  to 77 percent, to just 8.4 percent. Nationally, negative producer price  differentials were reported for this month in the 7 FMMOs that used the  new product formula pricing system. For the 11 FMMOs existing at the  time, de-pooling resulted in 33 percent less milk being pooled compared to  the same month in the prior year.
De-pooling reduces the overall value of the federal order pool and  increases differences in the abilities of processors to pay for raw milk. As a  result, dairy farmers do not receive uniform prices. Farmers marketing  milk with processors who are able to de-pool may receive higher prices and  thus an increase in farm income, while farmers marketing milk with  processors who do not de-pool may receive lower prices. According to the  June 2004 University of Wisconsin study, this situation represents an  inequity and is contrary to one of the stated purposes of the FMMO system:  orderly marketing conditions.
section_title: Relaxed Pooling Provisions
paragraphs: In some cases, the 2000 FMMO reforms resulted in more relaxed pooling  provisions. AMS officials noted that when USDA consolidated the  marketing orders, the pre-existing orders each had its own pooling  provisions, such as minimum amounts of raw milk required to be shipped  to processing plants participating in that order’s pool to qualify for its blend  price or restrictions on rejoining the pool after de-pooling. AMS officials  indicated that where two orders were combined that had different pooling  provisions, USDA applied the more liberal pooling standard to the  combined order to prevent farmers from being shut out of the consolidated  order pool.
According to AMS reports from 2000 and 2001, relaxed pooling provisions  contributed to the pooling of more distant raw milk to receive other orders’  attractive blend prices. Pooling was easier because most of the milk that  was pooled from outside individual federal orders was not required to  actually be shipped to those orders. Therefore, distant farmers were able to  share in an order’s blend price without incurring substantial transportation  costs for shipping milk. For example, under the Upper Midwest Order’s  pooling provisions, an Idaho dairy cooperative could choose to ship raw  milk from some of its Idaho farmers to a processing plant that participates  in the Upper Midwest Order. All subsequent milk deliveries of those  designated farmers would be priced under the Upper Midwest Order, even  if only one day’s production was actually shipped to the participating  processing plant. Other deliveries from these farmers would stay in Idaho  for processing. In 2001, USDA reported that raw milk from California was  pooled on the Central, Upper Midwest, and Western Orders. However, most  of this 4 billion pounds of milk was actually processed in California plants  that are not regulated by the federal order system. Also during 2001, large  volumes of raw milk from Minnesota and Wisconsin were pooled on the  Central, Mideast, and Northeast Orders, while increasing amounts of raw  milk from Idaho were pooled on the Upper Midwest Order.
According to some dairy experts, the increased pooling of milk across  orders has had mixed effects on farm income. Those farmers who were  able to have their milk pooled on distant orders that had higher blend  prices received an increase in their farm income after accounting for the  costs of transporting their milk. However, farmers in the receiving orders  had their farm income reduced as milk from outside the orders reduced the  value of the pool that could be shared among farmers in the receiving  orders. The combination of more milk pooled on these orders and constant  sales of higher-valued Class I and II products decreased the weighted  average value of the orders’ pools by decreasing the utilization rates of the  higher-valued classes.
In response to this loss in value, participants in some orders petitioned  USDA to hold hearings to address relaxed pooling provisions. For example,  through the hearing process, the Central and Mideast Orders tightened  their pooling provisions to control the large quantities of milk from  Minnesota and Wisconsin that were being pooled on these two orders. With  these tightened provisions, those seeking to pool milk on the Central or  Mideast Orders have to ship more milk per year or meet other requirements  to become eligible to share in the receiving orders’ blend prices. A number  of dairy experts indicated that these changes have significantly reduced the  incentive for distant pooling on these orders.
section_title: 2003 Classified Pricing Reforms
paragraphs: USDA made additional reforms to the classified pricing system that went  into effect in April 2003, modifying aspects of the Class III and IV pricing  formulas. The principal changes in 2003 were increasing the manufacturing  allowance in the formula that established a price for the other solids  component of milk used in Class III products; eliminating the lower bound  of zero on the Class III other solids component price; reducing the  product yield for the nonfat solids components of milk used in Class IV  products; and altering the Class III protein formula to prevent Class III  prices from being lowered by rising butter prices. The 2003 changes were  partly the result of a court-ordered injunction against the implementation  of other changes that USDA had proposed based on the 2000 requirement  that USDA reconsider the Class III and IV pricing formulas.
An analysis by researchers at the University of Wisconsin before  implementation of the changes indicated that the differences from many of  these changes would not be dramatic. However, the researchers  estimated that the changes would increase Class III prices by as much as  $0.57 per hundredweight. More specifically, the study found that the 2003  changes would eliminate the negative effect that rising butter prices were  having on the Class III price. Under the prior protein price formula, a $0.10  per pound increase in the butter price would lower the Class III price by  $0.04 per hundredweight. The researchers found that the revised formula  instead yields about a $0.04 per hundredweight increase in the Class III  price for a $0.10 per pound increase in the butter price. The study also  reported that the new protein price formula would make it somewhat less  likely that the advanced Class IV skim milk value rather than the advanced  Class III skim milk value would consistently serve as the mover for Class I  prices. Increased Class III prices would most likely benefit farmers in  areas where cheese is an important commodity and where processors do  not typically pay premiums in excess of federal order minimum prices.
section_title: Dairy Price Support Program Adjustments
paragraphs: Since 2000, USDA twice adjusted—or tilted—the purchase prices of butter  and nonfat dry milk as part of its efforts to administer the dairy price  support program. The first tilt occurred in May 2001, when USDA reduced  the nonfat dry milk purchase price by approximately $0.10 per pound (to  $0.90 per pound) and increased the butter purchase price by about $0.20  per pound (to approximately $0.85 per pound). USDA adjusted the tilt again  in November 2002 by reducing the nonfat dry milk purchase price another  $0.10 per pound (to $0.80 per pound) and increasing the butter purchase  price approximately $0.20 per pound (to $1.05 per pound). USDA took  these actions because the Commodity Credit Corporation (CCC) was  accumulating large stocks of nonfat dry milk, leading to high purchase and  storage costs for USDA, as well as significant market distortions.
As a result of the 2000 FMMO reforms, the federal order class prices and  the level of support provided by the price support program for nonfat dry  milk were tied more closely. Many dairy experts noted that, subsequently,  tilts became more politically controversial because they can have a greater  negative effect on the FMMO class prices. Lowering the purchase price of  nonfat dry milk while raising the purchase price of butter decreases the  overall Class IV price when market prices for nonfat dry milk are at the  level of the purchase price and market prices for butter are above the level  of the purchase price. When the advanced Class IV skim milk value is  serving as the mover for the Class I price, this reduction in Class IV prices  also reduces Class I prices. Further, because the advanced Class IV skim  milk value serves as the basis for Class II prices, Class II prices are  similarly reduced. This scenario occurred during both the May 2001 and  November 2002 tilts. A representative of one dairy cooperative stated that  these impacts were particularly pronounced in areas with high Class I  utilization rates, such as the Northeast and Southeast.
According to a report published by the International Trade Commission in  May 2004, estimates of the actual impacts of these tilts on farm prices  varied. The study presented a USDA estimate that the November 2002 tilt  reduced fiscal year 2003 average milk prices from $12.10 to $11.90 per  hundredweight. While USDA reported that this decrease lowered the  amount of raw milk produced and thus was partially offset by an increase  in butter prices from reduced production, it still led to a loss in net farm  income of $192 million. Alternatively, the study reported that the National  Milk Producers Federation estimated that the two tilts ultimately lowered  farm prices by $0.19 per hundredweight in 2001, $0.48 per hundredweight  in 2002, and $0.76 per hundredweight in 2003. With these price reductions,  the organization projected that farm income would fall by $156 million in  2001, $816 million in 2002, and about $1.3 billion in 2003. Another study  cited by the International Trade Commission’s report estimated that the  2002 tilt could have decreased average milk prices by $0.16 per  hundredweight, reducing production by 814 million pounds and farm  income by $371 million. However, that study also found that these impacts  varied substantially, depending upon the assumption of high or low prices  and the effects of other government programs.
While the tilts reduced farm income and raw milk production, a number of  dairy experts indicated that USDA’s tilts have increased economic  efficiency and reduced federal costs associated with the dairy price  support program. Additionally, some experts noted that by maintaining  nonfat dry milk prices at artificially high levels, the price support program  was inducing surplus production of nonfat dry milk. In some cases, nonfat  dry milk was produced specifically for sale to the government at the CCC  purchase price. From the beginning of October 2000 through the end of  May 2001, the CCC purchased approximately 330 million pounds of nonfat  dry milk (more than 40 percent of national production), and government  purchase costs exceeded $340 million. Furthermore, in 2002, the CCC  stocks of nonfat dry milk were equivalent to two-thirds of domestic  production and exceeded annual domestic consumption by more than 30  percent. By reducing the purchase price of nonfat dry milk, USDA reduced  the incentive to produce surplus nonfat dry milk. The International Trade  Commission study reported that while production of nonfat dry milk  continued to rise between 2001 and 2002, after the second tilt production  declined by about 5 percent between 2002 and 2003. The tilts also helped to  reduce federal costs associated with purchasing and storing nonfat dry  milk.
Some sources also indicated that the tilts affected the balance of trade in  dairy products between the United States and its trade partners. The  International Trade Commission study reported that during the majority of  the period from January 1998 to November 2002, U.S. prices for nonfat dry  milk exceeded international market prices by more than $500 per metric  ton. Consequently, domestic manufacturers had an incentive to import  alternative dairy protein products such as milk protein concentrates. By  lowering the purchase price of nonfat dry milk through the tilts, USDA  decreased this incentive because domestic manufacturers could obtain  nonfat dry milk more cheaply.
section_title: Introduction of the Milk Income Loss Contract (MILC) Program
paragraphs: With the introduction of the MILC program in 2002, dairy farmers began  receiving payments on milk production up to 2.4 million pounds annually  when the Class I price in Boston dropped below $16.94 per hundredweight.  MILC payments are equal to 45 percent of the difference between $16.94  and the lower Boston Class I price. From the program’s inception, MILC  payments were made every month from the retroactive start date of  December 2001 through August 2003 because there was an extended period  of depressed farm prices, which reached a 25-year low in early 2003. Prices  temporarily recovered from September through December 2003, so no  MILC payments were made in those months; however, payments resumed  during January and continued through April 2004. During the spring of  2004, farm milk prices reached record highs and remained strong through  the fall of 2004, so no MILC payments were required for the remainder of  fiscal year 2004.
As a result of depressed farm milk prices during 2002 and 2003, federal  costs associated with MILC payments exceeded original estimates. Based  on market conditions in March 2002, the Congressional Budget Office  estimated total federal costs of the MILC program at $963 million over the  life of the program (i.e., about 4 years). However, 1 year later, the  Congressional Budget Office revised its total cost estimate for the MILC  program to $4.2 billion. USDA distributed approximately $1.8 billion in  MILC payments to dairy farmers in fiscal year 2003. Thus, the cost of  MILC through fiscal year 2003 alone exceeded the previously estimated  total costs for the entire 4-year period through 2005 by about $800 million.  The Congressional Budget Office’s March 2004 estimate for total MILC  program costs was $3.8 billion, somewhat lower than the 2003 estimate  because of higher farm milk prices in 2004.
Many dairy experts indicated that by providing income support during low- price periods, the MILC program has helped keep some farmers,  particularly smaller farmers, in business. For example, some academic  experts noted that some farmers received MILC checks of about $20,000 to  $25,000, and others said that despite low prices, fewer farmers exited the  market in 2003 than in previous years. USDA officials indicated that these  payments delayed the supply response to low prices and maintained  depressed milk prices over a longer period of time. By providing direct  payments when prices were low, MILC obscured market signals that would  normally cause farmers to decrease production, and continued high levels  of production retained downward pressure on milk prices. To the extent  that these lower farm prices were passed on through the retail level,  consumers may have experienced lower prices for dairy products.
Despite this effect, dairy experts stated that smaller farmers receive a net  benefit from MILC because those with about 100 to 130 cows can have all  of their production covered under the 2.4 million-pound annual cap. In  contrast, larger farmers do not receive net benefits from MILC because the  negative farm income effects of reduced milk prices are greater than the  payments they receive under the production cap. A couple of dairy experts  noted that the break-even size, at which MILC payment benefits just offset  the negative farm income effects of prolonged low prices, is about 400  cows. Because the effects of MILC vary by producer size, they also vary  regionally. States with many small dairy farmers, such as Pennsylvania,  Wisconsin, and Vermont, have received greater proportional benefits from  MILC. However, the MILC program has disadvantaged states with larger  producers, such as western states.
section_title: Effects of Alternative Dairy Policies Differ under Various Scenarios
paragraphs: A number of options have been proposed or discussed to further modify  existing programs and policies or introduce alternative ones, all of which  could affect the policy considerations we identified in different ways.  These options span a range of existing and potential federal dairy programs  and policies, including FMMOs, price supports, MILC, target price  deficiency payments, the proposed National Dairy Equity Act, trade  restrictions and export incentives, risk management, and supply  management. Current international trade agreements and ongoing  negotiations can have implications for certain of these policy options, such  as price supports, export incentives, and trade restrictions. The purpose  of this analysis is not to take a position for or against any of these options  or to analyze them in terms of their overall economic impacts, but simply to  discuss their likely effects on the policy considerations we identified. The  likely effects of these alternatives sometimes differ under various  scenarios, such as high or low prices, and may be different in the short and  long terms.
In general, options that increase farm income over the short term also tend  to increase milk production and thus the potential for oversupply and  lower average farm prices over the long term. These options also tend to  be costly for the federal government during periods of low prices. In some  cases options that increase the economic efficiency of federal dairy  programs also increase price volatility because they allow clearer  transmission of market price signals. Further, to the extent that price  changes at the wholesale level are passed through to the retail level, a  number of options would likely have mixed effects on consumer prices  depending upon the particular product under consideration (e.g., butter,  cheese, or fluid milk). The potential impacts of the options also vary  according to the size of the producer and region of the country. In general,  options that affect farm income without respect to farm size or cost of  production could further shift production towards larger, western farms.  Production shifts toward larger farms could increase the potential for  oversupply in the market, because such farms have a greater capacity to  increase production in response to policy incentives. In some cases,  options that reduce support for farm income could have disproportionately  negative impacts on smaller farmers, who often have higher costs of  production.
subsections: section_title: Change the Federal Milk Marketing Order Program
paragraphs: Dairy experts have cited a number of concerns with FMMOs, including that  with the increasing ability to transport milk products longer distances, the  differences in Class I differentials provide incentives for overproduction in  some regions; that recent revisions to the classified pricing system  enhanced the effects of price volatility on dairy farmers; that changes in  pooling restrictions increased the flow of milk between different regions of  the country, which disrupts the market; that consolidation of the FMMOs  combined some areas of the country that were not part of the same natural  “milksheds;” and that it takes too long to change the federal order system  through the USDA hearing process. A number of options have been  proposed or discussed to modify the FMMO program, including revising  the classified pricing system, making administrative changes such as  tightening pooling provisions, or eliminating FMMOs altogether. Figure 36  shows the effects of various options to change the FMMO program over the  short and long terms. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?
subsections: section_title: Revise Classified Pricing
paragraphs: Academic, industry, and government sources cited a variety of concerns  with recent reforms in the classified pricing system, including that these  changes enhance the effects of price volatility on farmers; lessen the  transmission of market price signals; reduce incentives for market  participants to shift milk to its highest-valued use; discourage innovation;  and contribute to de-pooling during periods of price volatility. A number of  options exist to revise the classified pricing system, including basing the  class pricing formulas on competitive pay prices instead of product prices,  combining Class III and IV into a single manufacturing class of milk, and  changing the Class I mover from being the “higher of” the advanced Class  III or IV skim milk values to a weighted average of these prices.
Use Competitive Pay Prices Instead of Product Formula Pricing One option to reform the classified pricing system would be to return to a  system of competitive pay prices as the basis for the minimum prices that  manufacturers pay for raw milk. As indicated by AMS officials, the change  to a product formula pricing system has enhanced the effects of price  volatility on the prices that farmers receive for their raw milk. The AMS  officials, as well as academic and industry sources, noted that competitive  pay prices for raw milk would be a better basis for the minimum class  prices. However, the officials noted that the lack of good data is a major  challenge to developing a competitive pay system that is more broadly  based than the old Minnesota-Wisconsin price series.
In an earlier report, we compared the concept of a competitive pay system  to a product formula pricing system, among other options. We found that  while a product formula pricing system would be superior to other  mechanisms in reflecting national prices of manufactured dairy products,  the accuracy of price levels under the system would depend on a number of  factors, including whether the manufacturing allowances—deductions  made for the costs of manufacturing different dairy products—are  accurate. Setting accurate manufacturing allowances is difficult because  individual plants could have different cost structures. As noted earlier, we  heard from several academic, industry, and government sources that the  fixed manufacturing allowances in the current product pricing formulas  have negative impacts on the economic efficiency of the classified pricing  system by reflecting supply and demand conditions less clearly.
On the other hand, we found that while a competitive pay system for Grade  A milk was similar to a product formula pricing system in that it would  generally reflect national prices of manufactured dairy products, it would  more readily reflect national supply and demand conditions for raw milk  used for manufacturing. Also, it would more accurately reflect competitive  pressures from the fluid milk market because Grade A milk is used to meet  shortages in areas of the country with high Class I utilization. Furthermore,  we reported that a competitive pay system would be better than a product  formula pricing system at self-adjusting automatically because the  competitive system would be based on actual reported prices. Therefore, a  competitive pay system could improve the economic efficiency of the  classified pricing system by providing clearer market price signals.
AMS officials stated that if it were possible to obtain adequate data,  returning to a competitive pay system would introduce greater stability into  farm milk prices because basing the price formulas on competitive pay  prices allows manufacturers’ margins to be set outside the federal order  system. According to the officials, when manufacturing costs increase,  manufacturers tend to decrease their margins; they then increase their  margins when costs go back down. The AMS officials also stated that to the  extent the effects of price volatility are reduced by eliminating fixed  manufacturing allowances, raw milk production would increase, holding  average milk prices constant.
Combine Class III and IV A second option discussed by some of the academic and industry sources  we contacted would be to combine Class III and IV into a single  manufacturing class. While an objective of USDA’s FMMO reforms,  including developing separate manufacturing classes on which to base fluid  milk prices, was to avoid situations in which the price of milk used in  manufactured products rises above the price of milk used in fluid products;  as we noted earlier, this change has muted market price signals and has  reduced incentives to move milk to its highest-valued use. However, an  academic source indicated that a potential challenge in combining Class III  and IV is identifying an appropriate formula that considers the products in  an expanded class. In addition, AMS officials cited this issue noting that  one barrier would be finding a way to price the lowest-valued use, nonfat  dry milk, so that manufacturers of this product would be able to afford to  pay the minimum class price to farmers.
A number of industry and academic sources said that combining Class III  and IV into a single manufacturing class would allow milk to move to its  highest-valued use. With a separate Class IV, processors of butter and  nonfat dry milk can pay less for their raw milk supplies under certain  market conditions, which can stimulate additional allocation of raw milk  into Class IV products. Under such conditions, by reducing these market  distortions, combining Class III and IV might help to increase the economic  efficiency of the classified pricing system. It could also help to limit the  decline in market prices caused by overproduction of nonfat dry milk and  thus reduce the federal costs of CCC purchases of this commodity. Over the  long term, limiting overproduction incentives will help all farmers by  maintaining higher average farm prices. However, these benefits could be  limited by constraints on the extent to which raw milk is free to move  between different uses. Some USDA officials have indicated that  manufacturing capacity for different products varies by region and that  manufacturing plants are often specialized. In addition, fixed supply  agreements within the dairy industry may not allow manufacturers  significant freedom to shift raw milk between uses in response to price  signals in the short term.
Combining Class III and IV could have mixed impacts by region on farm  income because with a combined manufactured product price, high prices  for one particular use of milk would offset low prices for other uses in  creating a weighted average price. Utilization rates for the different  manufacturing uses vary among orders, and farmers whose average blend  prices might be higher based on utilization of their raw milk for a higher- valued use under a separate class price scenario could experience lower  average returns under a combined class price scenario if the price of their  higher-valued use were weighted down by the inclusion of the lower-valued  use. Conversely, farmers whose average blend prices might be lower based  on utilization of their raw milk for a lower-valued use under a separate  class price scenario could experience higher average returns under a  combined class price scenario. For example, in regions with higher Class IV  utilization, the loss of a separate Class IV could result in lower average  farm income during periods when Class IV prices would otherwise be  higher than Class III prices. In regions with higher Class III utilization,  however, the loss of a separate Class IV could result in higher average farm  income during periods when Class III prices would otherwise be lower than  Class IV prices.
If Class III and IV prices are kept separate, a third option to modify  classified pricing would be to use a weighted average of Class III and IV  prices as the mover for Class I prices. This option would tie fluid milk  prices more closely to market related manufacturing prices, particularly  when prices of Class III products are depressed relative to Class IV  products. One academic study that modeled the price volatility impacts of  using a weighted average of Class III and IV prices to set Class I prices  reported that using the weighted average, rather than the “higher of” the  advanced Class III or IV skim milk values, slightly decreases the volatility  of farm prices, largely through a more substantial decrease in the volatility  of the Class I price. As a result of this reduced volatility, the study  estimated that the average Class I price would decline by roughly $0.40 per  hundredweight, causing an average farm price decline of $0.09 per  hundredweight. The study found that there would be essentially no change  in the volatility of other class prices or product prices.
These effects are likely to vary by region. As the Class I price is expected to  decrease more than the average farm price, the effects of this option could  be more significant in regions with high Class I utilization of raw milk. The  reduction in farm prices could cause a marginal downward supply  adjustment over the long term, the effects of which would also be stronger  in high Class I utilization areas. The effects of reduced prices on farm  income could be partially offset by increased MILC payments as long that  program remains in existence. Increased MILC payments would raise  federal costs, particularly during periods of low prices. However, this  option could also help USDA minimize the costs of the price support  program by making it less controversial to adjust the tilt between butter  and nonfat dry milk purchase prices because these prices would no longer  exert as great an influence on the Class I price.
AMS officials cautioned, however, that this option could increase the  likelihood that manufactured product prices would rise above blend prices,  leading to more frequent negative producer price differentials and de- pooling. The officials noted that the purpose of implementing the “higher  of” the advanced Class III or IV skim milk values provision was to reduce  the frequency of negative producer price differentials. They said that  implementing an option that reduces blend prices makes it more likely that  the value of one of the manufacturing class prices will rise above the blend  price. The officials also indicated that consumers may benefit from lower  prices to the extent that the Class I and blend price decreases are  transmitted through the milk marketing chain. One AMS official questioned  the extent to which this option would reduce the volatility of Class I prices,  noting that since January 2000 the volatility of Class I prices would have  been about the same under a weighted average mover.
section_title: Change the Administration of FMMOs
paragraphs: Another set of options to modify FMMOs involves changing their  administration. Pooling provisions could be tightened by increasing the  amount of milk that must be shipped to an order to qualify for that order’s  blend price or by placing restrictions on de-pooling. Alternatively, federal  order reform could be reconsidered by splitting up some of the  consolidated orders. Finally, USDA may be able to shorten the time  between a hearing request and implementation of a final decision.
Tighten Pooling Provisions with Increased Minimum Shipment  Requirements Federal order reforms relaxed the pooling provisions of many orders,  which negatively affected some farmers by diluting their Class I utilization  rates and lowering their blend prices as increased amounts of distant milk  were pooled on their orders. In response, participants in some orders  called for hearings to tighten their pooling provisions, often by increasing  the minimum amount of milk that must be delivered to processing plants  participating in their pool to qualify for the blend price. With the end of the  Western Order, the concern that some milk formerly pooled on that order  could be pooled on the Upper Midwest Order led two groups of dairy  cooperatives operating there to request a hearing to tighten the order’s  pooling provisions.
According to some AMS officials, restricting the pooling of raw milk  through increased shipping requirements would not have a significant  national impact. However, they said there could be mixed regional effects  on farm income and production. Farmers in areas seeking to pool milk to  other orders would generally see a negative impact on their farm incomes  because they would incur greater transportation costs trying to share in the  value of another order’s pool and would, therefore, pool less milk in other  orders. However, farmers in the receiving order could see an increase in  their farm income because with less milk pooled from outside the order,  their pool would retain more of its value and they would receive higher  blend prices. In each case, there could be localized production effects  depending upon whether farmers experience an increase or a decrease in  their farm income. The AMS officials stated that tightening pooling  provisions would have minimal effects on price volatility because the  tighter provisions would not change overall supply and demand conditions.  However, the officials also indicated that the economic efficiency of the  FMMO system would increase to the extent that reducing the amount of  milk pooled on distant orders would reduce the amount of money spent on  transporting milk. Because impacts on national production levels are likely  to be limited, impacts on federal costs would be minimal.
Tighten Pooling Provisions with Restrictions on De-Pooling A second option for tightening federal order pooling provisions is to place  additional restrictions on those who choose to de-pool. As noted earlier,  price volatility leading to negative producer price differentials and de- pooling can negatively affect those who remain in a federal order pool  because the overall value of the pool is reduced. Some orders restrict de- pooling by preventing milk handlers who choose to de-pool from re-pooling  for a specific period of time. One such restriction recently proposed by  cooperatives in the Upper Midwest Order would limit a processor’s pooled  milk in any month to a specified percentage of that processor’s pooled milk  in the previous month. Under that restriction, if a processor partially de- pooled in one month, it could only partially re-pool in the subsequent  month. If it fully de-pooled, it would have to wait a month before it could  re-pool.
Restricting de-pooling would have mixed effects on farm income. Because  de-pooling allows some processors to pay farmers higher prices, some  farmers would be harmed if de-pooling were restricted. Conversely, those  farmers who are harmed by de-pooling could benefit if more of the pool  value were retained during periods of volatile prices. While nonuniform  farm prices do not help to achieve orderly marketing, restricting de-pooling  could make this problem worse if it encourages some processors to leave  the order system permanently. In that case, the reserve supply of milk for  fluid production would shrink, and orders would have to increase  minimum shipping requirements for remaining pooled processors and dairy  cooperatives. If restricted de-pooling actually caused fewer processors to  be associated with the federal order system, volatility in fluid milk prices  could increase because with less milk available in reserve to supply the  Class I market, seasonal or episodic fluctuations in milk supply and  demand could have greater price impacts. However, an AMS official  indicated that in general processors benefit over the long term from being  pooled, and so restrictions on de-pooling would not necessarily decrease  the supply of milk available for fluid milk products. If the supply of milk  available for fluid milk products did not decrease, then the volatility of fluid  milk prices would not increase. The effects of restricted de-pooling on  other policy considerations, such as federal costs or consumer prices, are  unclear.
Split Up Consolidated Federal Orders A third option to revise the administration of FMMOs is to split up some of  the consolidated orders where the combination of orders with different  utilization rates of the different classes of milk has created problems. Many  industry, academic, and government sources stated that federal order  consolidation has had some significant regional effects, including the  demise of the Western Order. One source stated that because of order  consolidation, some orders have become so large that they include milk  that would not normally be in the milkshed for particular marketing areas.  This increases the potential that some farmers’ blend prices will decrease  with lower utilization rates of raw milk in Class I products. To address this  problem, USDA is currently considering a proposal to split up the  Southeast Order and create a “Mississippi Valley” Order.
Splitting up certain orders could have mixed effects on farm income. In  cases in which experts have cited problems with federal order  consolidation, the problems developed because two previously existing  orders that had largely different Class I utilization rates were combined.  With the additional milk pooled under the consolidated order, farmers that  had been in the order with the higher Class I utilization rate saw a decrease  in their blend price. However, farmers that had been in the order with the  lower Class I utilization rate experienced an increase in their blend price.  Therefore, splitting up the consolidated orders in these instances would  affect farmers differently depending on the Class I utilization rates of the  new orders. AMS officials indicated that splitting up orders would affect  the distribution of farm income but would not affect overall production and  therefore would have minimal impacts on federal costs. They also noted  that splitting up orders could increase the movement of milk because  having smaller orders makes farm prices more closely reflect local supply  and demand conditions. Therefore, to the extent that smaller orders would  increase the blend prices in some areas, this option could create incentives  to transport more milk to those areas.
Accelerate USDA’s Hearing Process Some experts suggested that USDA’s federal order hearing system is too  slow to effectively respond to problems and changing market conditions.  The American Farm Bureau study reported that it can take 2 or more years  from the time USDA receives a request for a hearing or direction from the  Congress before USDA implements the rules of a final decision. The study  noted that within this long time frame, either the industry may have  struggled under faulty rules or, by the time final rules are effective, industry  changes may have occurred rendering the final rule obsolete. For example,  a couple of industry sources stated that the dairy industry is changing  rapidly, with a number of new products coming onto the market. They  indicated that USDA would have difficulty regulating these products  because it takes too long to get a decision on the class under which they  would be priced.
USDA faces a number of challenges in shortening the time between  receiving a hearing request and implementing the rules of a final decision,  while still ensuring the promulgation of economically sound regulation.
The USDA hearing process is set forth by law. Before issuing or  amending marketing orders, the Secretary of Agriculture must conduct a  formal on-the-record rulemaking proceeding. USDA must notify the  public and provide an opportunity for a public hearing and comments.  Before an order regulation or amendment to a milk marketing order can  become effective, it must meet certain requirements including that it be  approved by at least two-thirds of the affected dairy farmers in the  order, or dairy farmers who produce at least two-thirds of the milk  produced in that order.
If individual parties do not agree with the USDA decision, they can seek  review of that decision in federal court. For example, after the 2000  FMMO reforms, several industry groups received an injunction that  prevented USDA from implementing new pricing rules that would have  established separate Class III and IV butterfat prices. In response, USDA  issued a revised decision, but these new rules were not implemented  until April 2003.
Making informed decisions about changes in complex federal dairy  policy can be time-consuming. For example, such decisions require  thorough analysis and possibly modeling. In addition, AMS officials  indicated that hearing participants are not always ready on time, and  keeping a stricter schedule could result in an incomplete hearing record.  Furthermore, they stated that it is difficult to compile the hearing  transcripts quickly and accurately. However, they noted that USDA has  recently begun evaluating its transcript contracts using an approach that  considers timeliness and accuracy.
The politicized nature of dairy policy makes it difficult to agree on  proposed changes to FMMOs. Because FMMO provisions affect  cooperatives and processors in different ways, these entities may not  always agree on a proposed change. Moreover, given regional  differences in production and utilization, farmers in different regions  may not agree on changes in federal dairy policy.
AMS officials said that delays are also caused by the lack of available  judges and attorneys who deal with milk pricing issues. The officials said  that increasing the speed of the decision-making process is likely to  increase federal costs because more of these resources would be required.  USDA officials indicated that they do not believe the hearing process  inhibits the ability of FMMOs to respond to changing market conditions or  the marketing of new dairy products.
section_title: Eliminate FMMOs or Classified Pricing
paragraphs: Rather than trying to reform the FMMO system, some dairy experts have  considered the possibility of eliminating FMMOs and thus the classified  pricing system. To the extent that manufactured product prices stay  above the level of the price support program, market forces would set  prices for all uses of milk. In a 1988 report on FMMOs, we found that the  production and marketing conditions used to justify federally guaranteed  milk prices under marketing orders no longer existed because most milk  being produced is now Grade A and is eligible to serve the fluid milk  market during periods of supply and demand imbalance. Also, our study  noted that improvements in refrigeration and the transportation system  have made it less expensive to rely on milk supplies from other markets.  Further, we reported that the differences in Class I differentials—which  were, in part, intended to represent the costs of producing and transporting  milk from areas with a surplus to areas with a deficit—actually bear little  relationship to differences in either production or transportation costs for  milk, thereby providing incentives for overproduction in certain regions. A  2002 University of Wisconsin study argued that this overproduction has  hurt farmers in areas with low Class I utilization through an overall  reduction in the price of milk used for manufacturing purposes.
Academic and USDA studies have generally concluded that without the  classified prices established by FMMOs, fluid milk processors would likely  pay lower average prices to farmers, which would decrease farm income in  high fluid milk utilization areas, especially in the short term. Estimates of  impacts on farm prices varied among studies. For example, the American  Farm Bureau study estimated that average farm prices for raw milk would  fall by about $0.50 per hundredweight during the first couple of years  following federal order elimination. Another study, published by USDA,  estimated that eliminating the federal order system would decrease Class I  prices an average of $0.95 per hundredweight over the period from 2002  through 2007. Further, the 2002 University of Wisconsin study estimated  that farm prices would decrease around $0.05 to $0.10 per hundredweight.  AMS officials indicated that farmers would likely reduce production to the  extent they receive lower average farm prices.
The effects of FMMO elimination could be different based on farm size.  Some of the academic and industry sources we contacted noted that  farmers are at a disadvantage in terms of market power within the dairy  industry. Without the pooling of milk proceeds and the payment of uniform  blend prices, larger farms would have increasing incentives to establish  contracts directly with processors, and processors would increase their  efforts to procure milk directly from larger farms closer to their own  plants. Smaller and more distant farms could be more likely to be bypassed.  Also, to the extent that dairy cooperatives are unable to cover the costs of  balancing and other services they provide, processors may be able to  deflect the costs of these operations back to farmers.
Studies also indicated that the magnitude of these effects could vary by  region. Without classified pricing, the prices of raw milk used in fluid milk  products are likely to fall, while the prices of raw milk used in  manufactured products are likely to rise. As a result, farmers in regions  with higher utilization of raw milk for fluid purposes, such as the  Northeast, would be worse off without classified pricing, while farmers in  regions with high utilization of raw milk for manufacturing purposes, such  as the Upper Midwest, could be better off without classified pricing. For  example, the American Farm Bureau study reported that states with less  than 20 percent fluid utilization of raw milk would have higher average  farm prices with the elimination of federal orders, while those states with  fluid utilization of raw milk in excess of 35 percent have higher farm prices  with the federal order system in place.
In the short term, to the extent that lower farm prices paid for raw milk  used in fluid products are passed on to consumers, fluid milk consumption  could marginally increase. The American Farm Bureau study estimated a  2.5 percent increase in fluid milk demand, while the USDA study estimated  a 2 percent increase. On the other hand, the University of Wisconsin study  reported that the combination of less milk production and more fluid milk  consumption would reduce the amount of raw milk available for  manufactured products and increase manufactured product prices  accordingly. To the extent that manufactured product prices increase,  consumers may buy less of these products.
Over the long term, increased prices for milk used in manufactured  products could limit reductions in both farm income and production  resulting from elimination of FMMOs and classified pricing. In fact, the  American Farm Bureau study found that once a supply adjustment occurs,  average milk prices would return to levels similar to those prior to FMMO  elimination. However, to the extent that farmers in areas with high  manufacturing use experience higher prices for their milk, the incentive to  produce more milk could limit potential increases in manufacturing  product prices. In the end, some decline in production could be expected  over the long term because the overproduction incentive resulting from the  classified pricing system would be removed.
Eliminating FMMOs and classified pricing could also affect other federal  dairy policies and, therefore, affect federal costs. If MILC payments were  still based on the relationship between what fluid milk processors pay to  acquire milk in Boston and a target price of $16.94, MILC payments would  likely increase in size and frequency. At the same time, elimination of  FMMOs could decrease federal costs related to the price support program  because an increase in manufactured dairy product prices resulting from  eliminating classified pricing could reduce the need for dairy commodity  purchases by the CCC. However, it is unclear whether this effect would be  large enough to offset additional payments under the MILC program.
Some AMS officials also indicated that farmers could experience increased  price volatility without FMMOs. In the absence of minimum class prices,  greater price volatility could result, in part, from seasonal production  variation or short-term factors, such as holidays or weather events.  Further, while some sources questioned the extent to which a state  regulatory system, such as California’s, could continue to exist in the  absence of the federal classified pricing system, others indicated that state  regulation of milk could increase if the federal system were eliminated. A  couple of industry sources that we contacted indicated that an increase in  the number of states that regulate milk could make it more difficult for  them to do business and would be a less efficient system of regulation.
On the other hand, eliminating FMMOs and classified pricing could also  provide greater incentives for product innovation. Without classified  pricing, the market would price products more openly based on supply and  demand and would increase the incentives for processors to develop  alternative dairy products. To the extent that alternative products generate  new demand for milk, this innovation could benefit farmers. For example, a  recent study by researchers at Cornell University on the assignment of new  products under a classified pricing system found significant difficulties.  The study reported that the assignment of a new product to a higher-priced  class increases farm income in the short run; however, the incentive to  increase production provided by the use of raw milk in this higher-priced  class and reduced demand for raw milk stemming from these higher prices  can offset farm income gains in the long run. Furthermore, the study found  that whether the new product detracts from sales of existing fluid milk  products could also affect whether assignment to a higher-priced class  increases net revenues to farmers. One USDA representative stated that a  number of new products, such as low-carbohydrate milk beverages, have  recently entered the market. In some cases, according to the  representative, these products are intended to compete with Class I  products but are formulated to avoid regulation as Class I products.  Processors seek to avoid having these products regulated as Class I  products because they would then be required to pay more for raw milk.  Conversely, farmers want these products classified as Class I products so  that their raw milk used in these items will be priced at the higher level.
Some sources suggested that classified pricing could be eliminated without  eliminating FMMOs altogether. In this case, FMMOs might continue to  perform functions such as pooling revenue, auditing, verifying weights and  milk components, and collecting statistical information. A few dairy  experts indicated that these particular aspects of the FMMO system benefit  the dairy industry. While some of these functions might be picked up by the  private sector if FMMOs were eliminated, they would come at a cost to  dairy farmers.
Retaining FMMOs while eliminating classified pricing would probably  lessen the impacts of deregulating raw milk prices but would be unlikely to  change the direction of most effects or who benefits. For example, while  farm income would still fall without classified pricing, continuing to pool  revenues through FMMOs, if possible, could help cooperatives negotiate  over-order premiums because pooling could help cooperatives maintain  their market power relative to processors. Thus, farm income might fall by  less than it would if FMMOs were eliminated entirely. Moreover, by  continuing to pool revenues, retaining FMMOs could limit increases in  price volatility resulting from the elimination of classified pricing. In  addition, the orders would continue to aim to ensure equitable treatment  for producers and processors. Maintaining orders is not likely to change  the fact that farmers in regions with high fluid milk utilization would  experience greater reductions in farm income from eliminating classified  pricing than farmers in regions with high manufacturing utilization.  Production would still adjust downward in response to lower milk prices,  and retail fluid milk prices would also decrease to the extent that lower  prices for raw milk used in fluid milk products are passed on to the  consumer. However, to the extent that cooperatives are able to maintain  higher over-order premiums by retaining FMMOs, these production and  consumer price effects might be less than they would be if orders were  eliminated entirely. Effects on federal costs would still be mixed.
section_title: Change the Dairy Price Support Program
paragraphs: Dairy experts have raised several concerns about the price support  program in recent years, including that the support level is too low to  adequately support farmers; that the program provides incentives to  overproduce milk and certain commodities purchased by the CCC; that  USDA has not managed the program to maintain the established support  price during periods of low market prices; that there are additional costs of  selling dairy products to the government, which diminish the effectiveness  of the support price; and that the program stifles innovation in the industry.  Accordingly, a number of options have been discussed to modify the price  support program, including raising the overall level of the support price  (and thus the related commodity purchase prices), making administrative  changes such as allowing the CCC to purchase a wider range of dairy  products, and eliminating the program altogether. Figure 37 shows the  effects of various options to change the dairy price support program under  low- and high-price scenarios over the short and long terms. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?
subsections: section_title: Raise the Level of the Support Price
paragraphs: One option for modifying the dairy price support program is to raise the  support price and the related commodity purchase prices. Many dairy  experts indicated that the support price has fallen below the costs of  production for most farmers and, therefore, is not providing an effective  safety net during periods of low prices. Additionally, sources cited the  reduction in the support price as a factor in increasingly volatile milk  prices. For example, one academician we contacted stated that recent  volatility in milk prices has resulted from the virtual elimination of the  price support system as an effective price floor during periods of low milk  prices. The price support program also worked to reduce price volatility  during periods of high milk prices by releasing CCC stocks of purchased  dairy commodities when market prices reached 110 percent of the support  price. However, without purchasing sufficient quantities of manufactured  dairy products, the program does not perform this balancing function.
According to an economist with USDA’s Farm Service Agency (FSA),  raising the support price would increase farm income and, thus, raw milk  production. The economist indicated that this option, by raising the floor  for milk prices, would also reduce price volatility; however, increased  purchases of dairy products would mean higher federal costs for the price  support program. Similarly, the American Farm Bureau study found that  while raising the support price would reduce price volatility, it could create  a situation in which the CCC purchases surplus dairy products in most  years. The FSA economist noted that these federal costs might be offset, at  least in part, by a reduction in payments under the MILC program. The  economist also said that consumer costs would likely be higher, on  average, because increasing the support price would limit the fall of prices  for manufactured products.
The FSA economist also noted that increasing the support price would  decrease the economic efficiency of federal dairy policies, particularly to  the extent that a higher support price stimulates increased production.  Under this scenario, increased production would represent an allocative  inefficiency because resources would go into producing milk that is not  needed to supply the market. Some sources cited examples of how high  support prices under the program led to misallocation of resources into  surplus milk production. For example, from 1977 to 1981, the support price  for Grade A milk rose from $8.26 to $13.10 per hundredweight, and annual  government expenditures on dairy price supports increased from a few  hundred million dollars to over $2 billion.
section_title: Change the Administration of the Price Support Program
paragraphs: A number of options have been proposed or discussed to change the  administration of the dairy price support program. These options include  allowing the CCC to purchase a wider range of products, adjusting  commodity purchase prices based on market conditions, and setting  commodity purchase prices to reflect cost differences between selling to  the CCC and selling in the marketplace.
Allow the CCC to Purchase a Wider Range of Products One potential modification to the administration of the price support  program would be to allow the CCC to purchase a wider range of products  than butter, cheese, and nonfat dry milk. Some dairy experts and studies  indicated that by focusing on the purchase of a few specific commodities,  the price support program distorts the market by providing incentives to  overproduce these commodities, while at the same time dampening  incentives for innovation in the dairy industry. Manufacturers that develop  innovative products incur more risk because they will not be able to sell  their products to the government if they cannot obtain a market price high  enough to cover their costs. One cooperative representative said that while  nonfat dry milk contains protein and calcium—both valuable components  that could be used in other products, such as protein bars—manufacturers  continue to produce nonfat dry milk in excess quantities because that is  what the government is buying. A number of other sources, including  industry representatives, academicians, and a report by the International  Trade Commission, noted that by purchasing nonfat dry milk, the price  support program may be impeding development of a domestic milk protein  concentrate industry by creating disincentives to shift raw milk supplies to  innovative products.
USDA officials cautioned that in order for a product to function well as a  price support product, it must (1) represent a major use of milk; (2) have  enough extra capacity to absorb a substantial amount of milk; (3) be  storable for long periods; and (4) have an active, liquid wholesale market.  Given these conditions, it is questionable whether some alternative  products, such as protein bars, would be effective as price support  products. Furthermore, the officials argued that requiring the price support  program to incur the risk of product innovation through this approach  would alter the fundamental purpose of the program—supporting farm  prices.
If the CCC were to purchase a wider range of products, manufacturers  would have greater incentives to use milk in alternative ways because the  price support program would decrease the risks of trying to produce and  market a greater number of products. Consumers could benefit as  innovative products gained easier access to the market, causing consumer  prices to fall. However, one FSA economist stated that this option would  greatly increase the complexity of the price support program, potentially  increase federal costs, and require new legislation. Moreover, he noted that  this change would require close coordination between trade policies and  the price support program. For example, without tariff-rate quotas on some  products such as milk protein concentrates, the CCC could end up  supporting additional imports if the purchase prices were set too high. The  economist stated that this option could reduce production of nonfat dry  milk but would be less likely to affect price volatility.
Adjust Commodity Purchase Prices Based on Market Conditions A second potential modification would be to adjust—or tilt—commodity  purchase prices based on market conditions. Some dairy experts, as well as  academic studies, reported that because USDA does not tilt CCC purchase  prices frequently enough to maintain a balance between butter and nonfat  dry milk purchase prices that is based on current economic conditions, the  price support program has distorted the market with unclear price signals  and induced surplus production of certain goods (notably nonfat dry milk).  Therefore, some experts indicated that tilting prices based on established  criteria would be better. For example, one dairy processor recommended  changing the balance of butter and nonfat dry milk purchase prices  automatically if the ratio of CCC purchases of butter and nonfat dry milk  falls outside a certain range. Similarly, the American Farm Bureau study  suggested that to achieve the support program’s objectives without  distorting the market and increasing government costs, changes to  commodity purchase prices should be based on market conditions so that  they would not be subject to political pressure.
Basing the tilt of commodity purchase prices on market conditions would  increase the economic efficiency of the price support program by reducing  the price distortions that lead to surplus production of goods that are not  required to supply the market. Falling market prices for a particular  commodity suggest that the quantity supplied temporarily, at least, exceeds  the quantity demanded. If the CCC continues to buy the commodity in  significant amounts while the market price remains low, it distorts the  market by providing an incentive to produce that commodity purely for the  purpose of selling it to the government. This incentive not only delays a  market response to the lower commodity price but also prevents that milk  from going toward a higher-valued use. Moreover, a study by researchers at  the University of Wisconsin found that tilts make it more likely that fluid  milk prices will be driven by cheese prices because the price support  program would no longer be supporting the manufacturing prices of Class  IV products above market levels. This study reported that tightening the  relationship between cheese prices and Class I prices improves market  signals to dairy farmers because nationally, as noted earlier, a greater  percentage of raw milk is used in Class III products (cheese) than in Class  IV products (butter and nonfat dry milk).
According to one FSA economist, lowering the purchase price of a  particular commodity in the short term could reduce farm income;  however, by encouraging production levels to respond more quickly to low  price periods, tilting CCC purchase prices to reflect market conditions  could maintain higher farm prices over the long term. The economist also  indicated that this change could decrease federal costs for purchasing and  storing dairy products. The consumer price effects of market-based tilts are  less clear. For example, if market butter prices are high and market nonfat  dry milk prices are low, a market-based response would indicate that USDA  should raise the CCC butter price and lower the CCC nonfat dry milk price.  However, further price adjustments could result in the CCC purchase price  for butter exceeding the market price, which could trigger CCC purchases  of butter and raise the market price even higher. In such cases, assuming  that price changes at the wholesale level are passed on through the retail  level, consumers would benefit from lower prices on some commodities,  while potentially experiencing higher prices on others. The net effect to  consumers would then depend on the relative price changes for these  products and the quantities of each that were purchased.
Reflect Cost Differences in Selling to the CCC A third option to change the administration of the price support program  would be to set CCC purchase prices to reflect cost differences in selling to  the CCC versus selling in the marketplace. In recent years market prices  have fallen below the support price level in some months. For instance,  between July 2002 and June 2003, the Class III milk price was below the  $9.90 target level in 9 months. Although FSA officials indicated that USDA  is required to set product purchase prices in such a way that only the  average annual farm milk price, not the monthly price, is at the support  price, the Farm Security and Rural Investment Act of 2002 (2002 Farm Bill)  simply states that the price of milk should be supported at $9.90 per  hundredweight. Concerns over USDA’s management of the price support  program led to language in the Consolidated Appropriations Act, 2004  requiring the Secretary of Agriculture to more diligently support the farm  price of milk. Some dairy experts and studies indicated that one reason  that market prices sometimes fall below the CCC support price is because  there are additional costs of selling to the government that are not reflected  in the commodity purchase prices. Therefore, the effective support price is  actually below $9.90 because with higher costs of selling to the  government, the market price has to fall below the CCC purchase price  before processors are better off selling to the CCC than to the market.  Some of these additional costs include packaging for longer-term storage,  meeting stricter grading standards, and a time lag between when the  product is made and when it is approved for sale to the federal government.  An FSA economist estimated that these cost differences amount to about  $0.04 to $0.05 per pound for cheese.
One option for reflecting the differences in cost between selling dairy  products to the government and selling in the marketplace would be to  raise the CCC purchase prices of these products to reflect the additional  costs of manufacturing product for sale to the government. This would  help ensure that manufacturers receive a price for their products that  allows them to return at least $9.90 per hundredweight (the support price)  to farmers. One FSA economist indicated that this change could cause  farmers to marginally increase production, leading to increased CCC  purchases. Increased CCC purchases, in addition to higher purchase prices,  would increase the federal costs of the price support program and, at the  same time, higher manufactured product prices could translate into higher  consumer prices. However, it is difficult to estimate the added costs of  selling to the CCC because these costs are likely to vary widely among  different manufacturers. Thus, raising the product purchase prices could  provide unwarranted benefits to some manufacturers while still being  insufficient to induce sales to the government by some others. In addition,  according to one academic study, there is no clear evidence that higher  selling costs are the major barrier in selling to the government. Some  experts have put forth the possibility that fixed contracts between dairy  product manufacturers and their buyers may prevent manufacturers from  selling to the government.
An alternative way to reflect the differences in cost between selling dairy  products to the government and selling them in the market place would be  to require the CCC to alter product specifications and payment terms to  conform to those used on the Chicago Mercantile Exchange (the  Exchange). An FSA economist stated that some changes to product  specifications are already being considered and have been put out for  comment to the dairy industry. The economist stated that while these  proposed changes will help bring CCC product specifications into greater  conformance with market standards, some differences would remain. Most  notably, the CCC requires that products be storable for up to 3 years, a  longer period than is generally required in the market. To the extent that  this proposal reduces additional costs of selling manufactured dairy  products to the CCC by more closely aligning product specifications with  market standards, it could induce greater manufactured product sales to  the CCC and would keep market prices higher. Therefore, aligning these  specifications could increase farm income, provide a marginal production  stimulus, and raise federal costs related to additional CCC purchases. Also,  this option would not necessarily prevent the Exchange prices from falling  below CCC purchase prices because if there are barriers other than costs  (such as contractual obligations) that prevent manufacturers from selling  to the government, these barriers would still exist.
section_title: Eliminate Dairy Price Supports
paragraphs: Another policy option would be to eliminate the price support program  altogether and rely on alternatives available to farmers to assist them in  managing risk of low and/or highly volatile prices for their milk. A number  of dairy experts have argued that the support price has been set so low at  $9.90 per hundredweight that it is not having significant impacts. Thus  some academicians, as well as USDA, have studied the potential effects of  eliminating the program.
In the short term, eliminating the program would have a greater impact if  market prices were at or below the level of the support price. The May 2004  USDA study estimated that eliminating the price support program would  cause wholesale prices of nonfat dry milk to decline by 15 to 20 percent  over the first couple of years. For subsequent years, the study estimated  that prices would recover somewhat to 10 percent below baseline levels.  Further, the study estimated that the decline in nonfat dry milk prices  would encourage diversion of this milk to alternative uses, leading to lower  prices for these alternative uses. Generally, lower prices would reduce farm  income and potentially lead to lower consumer prices. Farmers would  likely respond to these lower prices by producing less milk.
According to an FSA economist, eliminating the price support program  would increase economic efficiency by allowing market price signals to be  transmitted more clearly. The economist also stated that volatility in milk  prices would increase. He noted that the combination of increased  volatility and reduced farm income would force less efficient farmers to  exit production. This exit would increase the economic efficiency of  national resource allocation by enhancing current shifts in production to  more efficient dairy farms. He added that in the absence of a price support  program, new entrants to dairy production would likely be larger, more  efficient operations. The FSA economist also said that eliminating the price  support program would provide a cost savings for the federal government  because the CCC would no longer have to purchase or store dairy  commodities. These savings would be greater during periods when farm  prices are low because when they are high, even if the program remains in  effect, the government purchases fewer dairy products and incurs less cost.  However, when farm milk prices are low, savings from eliminating the price  support program could be partially offset by increased payments under the  MILC program for as long as that program continues.
Over the long term, reduced production would mitigate some of the  impacts of eliminating the price support program, because reduced  supplies lead to increased prices (assuming demand stays the same).  However, the USDA study estimated that even with the positive price  effects resulting from reduced production, farm income would still  decrease by approximately $3.5 billion over the long term. Additionally,  without CCC purchases of dairy commodities, USDA would be unable to  balance high market prices by releasing these stocks, thereby contributing  to increased price volatility over the long term.
section_title: Extend the Milk Income Loss Contract Program
paragraphs: The MILC program has benefited many smaller dairy farmers during the  most recent period of low farm prices by providing them income support.  However, by providing support to some farmers who otherwise might have  exited the dairy industry, the program has slowed the normal downward  supply response to lower farm prices and kept aggregate production higher  during this period than it otherwise would have been. The MILC program is  scheduled to expire at the end of fiscal year 2005. If it is not extended in  some form, aggregate production is likely to respond more rapidly to future  low-price periods because smaller farmers are likely to exit production at  greater rates than they did during the most recent period of low farm  prices. With this more rapid production response, farm prices would likely  start rising again sooner than in the recent past when the MILC program  has been in place. However, although production levels in the short term  would likely decrease more during low-price periods, in the long term  aggregate production might not decrease substantially because higher  average farm prices would stimulate additional production from the dairy  farmers that stay in business. In addition, by allowing the MILC program to  expire, the government can avoid the costs of the payments to farmers that  the program provides.
There are several options to maintain the benefits of the MILC program to  some dairy farmers by extending it beyond 2005. One option is to extend  MILC at its current target price and eligible production limit. A second  option, a proposal introduced in the Senate in the 108th Congress, would  extend MILC through fiscal year 2007 with an increase in the eligible  production cap from 2.4 million pounds to 4.8 million pounds. A third  option would extend MILC with a lower target price but a higher or no  eligible production limit. Figure 38 shows the effects of various policy  options to extend the MILC program under low- and high-price scenarios  over the short and long terms. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?
subsections: section_title: Extend MILC in Its Current Form One analysis conducted by a researcher at the University of Missouri
paragraphs: estimated that compared to a baseline estimate in which the MILC program  expires in 2005, extending the MILC program through 2012 in its current  form would result in greater milk production and lower farm prices.
Production was estimated to be 0.8 billion pounds higher in 2006 and to  average 1.4 billion pounds per year higher from 2008 through 2012. The  estimated price difference was also greater in the longer term than  initially. Greater production and lower farm prices are consistent with the  expectation that extending the MILC program would keep some smaller  dairy farmers in the industry who otherwise might exit after 2005 if the  MILC program is allowed to expire then. This study also estimated that due  to the MILC payments, farm income would increase if the program were  extended, despite lower farm prices. Initially, in 2006, the estimated  increase in farm income was $0.43 per hundredweight, and even in 2012,  when the estimated farm price was $0.50 per hundredweight below what it  would be if MILC expires after 2005, the estimated increase in farm income  was $0.08 per hundredweight. In addition, extending MILC in its current  form would increase federal costs. This study estimated that, on average,  annual government costs from 2006 through 2012 would be about $1.2  billion higher than if the MILC program expires after 2005.
According to an FSA economist, lower farm prices resulting from  extending MILC in its current form could be passed on as lower retail  prices for consumers. However, the economist indicated that the effects on  price volatility are less clear. He added that the extension of the MILC  program as currently designed would continue to favor smaller farmers  over larger farmers, because a greater percentage of smaller farmers’  production is eligible for MILC payments. Thus, in general, the MILC  program would continue to benefit farmers in the eastern and upper  midwestern states over farmers in the western states. Therefore, for a given  level of milk production and to the extent that larger farmers in the West  are more efficient than smaller farmers in the East, extension of the MILC  program as currently designed would reduce the economic efficiency of the  allocation of dairy production resources nationally compared to the  allocation that would occur if MILC expires.
section_title: Extend MILC with a Higher Cap or with No Cap
paragraphs: An alternative proposal has been introduced in the Senate in the 108th  Congress that would extend the MILC program at its current target price  but increase the cap on eligible production. The University of Missouri  study examined the impacts of a similar option in which the cap on eligible  production is removed in 2003 and MILC is extended through 2012 without  a cap. This study estimated that extending MILC without a cap would  result in a larger increase in production and a larger decrease in farm prices  than extending MILC with a cap. For example, production in 2006 was  estimated to be 2.3 billion pounds per year higher than if MILC is allowed to  expire or 1.5 billion pounds greater than if MILC is continued in its current  form. Greater production and lower farm prices are consistent with the  expectation that making all milk eligible for MILC payments would provide  farmers who might otherwise exit the industry after 2005 (if MILC is  allowed to expire) an even greater incentive not to leave than is provided  by extending MILC in its current form. As with the previous option, this  study estimated that due to MILC payments, farm income would increase if  MILC were extended without a cap despite lower farm prices. Initially, in  2006, the estimated increase in farm income would be $0.63 per  hundredweight, and even in 2012, when the farm price was estimated to be  $1.05 per hundredweight below what it would be if MILC expires after 2005,  the estimated increase would be $0.18 per hundredweight. Moreover, this  study estimated that farm income would be higher with this option than  with extending MILC in its current form because the additional payments  to farmers due to eliminating the cap would more than offset the additional  farm price reduction resulting from greater production. Extending MILC  without a cap would increase federal costs even more than extending MILC  in its current form. This study estimated that, on average, annual  government costs from 2006 through 2012 would be about $2.5 billion  higher than if the MILC program expires after 2005, more than $1 billion per  year more than was estimated if MILC is extended in its current form.
An FSA economist indicated that consumers would likely benefit from  reduced retail prices under this scenario. Additionally, without the cap on  eligible production levels, the equity concerns about MILC would be  eliminated because the program would no longer favor smaller farmers  over larger farmers. However, the FSA economist also indicated that in  addition to the inefficiencies of increased surplus milk production, this  alternative would reduce economic efficiency of milk production  compared to allowing MILC to expire after 2005 to the extent that it  provided incentives for production by smaller producers with higher costs  of production.
section_title: Extend with Lower Target Price and Higher or No Cap
paragraphs: A third alternative, considered in the American Farm Bureau study, is to  extend MILC with a lower target price and a higher or no cap on eligible  production. The study argued that the $16.94 per hundredweight target  price is too high because MILC payments are triggered any time the Class I  mover is less than $13.69 per hundredweight; at this target price, MILC  payments could be expected in most months given that from 1990 through  1999 the Class I mover averaged $12.28 per hundredweight and was below  the $13.69 threshold in 104 of 120 months. The analysis concluded that a  target level for MILC payments of a Class I mover at $12.00 per  hundredweight or lower would help to make the program more  marketbased. Further, expanding the cap or eliminating it completely  would help to make the program more equitable among farmers of different  sizes.
The effects of extending MILC in the absence of a cap on eligible  production depend significantly on the level of the target price. If the target  price were set too high, it would stimulate surplus production. During  periods of low prices, the government would have to contribute additional  MILC payments to counteract the effects of lower prices. Additional  production would also decrease manufactured product prices, potentially  increasing the costs of the dairy price support program because these  prices would be more likely to reach the support level. At the same time,  these lower prices could provide benefits for consumers. While a lower  target price without a cap would treat farmers with different sized herds  the same way, it might not provide enough payments to keep farmers in  areas with high costs of production from exiting during periods of low  prices. Therefore, this option could increase the economic efficiency of  national dairy production, while also accelerating shifts in dairy production  to the West.
section_title: Introduce a New Target Price Deficiency Payment Program
paragraphs: Some dairy experts indicated that in lieu of maintaining both the dairy price  support and MILC programs, operating one new target price deficiency  payment program could be a better alternative. USDA and other dairy  experts stated that having both the price support and MILC programs is  problematic, particularly during periods of low prices. As noted in the  American Farm Bureau study, the idea behind establishing a target price  deficiency payment program is to allow markets to work to clear dairy  products at market prices and then, when the market price is below the  target price, to pay farmers based on the difference between these prices.  But with both dairy programs in force, MILC maintains and encourages  surplus milk production that must then be purchased by the CCC under the  price support program. This market distortion adds to the costs of both  programs.
Under a new target price deficiency payment program, dairy farmers would  receive a payment when the market price of Class III milk products drops  below a specific target level. Thus, the program would establish a floor on  farm income through a countercyclical payment to dairy farmers instead of  a floor on manufactured product prices with purchases by the CCC.  Instead of providing an incentive for manufacturers to continue producing  a particular product that the CCC is purchasing, the program would allow  the market to clear a wholesale product price and then pay farmers the  difference if the price were too low. This option would provide  manufacturers the incentive to shift raw milk supplies to their highest- valued use, further promoting the development of new and innovative  products. This option could also potentially reduce federal costs,  depending on the level of the target price; one expert estimated that with a  target price of $10.50 per hundredweight for Class III milk, the government  would have spent $300 million less than under the MILC program since its  inception in December 2001. With a target price of $10.00 per  hundredweight for Class III milk, these savings would have reached $1.2  billion.
Notwithstanding these potential benefits, dairy experts indicated that a  new target price deficiency payment program could have its own  challenges depending upon how it is designed. In particular, such a  program would require some key decisions regarding price level and  regional differences, and whether to cap program benefits based on  payments or quantities of production.
subsections: section_title: Set Price Level and Consider Regional Differences
paragraphs: Some dairy experts said that a problem with the target price deficiency  payment approach is that it would be hard to determine the appropriate  target price without creating distortions in production incentives. If the  target price were set too high, it would have the same effect as setting the  support price too high: it would lead to excess production by supporting  farm income at higher levels than would be available if farmers received  market prices. Long-term overproduction would place additional  downward pressure on market prices and increase federal costs for the  program. If the target price were set at a low level to avoid stimulating  production and increasing government costs, it might not maintain  adequate support for farm income, and could increase price volatility.  Additionally, by influencing domestic production levels, which in turn  influence U.S. market prices, the level of the target price can affect the  incentives of other countries to export manufactured products to the  United States. However, these incentives are also affected by the export  subsidies and lower production costs of some other countries.
The difficulty in setting the appropriate target price is exacerbated by  regional differences in costs of production. A certain Class III target price  might provide adequate support during periods of low prices based on the  costs of production in one region, but not in another. However, increasing  the target price to provide adequate support for higher-cost regions would  not only support production in areas where it is less economically efficient  to do so, but would also provide greater benefits to farmers in lower-cost  regions. These higher benefits would increase the incentives to  overproduce in those areas. Given current trends in the United States, this  scenario would encourage the western shift in dairy production.
section_title: Place Cap on Payments or Production
paragraphs: Another challenge in designing a target price deficiency payment program  would be to determine whether to cap the program’s benefits either by  limiting the payment a farmer could receive or by limiting the quantity of  milk production on which a farmer would be eligible to receive payments.  The MILC program calls for payments equal to 45 percent of the difference  between $16.94 and the Boston Class I per hundredweight price and has a  production cap (2.4 million pounds of production per dairy operation each  fiscal year). These controls have helped to keep federal costs lower than  they otherwise would have been during periods of depressed prices by  limiting incentives for overproduction. However, the production cap has  targeted the program’s benefits primarily to smaller farmers, raising  questions of equity.
If a target price deficiency payment program were implemented without  any controls, the risk of market distortions and increased federal costs  from establishing a target price level that is too high could increase  substantially. At the same time, a couple of researchers noted that  establishing the target price deficiency payment program without a  production cap could encourage farmers to enhance the efficiency of their  dairy operations. With a cap limiting eligible production, farmers have less  incentive to adopt new technologies that would increase production.  However, whether or not a cap is placed on eligible production, the  program is likely to confer benefits to farmers in varying degrees. If the  program did not cap eligible production, farmers who could increase their  production efficiency with new technology might have more of an incentive  to do so. But the farmers who would be most likely to take advantage of  this incentive would be larger farmers who may be more efficient, and  might have the resources and access to capital to undertake such an  investment. Conversely, capping eligible production would target benefits  to smaller farmers in the same way as MILC.
section_title: Adopt the National Dairy Equity Act
paragraphs: To address concerns about the pending expiration of the MILC program  and provide additional support to dairy farmers, the National Dairy Equity  Act of 2004 (NDEA) has been introduced in the House and the Senate.  This proposed legislation would change the federal regulation of milk  marketing through the establishment of regional dairy marketing areas in  which boards created to administer these areas would set minimum prices  that processors would have to pay for raw milk used to make fluid milk  products sold in those areas. The NDEA would have a similar effect as the  MILC program in that it might lead to higher incomes for some dairy  farmers. However, concerns have been raised about its impact on farm  incomes in some regions, retail fluid milk prices, coordination of milk  prices across regions, and existing trade agreements. Figure 39 shows the  effects of adopting the NDEA over the short and long terms.
The NDEA would create five marketing areas that together would  encompass the entire nation. States in the Northeast, Southern, and  Upper Midwest regions would automatically be participating in the  marketing area program established by the NDEA upon enactment of the  legislation. States in the Intermountain and Pacific regions could  become participating states by providing written notice to the Secretary of  Agriculture. The NDEA would authorize each region’s board to set an “over- order” minimum price for Class I sales that exceeded the FMMO Class I  price in that region, with an initial maximum of $17.50 per hundredweight,  subject to approval by farmers within the region in a referendum.  Although the boards would have discretion in setting the over-order price,  the legislation directs the boards to consider several factors including the  balance between production and consumption of milk and milk  products in the regulated area;  costs of milk production in the regulated area;  prevailing price for milk outside the regulated area;  purchasing power of the public; and  price necessary to yield a reasonable return to an eligible farmer.
The NDEA would establish a fund in the U.S. Treasury to carry out the  program. During months in which a region’s over-order price exceeded the  FMMO Class I minimum price in Boston, processors would be required to  pay the Secretary of Agriculture an amount equal to the difference between  those two prices, known as the over-order premium, times the quantity of  milk purchased for use in Class I products. The Secretary would deposit  these amounts into the U.S. Treasury fund, and the fund would make  payments to each board, which would distribute the payments to eligible  farmers in its region. Each month the board would receive at a minimum  an amount equal to the over-order premium times 50 percent of the milk  produced in that region. The proposed legislation would require CCC  funds to be transferred to the fund when necessary to allow the fund to  make the required payments; according to one analysis, such contributions  would typically be necessary because only one of the proposed dairy  marketing areas has a Class I utilization rate equal to 50 percent or higher.
The NDEA also would require boards to compensate the CCC for any  additional costs of CCC purchases of milk products resulting from  increases in milk production that exceed the national average growth rate.  To manage overproduction of milk that could result from the NDEA, the  NDEA would authorize boards to take action, including developing and  implementing incentive-based supply management programs.
In addition, the NDEA would link participation in the dairy marketing areas  with participation in the current MILC program. Farmers who participate in  the new program would not be able to continue to receive MILC payments.  If states in the Intermountain and Pacific regions chose not to participate in  the NDEA program, farmers in those states could continue to receive MILC  payments, and the NDEA would extend the authorization period for the  MILC program until the end of September 2007. States in the other regions,  which would become participants upon enactment of the NDEA, could  withdraw their participation. If they did, farmers in those states could also  continue their MILC payments through the end of September 2007.  Individual farmers in states that participated in the NDEA program could  choose not to participate in the new program and would then be able to  continue receiving MILC payments. However, those farmers would not be  able to extend their payments beyond September 2005 and would not be  eligible for subsequent participation in the NDEA program.
subsections: section_title: Impacts of the NDEA
paragraphs: Although the NDEA may lead to higher incomes for some dairy farmers,  academicians and industry participants have raised many concerns about  the proposed legislation’s impacts. These concerns include regional  divisiveness due to lower incomes for dairy farmers in some regions, higher  retail prices, reduced coordination of dairy prices across regions, and  potential conflict with World Trade Organization (WTO) rules.
The NDEA could lead to higher incomes for farmers in participating states  when milk prices are relatively low because processors would have to pay  the over-order prices set by the boards for Class I milk; however, the total  effect on farmers would depend on what happens to the price of milk used  for manufacturing purposes as well. To the extent that higher blend prices  stemming from higher Class I prices lead farmers to increase milk  production, the result could be lower prices for Class III and IV milk both in  participating and nonparticipating states. Even if all states participated in  the dairy marketing areas, the large differences in Class I utilization rates  across regions imply that different regions would be affected differently by  the combination of higher Class I prices and lower Class III and IV prices,  and farmers in regions with low Class I utilization rates might see a decline  in their incomes. If some states do not participate, their farmers would be  even worse off because unless these farmers pool milk in states that are  included in the marketing areas, they would not receive any benefits of  higher Class I prices. In a report that we issued in September 2001 in  which we analyzed the inter-regional impacts of various scenarios in which  some states were grouped in dairy compacts that functioned like the  NDEA’s dairy marketing areas, we reported that one effect of compacts was  to reduce farm income in noncompact regions. We estimated this effect to  be minimal when we examined the impact of the Northeast Interstate Dairy  Compact because the six New England states included in that Compact  produced only 3 percent of the nation’s milk. However, we estimated that  the effect was somewhat greater in a scenario in which states producing 27  percent of the nation’s milk supply were included in compacts.
To the extent that the NDEA would result in fluid milk processors paying  more to buy their milk from farmers, the NDEA would also lead to  increases in retail fluid milk prices. In our report on compacts, we reported  that several studies concluded that the Northeast Interstate Dairy Compact  resulted in higher retail prices for fluid milk in New England, with  estimated impacts ranging from $0.03 to $0.20 per gallon. Higher retail  prices could have a greater effect on retail sales in upcoming years than  occurred in the past, as some dairy experts believe that the demand for  fluid milk has become more responsive to price changes, given the  increasing number of beverages that are considered substitutes for fluid  milk, among other reasons. Consequently, retailers with whom we spoke  generally opposed the NDEA. Furthermore, declines in fluid milk sales  would cause more milk to be available for manufacturing purposes, which  would further depress the prices for Class III and IV milk.
Several academicians told us that they believed the NDEA would also  create regional distortions because price-setting in each dairy marketing  area would be controlled by its board, and prices for raw milk used in fluid  products would no longer be closely linked to prices for raw milk used in  manufactured products. This would be a major change from the current  system in which Class I prices are set based on differentials added to the  “higher of” the advanced Class III or IV skim milk values, with the  differentials still somewhat reflective of the costs of transporting milk from  the Upper Midwest, a key dairy surplus region. Before the 1960s, Class I  prices in different orders were not coordinated, and the resulting  disorderly marketing system led to the coordinated system that we now  have. Adopting the decentralized price-setting system of the NDEA risks  losing the advantage of more orderly marketing that the coordination of the  1960s brought to the dairy industry.
Concerns about whether the NDEA would make U.S. dairy policy less  consistent with existing agreements under the WTO arise because of the  effects of the NDEA on milk production and, hence, U.S. milk prices. As  indicated previously, recent U.S. commitments under the General  Agreement on Tariffs and Trade are leaning in the direction of more  liberalized trade. To the extent that the NDEA provides a subsidy for U.S.  milk production and reduces the prices of manufactured dairy products,  the act would reduce the competitiveness of imported products.
We identified one study that estimates the effects of the NDEA on milk  production, farm prices, and government costs compared to a baseline  scenario that did not include the NDEA. This study estimated that the  NDEA would increase milk production compared to the baseline by an  average of about 7.6 billion pounds per year during the period from 2006  through 2013. The increased production would result in estimated declines  in Class III and IV prices from the baseline such that average milk prices  would be $1.17 per hundredweight below the baseline estimate. The  estimated annual average increase in federal costs for payments to the  boards was $1.7 billion.
section_title: Change Trade Restrictions and Export Incentives
paragraphs: Recent concerns about the effects of imported dairy products, most  notably milk protein concentrates, on U.S. dairy prices have highlighted the  importance of U.S. trade policy—trade restrictions and subsidy  programs—as a foundation for domestic dairy policies. Several policy  options related to international trade in dairy products have been  suggested. As noted previously, current international trade agreements and  ongoing negotiations can have implications for certain policy options that  have been suggested. These options include (1) increasing trade  restrictions, specifically for imports of milk protein concentrates; (2)  relaxing trade restrictions; (3) introducing domestic subsidies for products  significantly affected by international trade competition, specifically  establishing a subsidy program for domestic production of milk protein  concentrates; and (4) changing the Dairy Export Incentive Program  (DEIP), either by using it more effectively or by eliminating it. Those  options that succeed in limiting imports or encouraging exports of  manufactured dairy products could support higher farm income,  production levels, and consumer prices. These options may also reduce  federal costs if higher farm prices reduce costs to the price support  program to a greater degree than the cost of these trade options. Figure 40  shows the effects of options to change trade restrictions and export  incentives over the short and long terms. ? ? ? ? ? ? ? ? ? ?
subsections: section_title: Increase Trade Restrictions/Establish a Tariff- Rate Quota for Milk Protein Concentrates
paragraphs: One international trade policy that has been proposed is to increase trade  restrictions within the constraints of existing international trade  agreements. More specifically, a bill entitled the Milk Import Tariff Equity  Act has been introduced in the Congress that would impose tariff-rate  quotas on dairy protein products such as milk protein concentrates and  certain casein products. Import quotas prior to the WTO Uruguay Round  Agreement on Agriculture did not cover milk protein concentrates and  casein. Therefore, no tariff-rate quota was established for these products  after the agreement was implemented. The May 2004 report by the  International Trade Commission showed that U.S. imports of some dairy  proteins increased significantly from 1998 through 2000 and then declined.  Some of these protein imports displaced domestic dairy proteins,  particularly those used in making processed cheese products not covered  by the Food and Drug Administration’s standards of identity.
The International Trade Commission report concluded that imports of milk  protein concentrates to the United States have the effect of lowering U.S.  farm prices either directly or indirectly, depending upon whether U.S.  market prices for manufactured dairy products are above or at the level of  the support price. If U.S. prices are above the support price, then imports of  dairy proteins could directly lower the market prices of nonfat dry milk,  butter, and cheese to the extent these proteins can be imported at lower  prices than proteins available in the domestic market. In turn, lower  product prices could reduce the prices received by U.S. farmers for their  raw milk. If U.S. prices are at the support price, then imports of dairy  proteins could indirectly affect U.S. market prices. Increasing imports of  proteins when U.S. market prices for manufactured dairy products are at  the support price will cause the CCC to purchase more nonfat dry milk as  this alternative protein source is displaced in the market. Eventually, these  increasing stocks could cause USDA to lower the purchase price of nonfat  dry milk in an attempt to reduce federal costs. This adjustment  would then lower prices for manufactured dairy products, in turn  decreasing the prices received by U.S. farmers for their raw milk.
Because introducing tariff-rate quotas on milk protein concentrate and  casein would likely reduce imports of these products, federal costs due to  CCC purchases and storage of nonfat dry milk under the price support  program would likely decrease. When U.S. market prices are above the  purchase prices established by the price support program, a reduction in  imports could maintain prices of some products, such as cheese, at higher  levels due to reduced domestic supply of dairy proteins used in these  products. Higher product prices could increase farm prices and thus  stimulate additional production. These effects could be more significant in  regions of the United States where raw milk is used to a greater extent in  the manufacturing of Class III products. (If U.S. trading partners  successfully challenge tariff-rate quotas on dairy proteins, compensation  such as increased market access for other products could be required,  reducing the benefits to U.S. dairy farmers.) Because production  adjustments tend to lag behind price changes, this additional production  could delay adjustments to lower market prices in the future. Therefore, to  the extent that the exclusion of imports masks market price signals that  would exist without the exclusion, this policy option would decrease  economic efficiency. Additionally, to the extent that changes in the  manufacturing prices of dairy products are passed on through the retail  level, consumers could experience higher prices for some products (such  as cheese) and lower prices for other products (such as butter).
section_title: Relax Trade Restrictions
paragraphs: A second option is to relax trade restrictions by reducing or eliminating  tariffs on dairy products. Trade restrictions such as tariff-rate quotas  support domestic programs such as the FMMO classified pricing system  and the dairy price support program by limiting the available supply of  dairy products to take advantage of higher U.S. market prices. Unilaterally  relaxing U.S. trade restrictions would likely increase imports of  manufactured products as foreign producers seek to take advantage of the  higher prices available in the U.S. market. Despite higher transportation  costs for imported products, some manufacturers might be able to import  certain dairy products from U.S. trading partners at prices below U.S.  market prices either because those partners provide export subsidies (as  the European Union does) or because they have lower milk production  costs (as Australia and New Zealand do). Relaxing trade restrictions such  as tariff-rate quotas is unlikely to increase imports of fluid milk products  because of health restrictions, transportation costs, and the perishable  nature of these products.
Increased imports could put pressure on the CCC to purchase larger  quantities of manufactured dairy products, thereby increasing federal  costs. At some point these pressures could become unsustainable,  leading to a reduction in the support price or the end of the price support  program and to a decline in the price of milk used for manufacturing  purposes. Moreover, because the price of milk used in fluid milk products  is based on the price of milk used in manufactured products, a decline in  the prices of manufactured products from increased imports could lower  average farm prices. As long as MILC is authorized, these lower prices  could trigger additional MILC payments to farmers, further increasing  government costs.
In the short term, increased imports could cause U.S. prices to fall,  resulting in a decline in farm income for U.S. dairy farmers. With reduced  farm income, production would also decrease as less efficient farmers exit  production. Over the long term, the decline in production could cause farm  prices to rebound toward the levels that existed before trade restrictions  were relaxed. Similarly, in the short term, lower farm prices are likely to  lead to lower consumer prices for fluid milk and other dairy products, but  as farm prices rise toward their previous levels due to production  decreases, consumer prices for fluid milk and other dairy products would  likely rise as well. Economic efficiency will increase with relaxed trade  restrictions because such relaxation will allow market price signals to be  more visible than with restrictions in place. These signals will lead to  increased imports when it is cheaper to substitute increased imports for  some domestic dairy production. Additionally, the economic efficiency of  U.S. dairy production resource allocation could increase with relaxed trade  restrictions as the reduction in domestic production is more likely to come  from less efficient domestic farmers.
section_title: Subsidize Domestic Milk Protein Concentrate Production
paragraphs: Another proposed option is to support the development of domestic casein  and milk protein concentrate production. Under the proposed U.S. Dairy  Proteins Incentive Program, the CCC would make subsidy payments, on a  bid basis, to entities that produce and market dairy proteins from skim  milk. The proposed legislation would provide, among other things, that  receipt of a payment is contingent upon the end use of the dairy proteins  produced; that no applicant receives a payment if the contract submitted  for review would undercut domestic prices for milk, nonfat dry milk, or  dairy proteins; and that the sale of the dairy proteins represents a new use  of domestically produced dairy proteins.
This program’s potential impact on domestic dairy protein production  depends on the relative profitability of these proteins, which, in turn  depends on production costs and demand. The International Trade  Commission’s May 2004 study on milk protein products found that, given  disincentives inherent in the price support program and constraints on U.S.  demand for dairy proteins other than nonfat dry milk, the profitability of  domestic protein production could be limited. For example, the study  reported that the price support program creates a disincentive for U.S.  processors to produce dairy proteins other than nonfat dry milk because by  purchasing nonfat dry milk the price support program reduces the financial  risk of manufacturing that product. Processors of other proteins would  need to invest in production facilities and then market their product  without the benefit of a standing government offer of support. The study  found that only under the most favorable conditions (high skim milk  protein yield and low variable costs) would it be beneficial for U.S.  processors to begin producing milk protein concentrate instead of nonfat  dry milk. Even then, positive returns were only for milk protein  concentrates with protein concentrations above 70 or 80 percent.
The classified pricing system could create an impediment to the  development of a domestic protein industry depending upon how milk  protein concentrate is classified. Based on analysis presented in the  International Trade Commission’s report, classification under a higher- valued class would require producers of milk protein concentrate to pay  more for their raw milk supplies, thus reducing their profits. In addition,  the report noted that since May 2002, the CCC has had a program to  provide incentives to convert nonfat dry milk held in its stocks to casein.  Under this program, the CCC accepts competitive bids for CCC-owned  nonfat dry milk stocks for the manufacture of casein. However, while  USDA has accepted some bids, in many cases processors’ bids have been  so low that USDA has rejected them.
Finally, the International Trade Commission’s report found that while milk  protein concentrate is considered a useful additive to standardize protein  content, the limitation on its use inherent in the Food and Drug  Administration’s standards of identity further restrict domestic milk  protein concentrate production. This limitation keeps the market for milk  protein concentrates relatively small in comparison to the market for other  dairy proteins. Given these restrictions, the International Trade  Commission estimated that the total U.S. market for milk protein  concentrate is 40,000 to 50,000 metric tons per year. A new production  facility in New Mexico reportedly is capable of producing 16,000 tons  annually. Therefore, barring a large drop in imports or changes to the  standards of identity, the demand for milk protein concentrate would have  to increase substantially to induce additional domestic production.
To the extent that the proposed program can overcome these challenges, it  could provide incentives for manufacturers to produce alternative dairy  proteins domestically. Should these proteins replace some nonfat dry milk  production, they could reduce federal costs for the price support program.
However, the overall impact on federal costs would depend on whether  these reductions are offset by the cost of the subsidy program itself.  Various dairy experts disagree as to whether subsidizing domestic dairy  protein production would result in a net increase or decrease in federal  costs. For example, a study that was published in May 2004 by researchers  at Cornell University concluded that reduced costs to the price support  program would not be great enough to offset the cost of the subsidy  program. Conversely, an analysis by the National Milk Producers  Federation found that a protein subsidy program providing assistance up to  $2.30 per hundredweight of skim milk would result in a net cost savings for  the federal government. The study by Cornell University researchers also  estimated that a subsidy program for casein and milk protein concentrate  would raise average milk prices by $0.40 per hundredweight, yielding an  increase in farm income of $913 million. These increases would have  greater impacts on farm income and milk production in areas of the  country with higher Class IV utilization, such as the West.
Also, should these proteins replace some nonfat dry milk production, the  resulting effects on the prices that consumers pay for products made with  dairy proteins could be mixed. If dairy protein prices increase with reduced  imports, consumer prices for those products for which they are an  ingredient (such as cheese), could also increase to the extent that these  price changes are passed through. However, additional production  resulting from higher farm prices could lower consumer prices for butter.  Over the long term, increased domestic production of casein and milk  protein concentrate could lower their production costs and also the costs  of other products for which they are ingredients. With the subsidy program  in place, the economic efficiency of resource allocation would likely  decrease as the government provides incentives for the production of  proteins that could potentially be supplied more cheaply through imports.
section_title: Change the Dairy Export Incentive Program
paragraphs: Some dairy experts indicated that DEIP can help reduce government  expenditures by allowing USDA to subsidize exports rather than purchase  products and maintain high stock levels through the price support  program. However, in some cases, academic experts indicated that under  current market conditions the impact of DEIP on U.S. prices is limited. For  example, one source noted that with CCC purchases of nonfat dry milk at  over 800 million pounds in 2002, and with over 1 billion pounds of CCC  stocks on hand, DEIP currently has no impact on U.S. prices. Also, WTO  commitments have limited the scope of DEIP. For example, in the Uruguay  Round Agreement on Agriculture the United States committed to reducing  the quantity of subsidized exports by 21 percent and the value of these  exports by 36 percent over the period from 1995 to 2000. Therefore, a  couple of alternative policy options have been discussed with regard to  DEIP, using it more effectively or eliminating it entirely.
Some dairy experts suggested that the government could make greater use  of DEIP. The American Farm Bureau study concluded that DEIP may be  underutilized, noting that it is difficult to develop foreign markets unless a  commitment is made to serving the market. Such a commitment is more  difficult if a given product is made available only when it is in surplus. The  study criticized USDA for (1) being slow to invite and accept bids and (2)  concentrating on products in surplus. Other dairy experts indicated that  invitations for DEIP bids may be announced too late in the year for  potential exporters to participate in the program due to seasonal sales  patterns. To improve the effectiveness of DEIP, the American Farm Bureau  study recommended three potential changes:  Exporters should be encouraged to submit bids for products and  countries that offer the greatest potential for longer-term market  development. USDA should use DEIP in conjunction with the Foreign  Agricultural Service to coordinate export assistance programs to fully  develop markets.
USDA should consider DEIP bids for any eligible products and not base  acceptance primarily on removing surplus products from the domestic  market. Bids should be accepted for products that may have the greatest  market development potential and do not violate WTO subsidization  volume limits.
USDA needs to act under shorter time frames in reviewing and  accepting DEIP bids to maximize the volume allowable under WTO  rules.
USDA indicated that it has announced and awarded subsidies under the  DEIP program up to the limits allowed by WTO rules for nonfat dry milk  and cheese and that DEIP-assisted exports of butterfat have varied  depending on market conditions. USDA also noted that the Foreign  Agricultural Service has worked closely with the dairy industry to ensure  that national and annual DEIP assistance optimizes longer-term market  development prospects and minimizes any potential detrimental effects on  the U.S. market. For example, a Foreign Agricultural Service official stated  that the Service generally tries to wait until the market for a particular  product, such as butterfat, is in surplus before inviting bids for DEIP export  subsidies. The official said that if the market is not in surplus, subsidized  exports would increase U.S. market prices for products manufactured with  butterfat, such as ice cream. USDA further indicated that expanding the use  of DEIP is not possible as the program is bound by quantitative and  monetary caps under WTO rules. Finally, USDA noted that the bid review  and acceptance process occurs within a time span equivalent to less than  one working day. Specifically, another Foreign Agricultural Service official  stated that USDA responds to all bid proposals by 10:00 a.m. on the next  business day after the proposals are submitted.
To the extent that USDA could identify ways to make greater use of DEIP,  the effects on the dairy industry of increased exports of U.S. dairy products  could be similar to the effects of an increase in demand. In the short  term, greater demand for dairy products would increase wholesale prices,  raising farm prices and, to the extent that these changes are passed on to  consumers, retail prices. While higher retail prices could cause marginal  declines in domestic consumption, higher farm prices over the long term  could stimulate additional production, which could put downward  pressure on wholesale and retail prices. Under such a scenario, price  volatility could decrease as the government balances swings in domestic  manufactured product prices by adjusting its level of support for DEIP.  However, economic efficiency would decrease to the extent that increased  use of DEIP induces additional production that would not have occurred  without the government program. Finally, in relation to federal costs, while  increased use of DEIP could increase federal costs for the program, these  increases might be offset by decreases in the costs of purchasing and  storing commodities under the price support program. Further, greater  competition for milk supplies used in manufactured products could  increase Class I prices, decreasing MILC payments while the MILC program  remains in existence.
Eliminating DEIP could lower U.S. market prices and increase government  costs, specifically for nonfat dry milk. For example, the May 2004 USDA  study estimated that exports of nonfat dry milk under DEIP account for  approximately 9 percent of total U.S. production. The study further found  that in comparison to just eliminating the price support program,  eliminating DEIP as well would reduce wholesale nonfat dry milk prices  another 5 percent below baseline levels. Under this scenario, the study  reported that for 2002 through 2007, farm income would decline by  approximately $5.3 billion and payments required under the MILC program  would increase by approximately $900 million. Therefore, while ending  DEIP would eliminate the costs of the subsidies provided by the program,  these cost savings could be offset by increased MILC expenditures. Also,  should DEIP be eliminated without eliminating the price support program,  there would be an increase in federal costs for purchases of commodities  that would otherwise have been exported.
The American Farm Bureau study reported that in the short term  eliminating DEIP would cause dairy products formerly exported under the  program to be commercially exported. However, the study found that over  the long term dairy product prices in the U.S. market would be too high  relative to world prices to allow formerly subsidized products to move as  commercially exported products. In the short term, a decline in the prices  of some manufactured products formerly exported under DEIP, such as  nonfat dry milk and cheese, would lower the blend prices farmers receive  which, in turn, would cause a decline in milk production. This reduced  production could cause butter prices to increase. However, the overall  effect is a decrease in both average milk prices and milk supplies. With  lower prices for some manufactured dairy products and higher prices for  others, consumer prices may rise or fall depending on the extent to which  these price changes are passed on by retailers. In other respects, the  elimination of DEIP could increase price volatility because USDA would  lose an outlet to help balance surplus production. However, the supply  adjustment could marginally increase economic efficiency as excess supply  is wrung out of the market. Further, to the extent that DEIP is providing  incentives for nonfat dry milk production rather than production of other  dairy products, elimination of these incentives would also marginally  increase economic efficiency.
section_title: Facilitate Risk Management for Dairy Farmers
paragraphs: The increased volatility in farm milk prices has increased dairy farmers’  interest in managing the risk that low prices will reduce farm incomes. Risk  management alternatives to stabilize dairy farmers’ incomes can take many  forms. These include, among others, increased use of forward contracting  to guarantee prices, such as through USDA’s Dairy Forward Pricing Pilot  Program; revenue insurance policies that pay farmers when dairy  proceeds fall below specified levels; and tax-deferred savings incentives  that encourage setting money aside during higher income years that could  be withdrawn during lower income years. Figure 41 shows the effects of  options to facilitate risk management under low- and high-price scenarios  over the short and long terms. ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?
subsections: section_title: Continue Dairy Forward Pricing Program
paragraphs: Forward contracting of milk—entering into a contract with a processor or  cooperative to sell milk in the future at a guaranteed price—is one way for  farmers to manage the risk that volatile prices create for their income.  Although forward contracting may prevent farmers from benefiting from  price increases, this risk management tool stabilizes their income and  ensures that the price they receive does not fall below the contracted price.  In this respect, forward contracting, like the MILC program, limits the  decline in farm income from a fall in farm milk prices.
Most, but not all, dairy cooperatives offer their members the ability to enter  into forward contracts to guarantee the prices members will receive for  their milk. One option that could allow dairy farmers to make more use of  forward contracting to manage their price risk would be to extend and  expand the Dairy Forward Pricing Pilot Program to cover Class I milk. The  program was mandated by the Congress in 1999 and is scheduled to expire  at the end of 2004. Under the pilot program, farmers are not allowed to  enter into forward contracts for Class I milk. However, if the program were  extended or made permanent, it could also be expanded to allow forward  contracting on all classes of milk.
The forward contracting pilot program offers farmers who sell to  proprietary processors an option to enter into fixed-price forward  contracts by providing processors with an exemption from paying the  otherwise required FMMO minimum prices. (Dairy cooperatives are  already exempt from paying the FMMO minimum prices.) Normally,  when either cooperatives or proprietary processors buy milk from farmers  under forward contracts, they can offset their risk that farm prices might  be lower at the end of the contract period (in which case they would pay  more for milk than their competitors who buy later at the lower price) with  a futures market transaction in which they would gain an amount  equivalent to the decrease in the farm price of milk. However, when  prices rise during the contract, the cooperatives or processors will lose  money on the futures market transactions and cannot afford to pay farmers  more than the contracted price. The pilot program encourages proprietary  processors to enter into forward contracts with farmers by exempting  these processors from having to pay farmers the relevant order minimum  price for the portion of their milk that is under forward contract. Without  this program, proprietary firms might not readily enter into forward  contracts because if they offset their risk of a price decline in the futures  market and the prices were to rise above the contract price, they might  have insufficient funds—including their futures market loss—to pay their  forward-contracted farmers the minimum price.
Some cooperatives have opposed proposed legislation that would make  permanent the authority for forward contracting by proprietary processors  on the grounds that allowing those processors to pay farmers less than the  minimum price could undermine the federal order pricing system.  However, one academic analysis of options to address price volatility  indicated that this exemption would not undermine the federal order  pricing system because while proprietary processors could pay farmers  less than the minimum price, these processors would still have to pay  minimum class prices into their federal order pools. Another  academician told us that even if allowing forward contracting on Class I  milk caused farmers to receive lower minimum prices in return for reduced  risk, neither that price reduction nor any other rationale would be a good  reason for not making fluid milk eligible for forward contracting by those  farmers who want to enter into such contracts.
In October 2002, USDA released a report that examined the performance  of the pilot program from its inception, in September 2000, through March  2002. The report found that the average monthly price received for milk  sold under forward contracts authorized by the pilot program was lower  than the average monthly price that would have been received for that  same milk if it had not been under contract by about $0.50 per  hundredweight, but that the variation in price for milk sold under forward  contracts was much less. At times the contract price exceeded the price  that would have been received without the contracts, and at times it was  lower. More recent USDA data show that the contract price exceeded the  price that would have been received without the contracts in each month  from April 2002 through July 2003, but for the remainder of 2003 the  contract price was lower. On average, for the entire period from April 2002  through December 2003, the contract price was about $1.40 per  hundredweight higher.
Participation in the program during the period covered by the USDA report  was relatively small and was concentrated most heavily in the Upper  Midwest Order, which has a low Class I utilization rate. More recent USDA  data show that participation remained relatively low through the end of  2003. Farmers in orders with high Class I utilization rates had less  opportunity to participate because Class I milk was ineligible, so it is  uncertain whether participation rates in those orders would have been  higher if farmers were allowed to enter into forward contracts for Class I  milk. One academic source also noted that even if the program were  expanded to include Class I milk, fluid milk processors might be reluctant  to engage in forward contracting for this milk because there is no good  hedge in the futures market for Class I prices. In addition, the USDA study  reported that participating farmers were generally more accustomed to  using risk management tools than were nonparticipants. Farmer education  on using forward contracting may be important to increase participation.
section_title: Provide Revenue Insurance
paragraphs: Another option to help dairy farmers manage their price risk is revenue  insurance. Revenue insurance allows farmers to protect themselves against  loss of revenue from, for example, low market prices, high feed prices, or  reduced production due to natural disasters. Revenue insurance can  stabilize farm income, reducing the need for direct payments such as under  the MILC program, during periods of low prices. Whether there would be a  savings to the government would depend on whether the subsidies required  to induce farmers to participate in the insurance program would offset the  savings from reduced direct income support. Overall production could  increase with this type of option because the revenue insurance would step  in when prices are low representing in effect, a countercyclical payment.  With this type of income support, downward supply adjustments during  periods of low prices might not happen as quickly. Consumers would then  benefit from prolonged periods of low prices to the extent that price  changes are passed through the retail level.
USDA’s Risk Management Agency currently operates several pilot  programs in selected states, using three different approaches to revenue  insurance. Although none of these programs applies to dairy farming, they  could, in theory, be extended to cover dairy farmers. Doing so could be  difficult, however, because the complexity of the dairy industry and the  variation in management expertise among farmers would make it hard to  estimate the probability of losses, a calculation that is necessary for pricing  the insurance.
section_title: Institute Tax-Deferred Savings
paragraphs: Tax-deferred savings accounts allow farmers to manage fluctuations in  farm income by accumulating cash reserves during higher income years  with deferral of some tax liability. Farmers could then withdraw from these  accounts in lower income years and, in essence, receive tax benefits if they  accumulated funds in these accounts. One study suggested that farmers  might be more comfortable with this risk management tool than with  forward contracting because these accounts resemble individual  retirement accounts and other familiar tax-deferred savings vehicles.
Similar to revenue insurance, this option has the potential for reducing  direct income support payments from the government, such as MILC  payments, by stabilizing farm income during periods of low prices.  However, whether these accounts worked as a risk management tool  would depend on whether the authorization of these new accounts—with  their tax benefits—led to substantial additional savings by farmers in  higher income years, or whether the new accounts were simply funded  with savings that would have been made anyway in other, not tax-favored,  accounts. Also, like revenue insurance, withdrawals from tax-deferred  savings would represent, in effect, countercyclical payments during  periods of low prices. Thus withdrawals from tax-deferred savings  accounts could maintain overall production by dampening supply  adjustments during periods of low prices. Similarly, consumers would  benefit from the prolonged periods of low prices to the extent that price  changes are passed through the retail level.
Many issues would have to be resolved to start this type of account, such as  the amount that farmers would be allowed to deposit in any year, whether  the government would match any funds deposited, and whether there  would be restrictions on farmers’ ability to withdraw funds from the  accounts based on price drops or income losses. Canada and Australia both  offer these accounts, and they were first proposed in the United States in  1996. Since then, there have been several proposals to adopt them here, but  none has been implemented.
section_title: Manage Raw Milk Supplies
paragraphs: According to one dairy expert, given the long-term declining demand for  fluid milk as well as the increasing productivity of dairy farmers, the best  way to maintain farm income is through some form of effective supply  management. Following periods of excess supply in the 1980s, the U.S.  government introduced supply management initiatives, such as the Dairy  Termination Program. Other options, such as production quota systems,  have been tried by different dairy-producing nations. Thus, a number of  options have been discussed to try to manage dairy supplies, including  reintroducing a program similar to the earlier Dairy Termination Program,  or establishing mandatory supply controls through quota allocations, as  has been done in other countries. Figure 42 shows the effects of options to  manage raw milk supplies under low- and high-price scenarios over the  short and long terms.
One option that has been discussed to manage milk supplies is to  reintroduce the Dairy Termination Program. This program was first tried  as part of the Food Security Act of 1985. Under the Dairy Termination  Program, farmers submitted competitive bids for the minimum raw milk  price per hundredweight for which they would be willing to comply with  the program requirements. If their bids were accepted, farmers were  required to sell for slaughter or export their entire herds and not participate  in dairying for the next 5 years. The program was in effect from April 1986  through September 1987 and resulted in the removal of more than 1 million  cows, or about 9 percent of the national dairy herd in 1985. In total, this  culling of the national dairy herd was estimated to decrease milk supplies  by about 39.4 billion pounds between 1986 and 1990 at a cost of more than  $1.8 billion. California farmers accounted for the largest portion of this  reduced production, but farmers in southeastern states had the highest  rates of participation.
In a 1989 report looking at the effects of the Dairy Termination Program,  we indicated that it was unlikely to have a lasting effect on milk  production, given that some participants would likely return to production  after the 5-year waiting period. In the short term, high market prices  resulting from lower levels of production reduced federal purchases of  surplus dairy products. In 1989, we estimated that these reduced purchases  provided a net cost savings to the government of $2.4 billion for fiscal years  1986 through 1990. However, over the long term, we predicted that  increased production would bring the return of excess milk supply.
The effects of reintroducing this supply management alternative would  depend on a variety of factors. In particular, the effects on federal costs and  milk production would depend heavily on how much farmers needed to be  paid to terminate their herds and agree not to produce for a specific period  of time. Farmers’ decisions about whether to participate in a new Dairy  Termination Program at a certain price would rest on the individual  profitability of dairy farms, the long-term production outlook of the  individual farmer, and the expectation of certain market conditions. For  example, with today’s high market prices, farmers may be unlikely to agree  to stop production except at payment levels that could make the program  prohibitively expensive. During low-price periods, the program could  potentially reduce supply to a level that reduces overall government costs  for both the price support program and the MILC program, as long as the  latter program remains in existence. In either case, the program would  likely increase price volatility and consumer prices, although higher  consumer prices for manufactured products could be mitigated by  additional imports. Given the fact that farmers in southeastern states had  the highest rate of participation in the Dairy Termination Program, a  reintroduction of this program is likely to strengthen western shifts in  production. As compared to western farmers, eastern farmers tend to have  lower profitability and higher costs of production. Consequently, they are  more likely to participate in this kind of program and less likely to return to  production after the program, because their re-entry costs are higher. Thus,  a new Dairy Termination Program could have disparate regional effects.
subsections: section_title: Establish a Production Quota System
paragraphs: A second option that has been discussed for supply management is to  implement a quota system, as has been done in Canada and in the  European Community. Under this option, production would be  controlled by allocating production shares, or quota shares, limiting how  much milk each dairy farmer could market. Such quota shares could be set  based on a farmer’s historical marketing level. Any milk marketed over the  allocated quota shares would be priced far below the cost of production.  Quota shares could be traded and increased over time as additional  supplies are needed.
A quota system would help manage supply by taking away incentives to  increase production based on the benefits provided by government  programs, such as MILC or the price support program. Moreover,  compared to other supply management alternatives, a quota system has a  greater likelihood of achieving long-term supply management, because  production incentives would continue to be limited by the number of quota  shares available in the system. With more effective supply management,  federal costs for other programs such as MILC and the price support  program would be reduced. Additionally, federal costs for administering a  quota system are relatively low. In the short term, price volatility might  increase, but as the market adjusts to a stabilized production level, long- term price volatility could be reduced.
Nonetheless, there are some drawbacks to implementing a quota system.  As quota shares reduced production, consumer prices could increase.  While demand for fluid milk products is relatively price inelastic, higher  prices could reduce long-term consumption by providing incentives to  purchase substitute goods. Also, the distribution of quotas would provide a  substantial benefit to current farmers to the detriment of farmers who  might try to enter the system in the future, entrenching geographical  production patterns and stifling incentives for technological  enhancements. Given the high production costs in some areas and the  greater efficiency of larger, newer dairy operations, this would represent an  economic inefficiency because milk would not be produced and marketed  as cheaply as possible. However, this drawback could be limited to the  extent that a well-functioning market is established to trade quota shares. If  participation costs in this market were kept low, farmers would still realize  incentives to adopt technology enhancements. The most efficient dairy  farmers’ willingness to pay for additional quota shares would represent  their cost advantage over less efficient farmers plus some assessment of  risk. To the extent that this willingness to pay was greater than the profits  realized by less efficient farmers, these less efficient farmers would have an  incentive to sell their quota shares to more efficient farmers. Thus, in the  long term, the quota system might not hamper increased economic  efficiency if trade is relatively easy.
section_title: Comments from the U.S. Department of Agriculture
paragraphs: The following are GAO’s comments on the Department of Agriculture’s  letter dated October 22, 2004.
subsections: section_title: GAO Comments
paragraphs: 1. We revised the report to reflect that farm prices during 2002 and 2003  were the lowest since 1979. 2. We revised the report to reflect that USDA has estimated that average  2004 farm prices will be more than $3 per hundredweight higher than  they were in 2003. 3. We agree that there are limitations on the use of commissary data as a  proxy for proprietary wholesale data. However, as noted in USDA’s  comments, there seems to be no viable alternative. We revised the  report to further discuss the limitations of using these data. 4. During the course of our work, USDA declined to provide us with a  draft of its study. Although USDA indicates that it submitted its study to  the Congress on September 10, 2004, we were unable to obtain a copy  until early October 2004, well after we had provided a draft of our  report to USDA for review and comment. Because of this timing, we  were unable to fully consider and analyze the results of USDA’s study  and related documents. Furthermore, although USDA notes that it  developed quantitative estimates of the effects on producers (dairy  farmers) and consumers and the cost of various federal programs  under various policy scenarios, the scope of USDA’s analysis was more  limited than the range of policy options discussed in our report. 5. We agree that the potential effects of various policy options in appendix  VII are examined independently and qualitatively within the existing  program structure. Our discussion of dairy policy options are not policy  recommendations. As stated in the report, to identify these policy  options and their potential impacts we relied heavily on a synthesis of  the views of leading dairy experts and the results of an extensive  literature search, including our review of more than 50 studies and  other publications. Time and resource constraints for completing our  work precluded us from developing or contracting for the use of an  economic model that would have provided quantitative estimates of  these potential impacts. In addition, some of the policy options would  have been difficult to model and quantify, such as the potential impacts  of accelerating USDA’s hearing and rulemaking process for amending  FMMOs. The report also notes that we compared the policy options  identified against a baseline scenario of policies in place as of August  2004. This baseline scenario existed at the start of our work and was  needed to provide a consistent context for our analysis. 6. Regarding caveats, as noted in the report, we examined the impact of  federal dairy program changes and policy options on six policy  considerations: farm income, milk production, federal costs, price  volatility, economic efficiency, and consumer prices. We acknowledge  in the report that other stakeholders may have different views on the  importance of these policy considerations or other considerations that  we did not include in our analysis. The report also states that the  potential effects of policy options on these considerations could vary  depending upon economic conditions and other policy decisions. In  this regard, we did not assess the options’ overall economic or  budgetary impacts, or their consistency with U.S. international trade  commitments or positions in ongoing negotiations. As indicated in the  report, each option has varying potential impacts on the policy  considerations used in our analysis. Despite these caveats, we believe  this analysis is informative and helpful to congressional decision  makers who must weigh competing interests in determining dairy  policy. 7. We have made some technical corrections and clarifications in light of  USDA’s comments, but we do not agree that we mischaracterized the  operation of current programs or the effects that changes to current  programs or the introduction of new programs would have on program  outlays, producers (dairy farmers), and consumers. See also our  responses in comments 8 through 19 below. 8. Although during the course of our work, USDA officials suggested that  it was possible that dairy farmers might divide their holdings to make  more of their milk eligible for compensation through the MILC  program, we deleted this discussion from the report in light of USDA’s  comment that it has no evidence that farmers have done this. 9. We correctly state in the report that farmers may choose the month that  they begin accepting their payments. However, in response to USDA’s  comment we revised the report to clarify that farmers’ discretion on  when they receive MILC payments is limited by USDA’s regulations for  implementing this program. Specifically, these regulations prohibit a  farmer from selecting a month to receive payments if the month has  already begun, if the month has already passed, or during which no  milk was produced. A farmer also cannot change a previously selected  start month after the 15th of the month before the month selected. Once  monthly payments begin, a farmer has no discretion in determining in  which month or months to receive payments. 10. The discussion of expanding the use of DEIP in the draft report did not  suggest that WTO rules, including quantitative and monetary caps and  product-specific restrictions, be violated. Rather, this discussion  identified ways in which dairy experts suggested that DEIP might be  used more effectively as a marketing tool. However, we have revised  the language in the report to more fully reflect USDA’s views and to  minimize confusion as to what we mean by increasing the use of DEIP  as a marketing tool without exceeding WTO caps. 11. We revised the language in the report to clarify that USDA has not  proposed or considered any proposal to eliminate the Dairy Price  Support Program. However, USDA analyzed the potential effects of  eliminating this program in the study it prepared in response to the  2002 Farm Bill mandate. 12. We agree with USDA that ensuring an adequate level of milk production  is not an objective of the FMMO program. We revised the report  accordingly and added language suggested by USDA to better describe  the FMMO program’s objectives. 13. We agree that price volatility contributes to disorderly market  conditions, and we revised the report to better explain the potential  causes of price volatility. We also agree that FMMOs cannot directly  address price volatility in wholesale dairy markets. However, by setting  minimum prices that must be paid to farmers for raw milk, the FMMOs  can affect the extent to which price volatility is reflected in the prices  that farmers receive. 14. We revised the report to reflect that cooperatives owning the capacity  to produce multiple products may still have an incentive to shift milk to  the higher-valued use, in order to provide greater returns to their  members. We also expanded our discussion of other factors that might  influence how milk is used, such as transportation costs and changes in  processing technology. 15. We acknowledge that the report does not explain how a competitive  pay price series could be created for use in the FMMO program.
However, this option was identified by stakeholders during the course  of our work. Other options discussed in the report also may present  challenging implementation issues and in many cases the report  discusses those issues. Nonetheless, we revised the report to reflect  that USDA and a panel of academicians attempted to devise a  competitive pay price series but ultimately were unsuccessful. We also  revised the report to note that a key difficulty in developing a  competitive pay price series is the need for data that are not already  influenced by the FMMO classified pricing system. 16. We acknowledge that the report does not explain how, after combining  Class III and Class IV, milk would be priced in the expanded class.  However, this option was identified by stakeholders during the course  of our work. Other options discussed in the report also may present  challenging implementation issues and in many cases the report  discusses those issues. Nonetheless, we revised the report to reflect  that a barrier to combining Class III and IV is identifying an appropriate  pricing formula that considers the products in an expanded class. 17. We revised the report to reflect this clarification and added language  suggested by USDA to better describe the FMMO program’s objectives. 18. We agree with USDA that any area’s supply of fluid milk can come from  local or distant farmers. USDA noted that the Class I price surface,  generated from different minimum Class I prices in different locations,  reflects the cost of moving milk from surplus to deficit markets.  However, as we pointed out in a 1988 report, when the price surface  does not also account for regional differences in production costs, it  can result in incentives for overproduction in certain regions.  Furthermore, the Class I price surface that resulted from the 2000  federal order reform differs from USDA’s recommended option. 19. The report accurately reflects the views of some stakeholders that the  slowness of USDA’s hearing and rulemaking process used to modify  FMMOs inhibits the agency’s ability to respond to changing market  conditions or the marketing of new products. The report also discusses  challenges USDA faces to improving this process while ensuring the  promulgation of economically sound regulation. Further, the report  notes that USDA has made efforts to improve the hearing process,  particularly in the way it evaluates its contracts for hearing transcripts.
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: Contacts
section_title: Acknowledgments
paragraphs: In addition to the individuals named above, Jay Cherlow, Barbara El Osta,  Joshua Habib, Eileen Harrity, Christopher Murray, and Cynthia Norris made  key contributions to this report. Important contributions were also made  by Beverly Ross, Jena Sinkfield, and Amy Webbink.
section_title: Related GAO Products
paragraphs: Dairy Industry: Estimated Economic Impacts of Dairy Compacts.  GAO- 01-866.  Washington, D.C.: September 14, 2001.
Dairy Industry: Information on Milk Prices and Changing Market  Structure.  GAO-01-561.  Washington, D.C.: June 15, 2001.
Fluid Milk: Farm and Retail Prices and the Factors That Influence Them.   GAO-01-730T.  Washington, D.C.: May 14, 2001.
Dairy Products: Imports, Domestic Production, and Regulation of Ultra- filtered Milk.  GAO-01-326.  Washington, D.C.: March 5, 2001.
Dairy Industry: Information on Prices for Fluid Milk and the Factors  That Influence Them.  GAO/RCED-99-4.  Washington, D.C.: October 8, 1998.
Dairy Industry: Information on Marketing Channels and Prices for  Fluid Milk.  GAO/RCED-98-70.  Washington, D.C.: March 16, 1998.
Dairy Programs: Effects of the Dairy Termination Program and Support  Price Reductions.  GAO/OCE-93-1.  Washington, D.C.: June 15, 1993.
Federal Dairy Programs: Insights Into Their Past Provide Perspectives  on Their Future.  GAO/RCED-90-88.  Washington, D.C.: February 28, 1990.
Milk Pricing: New Method for Setting Farm Milk Prices Needs to Be  Developed.  GAO/RCED-90-8.  Washington, D.C.: November 3, 1989.
Dairy Termination Program: An Estimate of Its Impact and Cost- Effectiveness.  GAO/RCED-89-96.  Washington, D.C.: July 6, 1989.
Milk Marketing Orders: Options for Change.  GAO/RCED-88-9.   Washington, D.C.: March 21, 1988.
Overview of the Dairy Surplus Issue—Policy Options for Congressional  Consideration.  GAO/RCED-85-132.  Washington, D.C.: September 18, 1985.
Effects and Administration of the 1984 Milk Diversion Program.   GAO/RCED-85-126.  Washington, D.C.: July 29, 1985.