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. 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. 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. 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.