Milk Pricing: Part 1
By: Helen Labun
What follows is a primer on how dairy pricing works in the Northeast and the logical framework behind it. It assumes that everyone involved is working rationally, trying to get the greatest good for the greatest number of people. That is a common economics policy assumption. It's not great for a plotline - where's the story without at least a little human weakness? - but if you want a good faith starting point for discussing what may, or may not, need to be done differently in the future, it’s a perfectly suitable approach. That isn’t to say that there aren’t many points along the way where reasonable people can differ - and through the wonders of digital publication everyone has the chance to skip off down diverging paths via links in the text.
PART ONE: The Framework for Dairy Pricing
Let’s say that you’ve decided to create the best possible pricing system for milk.
Let’s say, furthermore, that you’re in America and it happens to be the 1930’s, which is when our modern milk pricing system began.
In 1930’s America, you obviously have a lot on your mind, economics-wise, but in the world of dairy pricing there are a couple of big things. For one, the turn of the century brought a lot of change in transportation. Milk producers today are living separate from the biggest markets of milk buyers, and an intermediary, the milk handler, is connecting them. Those milk handlers come in a variety of forms, some bottling milk to sell to retailers, some selling on to processors to make into cheese and other items, some processing themselves. Even with the advent of refrigerated shipping and people to expedite milk’s journey through this system, milk is still perishable, and cows still produce it every day - no one has invented a switch to turn them on and off like a creemee machine. There’s a time constraint that gives the handler a whole lot of power over the producer, big problem number one. Compounding this problem is a serious concern about getting Americans enough nutritious food. It’s the 1930’s, well before modern era food security measures, the Great Depression has made the fragility of the food system clear, in a few years the U.S. will need to start food rationing as WWII begins. There is no assumption of abundance. So you’re thinking about not only the plight of the dairy farmer but also the plight of the entire food system because you need milk available throughout the country to keep people well nourished.
The central problem in all of this is that there’s a small group of people (handlers) controlling milk without necessarily being public minded about getting the best outcome for everybody (farmers and consumers). [What if the handler system is set up with farmers’ interests in mind?] As a publicly minded person yourself, you see trouble ahead. In a perfect microeconomic world, sellers would offer a commodity like milk at a starting price and if it’s a little high some consumers will decide it’s too expensive and not buy it, leaving extra milk -- if it’s a little low then more consumers will want it but fewer sellers will be attracted to sell, leaving not enough milk. All these pieces will shift around until you hit a balance point, the price at which supply equals demand. This shifting would happen at each link in the chain from farmer to consumer, so that the price signal of what the final consumers are willing to pay works its way back to the farmers and tells them how much to produce. If the handlers hold milk prices artificially low for the farmer, even if they charge a fair price to consumers, that takes the market out of balance and the handlers pocket the difference.
A perfectly balanced market is sort of like a perfect marriage; it doesn’t exist, but many people believe that it’s worth striving for and they put forward many philosophies regarding how to get there. The philosophy chosen by the federal government for getting closer to balance in milk markets was to regulate the prices that milk handlers pay farmers for their milk by setting minimums. And it’s that particular intervention point that becomes the regulatory world of the Federal Milk Marketing Orders (FMMO). [What if the intervention included milk supplies?]
Okay, so the solution is going to be controlling the prices paid to farmers for their milk. Which begs the obvious question - if you aren’t relying on a free market to determine that price, what will you rely on?
Even if you’ve never been a milk handler in 1930’s America, some of the factors that determine the price you’ll pay are concepts that will look familiar to the average grocery shopper. What you’re willing to pay depends on quality, what you’re using the milk for, and where you're located (Far away from milk? Where there's lots of milk? On an island in the middle of the Atlantic Ocean?). There are ways to back up a few steps in market transactions and answer these types of questions to get to the bigger question of what constitutes a fair price to be paid by handlers.
We’re talking about commodity milk - in other words it’s fungible, there is no craft beer of milk sneaking in here to send everyone into a tizzy of desire. Even a commodity, though, will have different characteristics; this is not precision manufacturing, this is cows. There’s variability in factors like butterfat content or somatic cell count (an indicator of inflammation in the udder).
One way to manage these differences is to simply not manage them - you’re setting a baseline, if a buyer wants certain qualities in their milk, they can pay a premium above the baseline price to attract sellers of that milk (what becomes an Over Order Premium). [Where do organic qualities fit in here?] Another way is to price not just milk itself but its components - fat, protein, and solids such as lactose. These elements vary between herds, sometimes significantly, and are considered the most relevant qualities when you look at how milk is used in manufacturing. We’ll skip from 1937 to 2018 here because today we have the technology to easily test each farm’s milk for these components and pay a set price for each of them. This third party testing is one function of the FMMO. In Vermont, farmers will get paid based on the component parts of their milk and those component prices are set based on what's happening in the wholesale markets (we'll explain more in Part 2).
What Milk Is Used For - Milk Class
The question of what milk will be used for divides milk into classes. Today we have four classes:
Class I: Fluid milk, which includes flavored milk, eggnog, and buttermilk.
Class II: Milk used for soft products like yogurt, cream, and ice cream.
Class III: Milk used for hard cheeses and cream cheese.
Class IV: Milk used for butter and dry products.
Each class gets its own assigned price.
One of the original goals, let's remember, was distributing the highly perishable beverage milk in a timely fashion to get it to market. Class I gets a premium price to incentivize that movement. Note that it’s the final use destination that makes this milk Class I (or II, III or IV) and determines this value. Premiums for what is in the milk (the previous section) get paid as part of the component pricing or as added premiums by the handler; class premiums reflect a priority for getting milk into Class I use first. If we decided we needed to incentivize ice cream making over all else, a Class II premium would go in here. And so on.
Location matters a great deal. In a fundamental sense it determines what FMMO you’re in - if any. Vermont is in the Northeast Marketing Area. In theory the regions combined in the Northeast FMMO have a comparable market - the Boston, New York, Philadelphia market. The FMMO’s have changed considerably over time, responding to a variety of factors including changes in transportation technology. They hit a high of 60 in the 1960s, and through reforms have dropped to 10. Some places don’t belong to any FMMO. States can also set up their own version of a milk marketing order within state borders - California and Maine have done so, although California has petitioned to enter the FMMO system. However, states cannot band together to regulate milk if, for example, the farmers are in one state and the processors are in another because that interferes with interstate trade - a federal issue [What if Congress grants permission to work together?]
The second geography is managed by county - every county gets assigned a differential that’s calibrated to the location where milk prices are set (aka where the customers are), in our case that location is Boston. With this differential Boston gets the highest number, counties progressively further away lower ones, and the difference goes towards transporting the milk to where it’s ultimately needed.
One thing to notice here, and in the math that’s about to happen, is a disparity in how quickly numbers change. Some of the numbers we’re about to look at are tied to financial markets that change constantly. Other numbers, like this location differential, are calculated and assigned. . . and then things start to move at the pace of government bureaucracy. That pace has its own ponderous beauty, but nonetheless leaves us with a location differential set in 2000 that remains the same in 2018.
Shall we get to some fast-paced numbers? Or as fast-paced as this is going to get? Okay, then it’s time for Part 2.
Notes from the Text
What if the handler system is set up with farmers’ interest in mind?
There are some relatively common ways to set up milk handlers with farmers’ interests explicitly part of the framework, and these are exempt from full price regulation. If a farm is purchasing and processing its own milk, a farmstead cheesemaker for example, then it can be fully exempt. Dairy farmer cooperatives are partially exempt, as they are owned by the farmers themselves who have a voice in how their milk is priced (although in practice most cooperatives in the Northeast take part fully in the Federal Order System). Some cooperatives fully manage some or all of their milk, processing it and bringing it to the retail customer, while others negotiate on behalf of their members with larger dealers. Cooperatives are part of the milk pool for handlers. This means their data goes into price setting, and they are also part of the Producer-Settlement Fund. This fund is a system of payment that, among other things, equalizes payments so that Cooperatives aren’t penalized for being processors, directing their members’ milk into a use like making butter (while the system wants to incentivize perishable fluid milk making it to market in time, it doesn’t want to over incentivize and pull in more fluid milk than the market wants to purchase). Cooperatives are not required to meet the minimum prices set by the FMMO. Nonetheless, because those minimum prices are fully public they are indirectly governed by them, since dairy farmers would know if they received sub-standard prices. As a side note, this price floor also means the businesses buying dairy from the cooperatives know the price floor and how much margin is being added - something which can become an issue for cooperatives looking to pay their members premiums. This type of Transparency Catch-22 will come up again when we look at contracting in Part 2.
What if that intervention included milk supplies?
Regulating supply is a small footnote here, but a big deal in the real world. Some countries, notably our Canadian neighbors, practice supply management - which limits the amount of milk on the market. Supply and demand will almost never equal each other naturally. Dairy farming has a lot of sunk costs and a lot of lag time between deciding to change output and actually getting that volume to change - in other words, supply changes slowly for both economic and biological reasons. Furthermore, the biological trend is upwards - more milk per cow. Setting a cap on volume of milk production prevents the price from being spiked downwards by oversupply; on the reverse side if the volume is set too low, it leads to inflated consumer prices.
Supply management happens in different ways. You can exercise soft management by setting a very low price on milk produced beyond a certain volume to disincentivize, but not prohibit, the extra supply. You can also impose quotas where each farm is assigned the amount of milk they’re allowed to sell. Notable about quotas is that it creates a second market, the market for selling the right to sell milk - those transactions allow for expansion and contraction in each business. Canada uses quotas that are layered on top of price minimums, which are set by an industry group based on costs of production and what is deemed a fair margin for dairy farmers. Without quotas, a farmer who had at or below the estimated cost of production would have little disincentive to continuously expand production since the return is guaranteed. Another important element of this quota-based supply management is that it only works if you also manage supplies coming in from beyond your borders, something which has been a point of contention between Canada and the U.S.
A corollary to lack of supply management is what happens when you have nowhere else to move the extra milk? It can go into powder to store for longer, but even that has its limits. When supplies get too much, an FMMO can grant permission to dump milk. Needless to say nobody likes this result. One issue raised in the current Farm Bill debates is the difficulty in donating excess supply - something that happens in other food businesses, but which is currently hindered by the narrow regulatory focus on making a sale as a part of “proper” milk handling.
Where do organic qualities fit in here?
Organic milk is not exempt from the FMMO. “Organic” is considered an over order premium. Some in the organic industry argue that that is unfair. Yes, organic designation does include a price premium but it also affects whether units of milk are interchangeable. Organic milk can go into the conventional milk stream if needed, but conventional milk cannot be sold as organic. Furthermore, the demand for organic milk is not distributed across product types in the same way as conventional milk - for example, demand for fluid milk and milk for making soft cheese products like yogurt is proportionally much higher. Some conventional dairy businesses argue that keeping organic in the pool is important because when organic milk gets sold into the conventional market, it’s usually as the premium fluid milk, pushing other milk into lower priced manufacturing categories and affecting everyone’s milk prices. Because the handlers’ pooling system is supposed to even out these disruptions, the argument is that organic should stay. It remains an open question.
What if Congress grants permission to work together?
In 1996, Congress granted the New England states permission to form the Northeast Interstate Dairy Compact for the purposes of setting a floor price for Class I fluid milk. Representatives from each state, including consumer representatives, set this floor at $16.94 cwt. The primary objection to the Compact was that it would cause price inflation and harm consumers (the degree and impact of such inflation was disputed). The Compact expired September 30, 2001 and failed to be renewed in the 2002 Farm Bill. The 2002 Farm Bill instead introduced a Milk Income Loss Contract program (MILC) that subsidized all farmers if the Boston price fell below $16.94 (adjusted for feed prices), but did not give states power to work collectively on pricing floors for their region. The MILC program ended in 2014, replaced by another program designed to compensate farmers when the margin between average national milk prices and average national feed prices fell too low. This Dairy Margin Protection Program remains in effect.