Federal Dairy Programs: Information on Dairy Pricing and Related 1995
Farm Bill Issues (Briefing Report, 03/27/95, GAO/RCED-95-97BR).

Pursuant to a congressional request, GAO provided information on the
dairy program, focusing on: (1) how the U.S. dairy pricing system
operates; and (2) dairy issues that may need consideration during the
1995 farm bill reauthorization.

GAO found that: (1) the U.S. dairy program sets minimum milk prices
through milk marketing orders (MMO) and the price support program; (2)
processors, not the federal government, pay farmers for milk; (3) 38
voluntarily adopted MMO cover 80 percent of U.S. Grade A milk
production; (4) MMO prices are based on geography and product classes;
(5) higher raw milk prices for Class I and II products are based on the
price for Class III products; (6) the free-market price for Grade B
milk, which is not covered by MMO, determines the price for Class III
products; (7) the price support program acts as a floor price for
commercial milk sales; (8) because the dairy program's market
environment has changed substantially since its inception, the program's
components may be unnecessary today; and (9) two issues that need
consideration during the farm bill reauthorization are the outdated
premises for pricing milk under MMO, which lead to excessive milk
production and inequitable producer prices, and price supports' creation
of barriers to a more market-oriented dairy industry.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  RCED-95-97BR
     TITLE:  Federal Dairy Programs: Information on Dairy Pricing and 
             Related 1995 Farm Bill Issues
      DATE:  03/27/95
   SUBJECT:  Dairy industry
             Dairy products
             Farm income stabilization programs
             Price regulation
             Commodity marketing
             Price supports
             Agricultural production
             Agricultural policies
             Food supply
             International trade
IDENTIFIER:  USDA Milk Marketing Order Program
             USDA Dairy Price-Support Program
             
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Cover
================================================================ COVER


Briefing Report to the Chairman, Committee on Agriculture, Nutrition,
and Forestry, U.S.  Senate

March 1995

FEDERAL DAIRY PROGRAMS -
INFORMATION ON DAIRY PRICING AND
RELATED 1995 FARM BILL ISSUES

GAO/RCED-95-97BR

Dairy Pricing and Related 1995 Farm Bill Issues


Abbreviations
=============================================================== ABBREV

  CCC - Commodity Credit Corporation
  GAO - General Accounting Office
  USDA - U.S.  Department of Agriculture

Letter
=============================================================== LETTER


B-260216

March 27, 1995

The Honorable Richard G.  Lugar
Chairman, Committee on Agriculture,
 Nutrition, and Forestry
United States Senate

Dear Mr.  Chairman: 

In deliberations on the 1995 farm bill, the Congress will again be
considering the policy for and changes to the U.S.  dairy program. 
To aid congressional consideration of the dairy program, you asked us
to provide information on (1) how the U.S.  dairy pricing system
operates and (2) dairy issues that may need consideration when the
farm bill is reauthorized in 1995.  We briefed your office on this
request on March 23, 1995.  This briefing report summarizes the
information presented in that briefing. 


   BACKGROUND
------------------------------------------------------------ Letter :1

The U.S.  dairy pricing system was created over 50 years ago to
ensure adequate milk supplies, stable prices for consumers, and
economic stability for producers.  The pricing system is carried out
by two federal dairy programs administered by the U.S.  Department of
Agriculture (USDA):  the Milk Marketing Order Program and the Price
Support Program.  Federal milk marketing orders specify practices,
terms and conditions of sale, and prices.  Each order contains two
basic sets of provisions.  One set fixes the minimum prices that milk
processors must pay.  The other set specifies how the returns for
selling milk are to be distributed among producers. 

Federal market orders are voluntary--producers must choose by a
two-thirds vote to have a market order apply to their specific
regional area of the country before it becomes effective.  Market
orders apply only to milk eligible for fluid use. 

Under the federal price support program, USDA stands ready to buy, at
designated prices, bulk cheese, butter, and nonfat dry milk that are
offered to it for sale.  Federal outlays for these purchases depend
on the extent to which milk production exceeds commercial purchases. 
Assuming a relatively stable commercial demand for dairy products,
high support prices generally lead to high milk production, which
leads to surpluses and more government purchases. 

Milk is the only commodity with both order pricing and price support
programs, resulting in one of the most complex agricultural support
programs.  The dairy industry, however, has changed significantly
since federal involvement in it began, and the milk marketing order
and price support programs have contributed to incentives to produce
more milk than can be marketed, causing periodic surpluses of dairy
products.  As a result, government costs grew to over $2.7 billion in
fiscal year 1983.  Since that time, the Congress has taken a number
of actions to reduce government costs and to make the dairy industry
depend less on federal financial support and involvement.  However, a
basic understanding of how the current pricing system works and the
impact it has on this industry in today's environment can assist
discussions on dairy pricing issues. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

The federal dairy program is built around the establishment of
minimum prices paid to milk producers and dairy processors.  Milk
marketing orders set minimum prices that processors must pay dairy
farmers for Grade A milk, which is the only milk used for fluid milk
products.  These orders, entered into voluntarily by dairy farmers,
regulate about 72 percent of all milk produced in this country.  The
remaining 28 percent falls under state orders or is not regulated at
all.  In addition, the price support program sets prices for
processors' sale of dairy products to the federal government; these
prices tend to act as a minimum price for dairy products in the
commercial market. 

The market environment in which federal dairy programs operate has
changed dramatically since their inception.  The program components
that were necessary in previous decades may be unnecessary today.  In
this context, two issues we have previously reported on could be
addressed by the Congress as it considers federal dairy policy during
the reauthorization of the farm bill in 1995.\1 First, the premises
for pricing milk under federal milk marketing orders are outdated and
have resulted in both excess production and the unfavorable treatment
of some producers.  Second, the dairy price support program creates
barriers to the U.S.  dairy industry's becoming more market-oriented
to maintain its viability.  For example, the U.S.  dairy industry has
not developed the marketing mind-set necessary to take full advantage
of the potential opportunities for expanding the international market
for dairy products.  Instead, it has adapted to the existing federal
support environment, including import restrictions, and emphasized
domestic commercial sales and sales to the federal government under
the price support program. 

This report has two sections--section 1 describes how the dairy
pricing system operates with its two federal programs, and section 2
summarizes two previously reported dairy issues that may need
consideration during the 1995 farm bill deliberations. 


--------------------
\1 Milk Marketing Orders:  Options for Change (GAO/RCED-88-89, Mar. 
21, 1988) and Dairy Industry:  Potential for and Barriers to Market
Development (GAO/RCED-94-19, Dec.  21, 1993). 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :3

To address the briefing objectives, we relied primarily on GAO
reports that examined federal dairy programs.  (See Related GAO
Products.) We also obtained information from and discussed our work
with officials from USDA's Economic Research Service, Agricultural
Marketing Service, and Consolidated Farm Service Agency.  In
addition, we reviewed reports in USDA's Dairy Market News and the
Dairy Situation and Outlook series.  We did not obtain written agency
comments on this report. 


---------------------------------------------------------- Letter :3.1

We are sending copies of this briefing report to the Secretary of
Agriculture.  We will also make copies available to others on
request.  Please contact me at (202) 512-5138 if you or your staff
have any questions about this briefing report.  Major contributors to
this briefing report are listed in appendix I. 

Sincerely yours,

John W.  Harman
Director, Food
 and Agriculture Issues


BRIEFING SECTION 1 HOW THE DAIRY
PRICING SYSTEM OPERATES
============================================================== Letter 



   (See figure in printed
   edition.)


   BACKGROUND
------------------------------------------------------------ Letter :4

Federal involvement in the dairy industry began in reaction to
unstable marketing conditions and low milk prices before and during
the Great Depression.  During this time, consumers purchased fewer
dairy products, and milk production began to exceed consumption. 
This situation resulted in lower milk prices for farmers and
contributed to unstable market conditions.  In response to these
conditions, the Congress initiated the U.S.  dairy pricing system to
ensure adequate milk supplies and stable prices for consumers while
providing economic stability for producers. 

In addition, the pricing system attempts to provide some market
stability throughout the year.  Americans buy milk in fairly constant
quantities throughout the year, but milk production is more seasonal
than consumption.  Most milk is produced in spring and early summer,
while the least amount is produced in late fall.  In addition,
because fluid milk is highly perishable and subject to bacterial
contamination, it must be handled under sanitary conditions, and
marketed quickly.  Milk not consumed in fluid form must be processed
into manufactured products to prevent loss.  Thus, ensuring an
adequate but not excessive supply of milk can be a complicated task. 

The U.S.  dairy pricing system is made up of two interrelated federal
programs:  the Milk Marketing Order Program and the Price Support
Program.  Before discussing these programs, a brief description of
the flow of dairy products and the flow of dairy revenues within the
industry



   (See figure in printed
   edition.)


      DAIRY PRODUCERS SELL MILK TO
      PROCESSORS
---------------------------------------------------------- Letter :4.1

In the dairy industry, producers sell their fluid milk to processors,
including cooperatives, that manufacture dairy products.  Eighty
percent of all milk is produced by members of dairy farmer
cooperatives.  Many of these cooperatives own and operate dairy
manufacturing and bottling plants that process milk produced by their
farmer members.  Processors, in turn, sell their products in the
commercial market or to the federal government at specified



   (See figure in printed
   edition.)


      PRODUCERS RECEIVE PAYMENT
      FROM PROCESSORS, NOT
      GOVERNMENT
---------------------------------------------------------- Letter :4.2

Revenues generated by commercial and federal sales are the sources of
funds that processors use to pay producers for their milk.  No
federal funds go directly from the federal government to milk
producers for the sale of dairy products. 

The objectives of federal dairy policy have been to support farmers'
prices and incomes, expand consumption, ensure an adequate supply of
good-quality milk, and stabilize dairy prices and markets.  The
policy is carried out principally through two interrelated
programs--the Milk Marketing Order Program, created in 1937, and the
Price Support Program, created in 1949.  While the Congress has
adjusted these two programs periodically, they remain the principal
means of regulating the dairy industry.  The Congress has also
implemented import controls to help



   (See figure in printed
   edition.)


   FEDERAL MILK MARKETING ORDERS
   ESTABLISH THE MINIMUM PRICES
   THAT PROCESSORS PAY PRODUCERS
------------------------------------------------------------ Letter :5

Within the United States, 38 federal marketing order areas cover 80
percent of the country's Grade A milk production.  Federal marketing
orders are administered by the U.S.  Department of Agriculture (USDA)
and are voluntarily adopted by dairy producers within a specific
regional area. 

This section describes how milk marketing orders establish the
minimum prices that processors must pay producers for Grade A
milk--milk that is of high enough quality to be used for fluid
consumption.  Overall, market order prices are based on how the milk
is used in each



   (See figure in printed
   edition.)


      MOST MILK PRODUCED IN THE
      UNITED STATES IS GRADE A
---------------------------------------------------------- Letter :5.1

Milk produced in the United States is designated as either Grade A or
Grade B.  States establish Grade A and Grade B production standards. 
Grade A is produced under higher sanitation standards and is the only
type of milk that can be used for fluid consumption; however, Grade A
milk can also be used for the production of other products.  Its
prices are generally higher than Grade B prices. 

Grade B milk can be used only for the production of hard dairy
products--nonfat dry milk, cheese, and butter. 

About 42 percent of Grade A milk is used for fluid consumption.  The
remaining 58 percent is used for both



   (See figure in printed
   edition.)


      MARKETING ORDERS SET MINIMUM
      PRICES FOR GRADE A MILK
---------------------------------------------------------- Letter :5.2

Marketing orders regulate only Grade A milk and establish the minimum
prices processors must pay producers for this milk.  Federal milk
marketing orders intervene in the pricing system between the
processor and the dairy producer for



   (See figure in printed
   edition.)


      MARKETING ORDERS CLASSIFY
      GRADE A MILK
---------------------------------------------------------- Letter :5.3

Minimum prices for Grade A milk are established through three basic
classes on the basis of how the milk is used in end products: 

Class I milk, which is sold for fluid consumption, generally receives
the highest price.  This class includes whole milk, low-fat milk,
skim milk, milk drinks, and buttermilk. 

Class II soft products include ice cream, cottage cheese, and yogurt. 

Class III hard products include cheese and butter.  Recently, a
separate Class IIIA was established for nonfat dry milk, which is a
co-product of butter production.  The Class IIIA price for nonfat dry
milk was added to the pricing system in 1993 and is below



   (See figure in printed
   edition.)

The federally established Class III price is the basis for setting
the class II and class I minimum prices within the milk marketing
order pricing system.  It is based on a monthly survey of milk prices
paid by processors in Minnesota and Wisconsin that purchase Grade B
milk.  Grade B milk is not covered by federal orders, and its price
is basically determined by market



   (See figure in printed
   edition.)

Class II prices are slightly higher than class III prices, are
determined by a federal formula, and average about 15 cents per
hundredweight\2

--------------------
\2 Hundredweight is a measure of milk equating to about 11.6 gallons
With the exception of some western states, including Arizona, Idaho,
Oregon, Utah, and Washington, Class I prices are also based on the
Class III price and include three components--(1) the Class III price
plus (2) a Grade A differential of $1.04 per hundredweight plus (3) a
distance differential of about 15 cents per hundredweight for every
100 miles that a processor is from Eau Claire, Wisconsin.  The Grade
A differential was established to encourage adequate production of
Grade A milk for fluid consumption throughout the United States. 
When a national pricing system was established in the 1960s, the
Upper Midwest was considered the nation's primary milk surplus
region.  Distance differentials were intended to represent the cost
of transporting milk from surplus milk-producing areas to deficit
areas to avert shortages that might develop otherwise.  They were
established to encourage Upper Midwest producers to ship milk
elsewhere when Because of the Class I distance differential, Class I
milk prices vary by location.  Generally, locations that are further
away from Eau Claire, Wisconsin, receive higher Class I
utilization--fluid consumption--tends to vary by area.  For example,
about 20 percent of the Upper Midwest's production, including
portions of Minnesota and Wisconsin is used for fluid consumption; in
contrast, over 90 percent of southern Florida's production is used
for After establishing milk classes, and the prices per class, each
order must determine how it has used milk by class in determining how
much to pay its producers.  Each of the 38 marketing order areas
calculates a monthly average or "blend" price to be paid to producers
that is based on the class utilization rates for that marketing area. 
This blend price becomes the minimum price that processors must pay
producers for milk in each of the As this hypothetical case shows,
the blend price is equal to the percentage utilization for each class
times the respective class price.  The total of the three classes
Because of differing class utilization rates and differing Class I
distance differentials, blend prices differ by marketing area.  As
shown above, Florida uses a much larger portion of the milk produced
in this order for Class I usage as compared to Eau Claire.  Because
Class I dairy products are guaranteed a higher price, the average A
MINIMUM PRICE FOR GOVERNMENT PURCHASES The milk price support program
helps ensure dairy farmers a minimum price for the milk they produce. 
Under the program, the USDA, through its Commodity Credit Corporation
(CCC), must purchase at specified prices all quantities of butter,
cheese, and nonfat dry milk (Class III products) that are offered and
meet USDA's specifications.  Such purchases reduce excess supplies of
dairy products on the commercial market and help maintain the minimum
price farmers receive for milk.  In general, the program's costs
depend upon the degree to which milk production exceeds commercial
use.  The larger the surplus, the more dairy products the federal
government purchases as a Minimum Price for Commercial Sales By
mandating that the federal government purchase all hard products
offered to it for sale at specified prices, the price support program
acts as a floor price for sales to the commercial market.  That is,
if the commercial market price falls to or below the support price
level, processors will start to sell to the federal government
because they can obtain an equivalent or better price.  Recently,
federal purchases have been about 5 percent of dairy sales by
processors--about 5 percent of all sales are to the federal
government and about 95 percent are sales to the commercial sector. 
BRIEFING SECTION 2 REAUTHORIZING THE FARM BILL IN 1995 FEDERAL DAIRY
PRICING POLICIES This section describes two issues GAO has previously
reported on that have developed because (1) milk marketing orders are
considered outdated and create pricing inequities and (2) the dairy
industry faces the need to become more market-oriented. 

\3 Milk Marketing Orders:  Options for Change (GAO/RCED-88-89, Mar. 
21, 1988) and Dairy Industry:  Potential for and Barriers to Market
Development (GAO/RCED-94-19, Dec.  21, 1993). 


   CURRENT ENVIRONMENT RAISES KEY
   ISSUES ABOUT AS WE HAVE NOTED
   IN PREVIOUS REPORTS,\3 THE
   ENVIRONMENT THAT LED TO THE
   CREATION OF THE DAIRY PRICING
   SYSTEM HAS CHANGED AND THE
   PREMISES FOR MILK PRICING UNDER
   FEDERAL ORDERS ARE OUTDATED. 
   MILK MARKETING ORDERS WERE
   CREATED IN PART TO ENCOURAGE
   AND MAINTAIN A LOCALLY PRODUCED
   SUPPLY OF GRADE A MILK.  AT
   THAT TIME, TRANSPORTING FLUID
   MILK WAS DIFFICULT BECAUSE THE
   NECESSARY TECHNOLOGIES TO AVOID
   SPOILAGE--REFRIGERATION AND
   RECONSTITUTION--DID NOT EXIST. 
   FURTHERMORE, THE TRANSPORTATION
   INFRASTRUCTURE WAS NOT
   DEVELOPED ENOUGH TO MAKE LONG
   HAULS FEASIBLE.  LIKEWISE, WHEN
   THE ORDER SYSTEM WAS
   ESTABLISHED, THE FEDERAL
   GOVERNMENT PROVIDED INCENTIVES
   FOR PRODUCERS TO UPGRADE THEIR
   FACILITIES TO MEET THE HIGHER
   SANITATION STANDARDS FOR FLUID
   MILK (GRADE A MILK).  SINCE
   THESE PROBLEMS HAVE LONG SINCE
   BEEN RESOLVED, THE RATIONALE
   FOR THE PRICING INEQUITIES
   CREATED BY THE MARKETING ORDER
   SYSTEM MAY NEED TO BE
   RECONSIDERED. 
------------------------------------------------------------ Letter :7

At the same time, the Price Support Program has contributed to the
U.S.  dairy industry's placing more emphasis on production than on
marketing.  As a result, the industry is not taking full advantage of
an expanding



   (See figure in printed
   edition.)


   MARKETING ORDERS CAN RESULT IN
   PRICING INEQUITIES
------------------------------------------------------------ Letter :8

Initially, the distance differential was established to make it
profitable for surplus milk-producing areas like the Upper Midwest to
ship milk to deficit milk-producing areas if necessary.  Since that
time, however, the distance differential has served as an incentive
for some of the historically deficit milk-producing areas to increase
their production capacity.  Some of these areas have now become
surplus milk-producing areas.  As a result, the distance differential
has produced a regional price structure that in some cases bears no
relationship to regional variations in the cost of production or to
the cost of obtaining supplies from alternative sources. 

Also, higher distance differentials in several regions of the United
States encourage additional production, and at times surpluses, by
guaranteeing higher milk prices and higher profits to producers in
some regions at the expense of producers in other regions.  This
incentive is particularly strong in the Southwest, once a deficit
milk-producing area, because its production costs are less than the
Upper Midwest's.  According to dairy industry sources, Southwestern
producers sometime transport surplus milk as far as the Upper Midwest
to find dairy plants with available processing capacity because
processing plants are either operating at full capacity or are not
available in the Southwest.  As a result, the increased shipments of
lower-cost milk to the Upper Midwest processor plants decreases milk
prices paid to Upper Midwest producers. 

Additionally, the grade A differential, originally created to provide
farmers with financial incentives to produce Grade A milk, is far
higher than the additional costs of producing Grade A milk rather
than Grade B milk.  According to a 1986 study, the added cost is no
more than about 15 cents per hundredweight, while the current price



   (See figure in printed
   edition.)


   A MORE MARKET-ORIENTED APPROACH
   MAY HELP INDUSTRY EXPAND
   INTERNATIONAL MARKETS
------------------------------------------------------------ Letter :9

The dairy industry is not taking full advantage of what could be an
expanding international market for dairy products.  Although the
United States is the world's third largest producer of milk, it plays
a relatively small role in most foreign dairy markets, exporting only
about 1 million out of 68 million milk-equivalent metric tons of U.S. 
domestic milk annually. 

By comparison, New Zealand, which provides little or no subsidies to
its farmers, is a major player in international dairy markets. 
According to industry studies, the U.S.  dairy industry has
opportunities to develop and expand markets.  Exports to Mexico and
the Pacific Rim countries, particularly, appear to offer the greatest
potential for new market development and expansion because of their
growing economies, current low level of dairy consumption, and
changing diets and eating habits. 

Two major interrelated factors have hindered the U.S.  industry from
more effectively expanding and competing in global markets.  The
price support program encourages the production of dairy products
that do not always meet customers' demand and often results in U.S. 
prices that exceed world prices.  The U.S.  dairy industry has placed
more emphasis on production than on marketing and has not developed a
marketing mind-set that focuses on global consumers' preferences. 
Instead, it has emphasized domestic commercial sales and sales to the
federal



   (See figure in printed
   edition.)

The United States is a major player in world dairy production,
ranking third after the European Community and



   (See figure in printed
   edition.)

While the U.S.  dairy industry is a major producer, it plays a
smaller role in dairy export markets, ranking far behind other major
industrialized countries.  New Zealand, for example, exports
approximately 50 percent of its dairy production, while the United
States exports only



   (See figure in printed
   edition.)

Although Mexico borders the United States, the United States provides
only one-fourth of Mexico's cheese imports.  In contrast, the
European Community, which has significantly larger shipping costs,
accounts for nearly one-third of all Mexican cheese imports. 

   Note:  For presentation
   purposes, Western Europe
   comprises the non-EC countries
   of Austria, Finland, Norway,
   Sweden, and Switzerland.

   (See figure in printed
   edition.)


MAJOR CONTRIBUTORS TO THIS
BRIEFING REPORT
=========================================================== Appendix I

RESOURCES, COMMUNITY, AND ECONOMIC
DEVELOPMENT

Luther L.  Atkins, Jr., Assistant Director
Patrick J.  Kalk, Project Leader
Carol Herrnstadt Shulman, Communications Analyst
Lynne L.  Goldfarb, Publishing Adviser

KANSAS CITY REGIONAL OFFICE

Sheldon H.  Wood, Jr., Evaluator
Dale A.  Wolden, Evaluator
Frederick C.  Light, Evaluator
Thomas M.  Cook, Evaluator

RELATED GAO PRODUCTS

Dairy Industry:  Potential for and Barriers to Market Development
(GAO/RCED-94-19, Dec.  21, 1993). 

Federal Dairy Programs:  Insights Into Their Past Provide
Perspectives on Their Future (GAO/RCED-90-88, Feb.  28, 1990). 

Milk Pricing:  New Method for Setting Farm Milk Prices Needs to Be
Developed (GAO/RCED-90-8, Nov.  3, 1989). 

Milk Marketing Orders:  Options for Change (GAO/RCED-88-9, Mar.  21,
1988). 

