Mark Stephenson
Chuck Nicholson
Agricultural Economists
Cornell Program on Dairy Markets & Policy

Federal Milk Marketing Orders have program objectives to “stabilize market conditions, benefit producers and consumers by establishing and maintaining orderly marketing conditions, and assure consumers of adequate supplies of pure and wholesome milk at all times”. Those objectives are partially met by specifying the minimum prices that must be paid to dairy farmers or their organizations (cooperatives) for the milk purchased. Plants are welcome to pay more than the minimum price and often do through over-order premiums. But, determining an appropriate value for the minimum price can be a tricky business.

USDA decided in January of 2000 that minimum prices would be calculated using product price formulas. These formulas rely on surveys to capture the wholesale price of cheese, dry whey, nonfat dry milk and butter. The survey prices are then used to impute the value of milk. Changes in the wholesale prices of these products is why your milk prices change on a monthly basis.

There are two parameters in the product price formulas that are important to the calculation of the minimum milk price. These parameters don’t change often, but they must be reconsidered occasionally. They are the yield estimate and the make allowance. The yield estimate, for example, determines how many pounds of cheese you can make from 100 pounds of milk and the make allowance recognizes the cost of transforming milk into cheese.

Recently, USDA held hearings to take testimony on changes in the cost of processing. This testimony provided the basis for the tentative recommended decision to change the make allowances in the product price formulas. Their decision was to increase the allowances as follows: Cheese from 16.5¢ per pound to 16.82¢, butter from 11.5¢ to 12.02¢, nonfat dry milk from 14.0¢ to 15.7¢ and dry whey from 15.9¢ to 19.56¢. In the near future, these increases will have the effect of lowering the minimum prices that must be paid to dairy farmers.

It is easy enough to do the math and determine the impacts on federal order class prices. However, this simple calculation will not capture the actual impacts on dairy producers. To make that estimation, you really have to consider the response of dairy producers to a change in their milk price, the response of processors to changes in the cost of milk and of consumers to the change in dairy product prices.

Let’s consider how these changes will take place over time. First, dairy farmers react to lower milk prices by reducing inputs such as concentrate feeding or rbST and milk per cow declines, or is off trend, nationally. Later, you may cull a bit more heavily and reduce the number of cows. Together, the milk supply is less than it would otherwise have been.

Consumers are initially unaware that anything is different in the dairy case and choose to purchase what they have been purchasing at the same price. Dairy processors however, react to lower milk prices and better margins but wanting to sell more dairy product. This isn’t possible without more milk and there is even less available so they must increase over-order premiums to producers.

Unless the over-order premiums are equal to the loss from blend prices, we are still not going to have as much milk produced. Eventually, dairy processors must try and pass along some of the higher costs of premiums to consumers who will buy somewhat less dairy products than before. Of course, higher product prices are captured in the product price formulas and return a higher milk price to dairy farmers. Thus, the whole industry works its way back to an economic balance that economists call “equilibrium”.

So, from the dairy producer’s perspective what is the bottom line? We have a dynamic model of the dairy industry that allows us to look at this question. The model was run with and without changes in the make allowances were made. Figure 1 shows what happens to the federal order blend price over time. Initially, it declines by more than 20¢ per cwt. However, as milk supplies tighten the blend price recovers and, since it takes several months to begin to rebuild the national herd from the culling that occurred, we even get much stronger blend prices than we would have after a couple of years.

And, it isn’t all suffering in the first few months. In Figure 2 you will notice that over-order premiums increase 10-15¢ per cwt. to partially offset the blend price declines in the first several months. Over the four years after the change in make allowances, we project that total milk production declines on net about 1.8 billion pounds. But because of the higher overall milk prices, total producer revenues are greater over the four years with the increase in make allowance. The combined blend plus premiums give an all-milk price that is nearly 11¢ per cwt. higher on average over the four years.

How can this be? Well, it comes down to what economists call “elasticity”—or how much change in quantity occurs for a change in price. It turns out that consumers are more insensitive to changes in price for dairy products than dairy farmers are in their price for milk.

As long as we have product price formulas, make allowances will occasionally have to change to keep pace with the cost of processing. Otherwise, processors go out of business. That, too, impacts dairy farmers in the region of the plant who now must pay more to haul their milk to more distant processing.

The dairy industry is complex. Changing make allowances is not simply a matter of taking twenty-some cents out of a dairy farmer’s pocket and putting it in a processor’s pocket. The industry will respond over time, and everyone from farmers to consumers ultimately share increased costs.