Dr. Roger Ginder Econ 338 Fall 2007 Lecture #21 Dairy Marketing Dr. Roger Ginder Econ 338 Fall 2007 Lecture #21

Example of Central Market Order Pooling

Producer Settlement Fund A fund that is used to collect and disburse funds to handlers to equalize blend price paid to farmers and the classified value of milk used Fluid distributing plants typically pay into the fund Higher fraction of milk bought has class one value (above blend price) Lower fraction in Class II, III and IV Other supply plants may pay into or draw from the fund depending on product mix and fluid provided Pay in if fluid and Class II uses are high Draw out if Class I & II are low relative to Class III & IIIa

Producer Settlement Fund Cooperative association plants typically draw from the pool Handle large quantities of milk Perform balancing function Process more Class III and IIIa products Cooperatives typically have lower performance requirements in recognition that They are farmer owned patronage organizations They perform balancing functions in the market when supplies are high

Table 6.2. Computation of an example marketwide pool Hiland Mid-Am Kraft Total market Handler (cwt) (%) (cwt) (%) (cwt) (%) (cwt) (%) Producer receipts Class I 38,400 96 0 0 25,000 50 63,400 36 Class II 400 1 5,500 6 0 0 5,900 3 Class III 1,200 3 80,000 90 25,000 50 106,200 59 Class IIIa 0 0 3,500 4 0 0 3,500 2 Total 40,000 100 89,000 100 50,000 100 179,000 100 Transfer the total quantities over to next chart and multiply by the class prices

Table 6.2. Computation of an example marketwide pool (cont’d) Hiland Mid-Am Kraft Total market Handler $ $/cwt $ $/cwt $ $/cwt $ $/cwt Class I 556,800 14.50 0 14.50 362,500 14.50 919,300 14.50 Class II 5,040 12.60 69,300 12.60 0 74,340 12.60 Class III 14,400 12.00 960,000 12.00 300,000 12.01 1,274,400 12.00 Class IIIa 0 36,750 10.50 0 36,750 10.50 Total Amt. Paid $ 576,240 40K $ 1,066,050 89K $662,500 50K $2,304,790 179K Average classified value 14.41 11.98 13.25 12.88 Note: Classified prices ($/cwt) used in this analysis are as follows: Class I: $14.50; Class II; $12.60; Class III: $12.00; and Class IIIa: $10.50.

Table 6.2. Computation of an example marketwide pool (cont’d) Hiland Mid-Am Kraft Total market Handler $ $/cwt $ $/cwt $ $/cwt $ $/cwt Class I 556,800 14.50 0 14.50 362,500 14.50 919,300 14.50 Class II 5,040 12.60 69,300 12.60 0 74,340 12.60 Class III 14,400 12.00 960,000 12.00 300,000 12.01 1,274,400 12.00 Class IIIa 0 36,750 10.50 0 36,750 10.50 Total 576,240 40K 1,066,050 89K 662,500 50K 2,304,790 179K Average classified value 14.41 11.98 13.25 12.88 Note: Classified prices ($/cwt) used in this analysis are as follows: Class I: $14.50; Class II; $12.60; Class III: $12.00; and Class IIIa: $10.50.

Payments made into the fund by handlers whose pool obligation is greater than the blend Price to be received by the farmers and handlers who supply it. Producer Settlement Fund Payments received from the fund by handlers whose pool obligation is less than blend Price to be received by the farmers and handlers who supply it.

Table 6.3 Computation of an example producer settlement fund Blend price paid Amount paid Classified value Producer producers ($/cwt) producers ($) of milk ($) settlement fund ($) Hiland 12.88 515,037 576,240 61,203 Mid-Am 12.88 1,145,957 1,066,050 (79,907) Kraft 12.88 643,796 662,500 18,704 Total market 12.88 2,304,790 2,304,790 0

Payments made into the fund by handlers whose pool obligation is greater than the blend Price to be received by the farmers and handlers who supply it. Producer Settlement Fund Payments received from the fund by handlers whose pool obligation is less than blend Price to be received by the farmers and handlers who supply it.

Diversion to Class I Uses

Seasonality of Milk Production/Consumption 1990’s Commercial Production Disappearance Surplus/ Mo. Bil. # Bil# Deficit Bil.# % ________ __________ _____________ ________________ Jan-Mar 37.6 33.5 +4.1 (+12.25%) Apr-June 39.4 36.3 +3.1 (+8.5%) July-Sept 37.4 38.2 -1.8 (-4.7%) Oct-Dec 36.6 37.3 -0.7 (-1.8%)

Supply Plant Pooling Incentive Class III 1995 MW (3.5 BF) IA Blend (Z1) Difference Jan 11.35 12.04 +.69 Feb 11.79 12.14 +.25 Mar 11.89 12.22 +.33 Apr 11.16 11.90 +.74 May 11.12 11.90 +.78 June 11.42 11.78 +.36 July 11.23 11.71 +.48 Aug 11.55 12.09 +.54 Sept 12.08 12.30 +.22 Oct 12.61 12.83 +.22 Nov 12.87 13.22 +.35 Dec 12.91 13.25 +.34 __________ Avg. +44¢ (Avg ‘93 = +51¢)

Balancing Requirements Seasonality creates the need for some plants to serve the “balancing function” in the market Having the plant capacity to take and process all the product in the peak or “flush” season means that there will be excess plant capacity at some times of the year What problems does this cause? Some plant capacity will be under utilized during the short supply parts of the year In many cases this means that some plants may even have to be shut down for some period of time Fixed costs of these plants continue even though they are not operating No one wants to be the one who performs “balancing function” No one wants to give up milk to the Class I distributing plant

Performance Requirements One purpose of Class I premiums is to ensure an adequate supply of fluid products for consumers Pooling is a means used to share the Class I premiums among those providing milk for Class I uses Most Class III and IV plants in the market order would prefer to be pooled since pay prices are higher It is necessary to make sure that those who pool in the order “perform” or actually contribute to the supply available for Class I uses in the order when it is needed Orders may impose “ Minimum Performance Requirements” that must be met in order to become part of the pool

Market Conflicts During Periods When Supply is Short Consider the following Market Players: Westhoff and Welpers’s Pool Butter and Non-Fat Dry Inc. Simon and Sheehan’s Fabulous Fluid Milk Co. Strein and Koppes Luscious Low Fat Milk Co. Kaitlin and Kaitlin’s Non-Pooled Better Butter Inc. Jaschen, Brucker and Raun’s Blocks and Barrels O’ Non-Pooled Cheddar Grade A and Grade B producers J.Tekippe Market Order Administrator Blend Price in pool = $12.75 Class III price = $12.00 & Class IV price = $11.50

Pool Riding Problem Some Grade A Class III/IV manufacturing plants attempt to be pooled so as to share in the proceeds from Class I sales Want to be more price competitive for producer milk while, at the same time, having no or very little incentive or intent to supply milk for Class I needs. Offering the blend price instead of the Class III or Class IV price gives them an advantage in the procurement market over those who are not pooled Pool Riders attempt to “have the best of both worlds” at no additional cost or inconvenience to themselves So who doesn’t? What is wrong with trying to be more competitive?

Pool Riding Problem Pool riding reduces incentive for providing Class I sales by increasing the quantity of Class III milk in the pool. This reduces blend price for all producers because the Class III milk draws from the Producer Settlement Fund Quantity available for Class I use may actually decline as a result of the reduced price incentive Affects competitive position of non-pool Grade A Class III/IV plants adversely when a competing firm rides the pool WHY?

Performance Requirements Market orders can impose requirements to ensure that those in the pool actually provide milk when it is needed for fluid purposes At the times of the year that supplies are down and demand is high class III plants that are allowed into the pool must be willing to divert Diversion provisions require them to give up supply to distributing plants for packaging Class I products

Performance Requirements The amount of milk must be diverted or at least offered up varies according to the requirements specified in the order Performance requirements are generally more rigorous in areas where milk is less plentiful (e.g. the East and Southeast Failure to perform cans mean financial penalties or in some cases expulsion from the pool

FMMO Seasonal Pricing Plans 1. Louisville Type Plans Take money out of PSF in the spring Flush when supply is good Pay back in the fall to provide higher differentials to those who supply milk when the supply is tight Increase incentive to divert milk to Class III in spring Decrease incentive to divert milk to Class III in fall to use plant capacity

FMMO Seasonal Pricing Plans 2. Seasonal Base Plans (Base-Excess Plans) Base forming period in fall when production is low Sets the base for quantity that will receive the Class I price in spring for producers Base and a lower over-base price paid in spring for class I Gears amount that is pooled in the spring to what has been provided in the fall when it is most needed

Allocation to Pool Class I Producers

Diversion Provisions Rules that specify the maximum proportion of a supply plant’s milk that can be diverted (away from a pool plant) directly from the farm to a non-pool plant and still be pooled in the order Allocation & Transfer Provisions Accounting rules for determining how milk that is received from or shipped to a different source is classified and priced Down Allocation The assignment of milk to a utilization class less than the Class of product it was actually used to produce

Impacts -- Down Allocations Gives local order producer milk supplies priority on Class I sales, even if the milk they delivered wasn’t used in Class I Local handlers cannot bring in outside milk and use it for Class I or II products at the expense of those producers pooled on the order Requires local handlers to pay local order Class I prices regardless of where milk is purchased Compensatory Payment A FMMO payment (equal to Class I P - Class III P) required of Pool handlers on other source milk allocated to Class I sales

Reconstituted Milk Remove water thru evaporation or membrane filtration techniques (also known as reverse osmosis or R-O) ; then recombine water and solids to form fluid product (cost x 35¢-45/¢cwt.) Permits local handlers to bring milk into the order from outside the boundaries at a lower transport cost Rationale: Cheaper to take water out before shipping Under FMOs reconstituted milk is down allocated and subject to a compensatory payment

Down Allocation Local Order Other Source Milk Milk (e.g., R-O Milk) Quantity (cwt.) 10,000 1,000 UTILIZATION: Class I 7,000 1,000 Class II 1,000 Class III 2,000 CLASSIFICATION: Class I 8,000 Class III 1,000 1,000 LOCAL POOL OBLIGATION: Class I 8,000 x 13.67 7000 x 13.67 Class II 1,000 x 12.52 1000x 12.52 Class III 1,000 x 11.26 2000x 11.26 ____________ _____________ = $133,314 ($13.314/cwt) vs. $131130 ($13.11/cwt) Otherwise only 7000cwt. of class I and 2000cwt. of class III would be calculated

Down Allocation Local Order Other Source Milk Milk (e.g., R-O Milk) Not Computed in Pool Q (cwt.) 10,000 1,000 UTILIZATION: Add to Class I Class I 7,000 1,000 Class II 1,000 Class III 2,000 CLASSIFICATION: Class I 8,000 Class III 1,000 1,000 Subtract from Class III LOCAL POOL OBLIGATION: Class I 8,000 x 13.67 Class II 1,000 x 12.52 Class III 1,000 x 11.26 ____________ = $133,314 ($13.314/cwt) Treats Non-Pooled Milk as if used in lowest class and pushes pooled milk into higher class thereby increasing the blend price for pooled producers to receive.

ANOTHER APPROACH---COMPNESATORY PAYMENTS

Valley decision – compensation payment Table 6.5. Example computation of the uniform blend price from the Lehigh Valley decision – compensation payment Classified price ($/cwt) Use (cwt) Value ($) Class I 14.00 2,000 28,000 Class III 10.00 2,000 20,000 Total pool milk 4,000 48,000 Uniform blend price 12.00 Assume: 500 cwt was brought in from outside the order @ BFP for use in Class I.

the uniform blend price without compensatory payment Table 6.6. Effect of 500 hundredweight of nonpool milk for Class I use on the uniform blend price without compensatory payment Classified price ($/cwt) Use (cwt) Value ($) Class I 14.00 1,500 21,000 Class III 10.00 2,500 25,000 Total pool milk 4,000 46,000 Uniform blend price 11.50 Table 6.7. Effect of a compensatory payment on 500 hundredweight of nonpool milk on the uniform blend price Classified price ($/cwt) Use (cwt) Value ($) Class I 14.00 1,500 21,000 Compensatory payment (nonpool milk) 4.00 500 2,000 Total pool milk 4,000 48,000 Uniform blend price 12.00 500 Forces pool Class I into Class III Bottler compensates pool for outside milk

the uniform blend price without compensatory payment Table 6.6. Effect of 500 hundredweight of nonpool milk for Class I use on the uniform blend price without compensatory payment Classified price ($/cwt) Use (cwt) Value ($) Class I 14.00 1,500 21,000 Class III 10.00 2,500 25,000 Total pool milk 4,000 46,000 Uniform blend price 11.50 Table 6.7. Effect of compensatory payment on 500 hundredweight of non-pool milk on the uniform blend price in the order Classified price ($/cwt) Use (cwt) Value ($) Compensatory payment (nonpool milk) 4.00 500 2,000 Total pool milk 4,000 48,000 Uniform blend price 12.00 Bottler has to pay class I price on 1,500 cwt plus a $4.00 /cwt. Pmt. for 500 cwt.

Other Possible Adjustments to Producer Price 1. BF Differential 2. Protein Differential 3. Other Solids Differential 4. Quality (somatic cell count) 5. Hauling 6. Insurance 7. Coop Membership Fee 8. Advertising 9. Government Assessments (Taxes)

Price Discrimination Definition: Selling same product at different prices to different buyers Necessary conditions: 1. Seller control over price 2. Different buyer elasticities of demand 3. Different buyers are separated

Relatively Elastic Market Demand Price $/# P1 Po Demand Qo Q1 Quantity # of milk Relatively Elastic Market Demand

Relatively Inelastic Market Demand Price $/# P1 Po Demand Q1 Qo Quantity # of milk Relatively Inelastic Market Demand

FMMO Effects 1. Increase Class I Fluid Prices Mean: Production increase fluid milk Consumption decrease but not much 2. Grade B prices may decline due to increased Grade A 3. CCC expenses may increase with higher production 4. Enhanced coop bargaining efforts are made possible 5. Enhanced equity among producer prices 6. Enhanced stability in the market 7. Assured adequate supplies of milk

State Milk Control/Order Provisions 1. Retail pricing (5 states) 2. Price filing requirements (monthly wholesale) (8 states including IA) 3. Limits on sales below cost (20 states including MN, WI) 4. Producer pricing (12 states including CA) 5. Producer base programs (7 states including CA)

CA Milk Classes Class Product I Fluid, Yogurt, 1/2 & 1/2 II Heavy cream, cottage cheese, buttermilk, sterilized cream III Frozen products including ice cream IVA Butter and nonfat dry milk IVB Cheese

CA Pricing Class prices determined by economic formula e.g., Class I is a function of (production costs, butter/powder price, CA wages) Producer prices = BF and Solids Not Fat prices for 1. Quota (Class I share) 2. Base 3. Overbase lower price

Market Administrator Agent of secretary of agriculture Charged with administering the order Ensures that handlers properly account for milk used in different classes Ensures that payment is made according to use Conducts audits of plants and handler’s records Reports to the public on class prices, uses, and blend price Funding for services is not paid by tax dollars

STEPS IN IMPLEMENTING OR AMENDING A federal marketing order: 1. A proposal/request sent to USDA 2. A preliminary USDA investigation is made 3. A public hearing is held 4. A recommended USDA decision is issued 5. Filing of objections 6. Final USDA decision is issued 7. A producer vote is conducted (2/3 Majority Required)

Past & Present FMMO Issues 1. Class I differential levels 2. Multiple basing points for establishing Class I differentials 3. Class II pricing levels 4. Reconstituted milk pricing 5. MW Price or Basic Formula Price (Class I mover) 6. Pooling requirements

What federal orders do not do: 1. Control production 2. Establish sanitary/quality production standards 3. Guarantee producers a fixed price 4. Set retail prices 5. Guarantee producers a mkt. for their milk 6. Require a handler to buy a specific quantity or buy it from a specific seller 7. Directly raise government (taxpaper costs) due to administration expenses