The Logic Behind Federal Milk Marketing Order Pricing

Geoff Vanden Heuvel

Director of Regulatory and Economic Affairs


There seems to be an uptick in complaining about Federal Milk Marketing Orders (FMMOs), with a fair amount of calling for “reform” of the FMMO system. I have read some of this commentary, as maybe you have, and would like to respond to it.


There is a rap on the FMMOs that they are complicated. They are. But that does not mean there is no logic behind them. The logic is simple: because milk is perishable, dairy farmers must sell it every day to a buyer who doesn’t have to buy it every day. In a normal market, you have a balance between the buyer and seller, but because of the perishability of milk, producers are inherently vulnerable. The FMMOs function as a referee. They establish milk prices based on what milk is ultimately used for according to a classification system. Class I is fluid milk, which is the most perishable dairy product. The logic of the FMMO is that Class I should be the highest-priced milk. If the FMMOs did not price fluid milk, who do you think would? The producers? Or the big box stores?


To establish the value of milk, the FMMOs discover what the price of cheese, dry whey, butter and nonfat dry milk is in the unregulated and competitive market. It then converts those market prices for dairy products into a milk value, which is then used to establish the Class I price. The logic of this system is that Class III and IV represent the base commodity value of milk and Class I is then priced at a differential above that.

You might wonder why there is not just a single manufacturing class instead of separate Class III and Class IV prices. The reason is that they are different markets. While each uses milk, the equipment needed to make cheese and whey products, or butter and powders, is not interchangeable. It was decided a little over 20 years ago, as consumers began to eat more of their dairy products rather than drink them, that the FMMO system should recognize the unique equipment and marketing needs of the two major dairy commodity uses and have a separate class for each. This was a logical conclusion, but it did have tradeoffs. If we only had a single manufacturing price, then there would theoretically be increased incentive for milk to flow to the higher-valued use. That incentive still exists but it is less dramatic than if there was only one manufacturing price. The costs of creating excess processing capacity to accommodate the free movement of milk between the two uses would be very high. Establishing separate classes enabled very efficient, single purpose manufacturing plants to be constructed. Over the past 20 years this is what has happened, and efficient new manufacturing plant capacity continues to be constructed under the current FMMO system.


There seems to be three main reasons usually given for why we need major FMMO “reform”:

1) Fluid milk consumption is dropping, so the system no longer works as designed; 2) Exports are the key to future dairy industry growth and the FMMO system impedes that; and 3) The FMMO system is based on low value commodity products, so that hurts milk prices.


Fluid Milk

The fact that the fluid milk share of a much bigger dairy market is shrinking does not mean it is unimportant. Price elasticity in Class I still exists. It is true that per capita consumption of Class I milk has dropped for the past 25 years. Consumer preferences change all the time. A recent study on fluid milk points out there are a whole variety of reasons why fluid milk consumption is dropping, with the drop in breakfast cereal consumption being one of them. The impact of an average Class I price differential on a cup of fluid milk is less than 2 cents. It is hard to believe that making Class I milk a little cheaper would change these trends.


Exports

The U.S. now exports almost 20% of milk production. Remember, that happened – and is continuing to grow – under the current FMMO system. No evidence here of failure.


Commodity Products

And yes, FMMO Class III and IV formulas are based on commodity values, but making commodity products is never a high margin enterprise whether we are talking about dairy products or widgets. That market reality drives processors and producers to move up the value chain if they want to earn more money for their milk. There is plenty of evidence of this happening around the country. Millions of daily pounds of processing capacity have come online in the last few years in the U.S. and much more capacity is on the way.


The secret to the success of the FMMO system is that, other than Class I, it is a VOLUNTARY system. No Class III or IV usage is required to pay regulated minimum prices unless it voluntarily associates with the FMMO pool. The FMMO provides structure, but does not limit or restrict innovation in product mix or pricing of any other dairy product other than fluid milk. If you are in a region that has almost no Class I usage, there is no reason to be part of an FMMO. Idaho is not in the FMMO system and there is no pressure on them to join. If you want to make products for export, as long as it is not a Class I product, you can operate complete outside of the FMMO system. However, the presence of the FMMO system gives producers a benchmark to assess if the price they are paid for milk is competitive.

When we look at the 85 years that the FMMO system has been around, it has not prevented different regions of the country from benefiting from comparative advantages they might have enjoyed. When FMMOs were established, New York was the largest milk producing state. Then Wisconsin figured out how to take advantage of their natural resources and industry ingenuity to develop as America’s Dairyland. The fact that New York always had more people and more Class I sales did not prevent Wisconsin from succeeding. Then California emerged, exploiting a state order to incentivize the expansion of plant capacity to accommodate a huge cost of production advantage that came from large scale dairy operations, made possible by mild weather and ample feed supplies. Then urbanization pressure scattered southern California dairies. They headed to Idaho, Washington, New Mexico, Texas, back to Wisconsin, Illinois, Michigan, Iowa, Indiana and even South Dakota, Nebraska and Kansas along with lots of others. Each area is having its growth spurt – all under the FMMO program.


My view is that the FMMO system, while not perfect, is a remarkably successful program. The success of government economic regulation should be judged on whether it significantly hindered what the market forces would have produced if the regulation had not been in place. In other words, does the regulation stabilize, but otherwise not interfere with, where market forces would have taken the industry.


Could the FMMOs benefit from some tweaks and updating? Yes. A mistake was made in 2018 when Congress accommodated a request from National Milk Producers Federation and the International Dairy Foods Association to change the base price for the Class I formula from using the “higher of” either the value of milk for cheese/whey, or butter/NFDM, to using an “average of” plus 74 cents calculation. This change would not normally be a problem, but, in retrospect from a policy standpoint, since FMMOs are voluntary and the incentive to associate with the FMMO pool is access to Class I revenues, then it is important to set Class I prices at a level where they will almost always be the highest milk price in the area. As we saw during the pandemic, the “average of” formula can spectacularly fail under an extreme circumstance. This should be fixed, but if the price to fix it is to open up the FMMO rule making process, then I am not sure that risk is worth it. There are processors who want to increase make allowances because the current allowances are based on costs from 15 years ago. But I wonder if the product yields don’t also need a look since the yields in the formulas are based on processing technology from a couple of decades ago. It is possible that increases in costs per unit could be canceled out by increases in yields and the net effect would be not much change in regulated milk prices.


Despite the grumbling about FMMOs, there is no consensus in the industry on what should be done. USDA Secretary Tom Vilsack recently told the industry that he wanted to see more agreement in the industry before USDA would consider holding a hearing on FMMOs. I take comfort from these comments. Right now, I see more downside risk for producers than upside potential from opening up the FMMOs to change. But if we are going to have change, then we need to be careful what we ask for.

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