Judge Doty's surprise ruling that current Class I price differentials are unlawful presents the industry with a great deal of uncertainty in the months ahead. The ruling characterized the differentials, which increase with distance from the upper Midwest, as "arbitrary and capricious." If the differentials are arbitrary and capricious in legal terms, they are hardly arbitrary and capricious from the standpoint of how the present system of Federal order pricing has evolved and been refined over the years.

The Federal order system initially adopted Class I differentials in the 1930's because they reflected the pricing policy of cooperatives selling producer milk to processors since the early 1900's. The concept of distance differentials was adopted formally by the order system in the 1960's on the basis that it reflected actual fluid milk prices across the country east of the Rocky Mountains. The current differentials themselves were promulgated by Congress in the 1985 Farm Bill. This action sparked the regional squabble that prompted the Minnesota lawsuit. Present differentials were confirmed in a 1993 final decision by USDA based upon a 1990 national hearing that produced over 10,000 pages of testimony.

Possible Developments. One of the few things known for sure at this writing is that market administrators will enforce minimum price provisions and pooling for November milk checks based on October shipments. Secretary Glickman may appeal the order and attempt to delay enforcement until the current order reform process is completed. Or he could, as some industry pundits have wryly suggested, let the system go down the tubes. The resulting chaos might then force the industry to a consensus on dairy policy. Lack of consensus in the 1996 Farm Bill debate prompted Congress to punt a complex problem to the Secretary, and has pretty well placed him in a lose-lose situation politically.

Technically, the Judge's order applies to only 28 "surplus and balanced" orders, presumably leaving the Florida orders free to continue classified pricing. It can be argued that a number of other orders, including the Carolina order, are deficit. However, this is a moot point. Prices in the deficit orders, whichever ones they are, will have to reflect those in surrounding markets.

Potential Impacts. Any estimate of the potential price impact of suddenly eliminating a price structure that has existed for 60 years is completely conjectural. Quite obviously, the bounds in any market are the current Class I price including premiums and the Class III price. This is not too helpful. The December difference in the announced Class I over order premium and the Class III price in the Carolina order is $4.44. Most observers believe that cooperatives will have a difficult time holding the price line at the current Federal order Class I minimum, much less at the premium. Any remaining premium would be cost or service related. But prices will fall to nowhere near the Class III level.

At least, three recent studies have examined the regional price impact of FMMO deregulation -- Mark Stephenson at Cornell, FAPRI at the University of Missouri, and Tom Cox at the University of Wisconsin.

Below are the averages of their estimates:

      Upper Midwest -    $+.34 cwt (range, $.07 to $.86)(1)
      Mid-Atlantic -     $-.40 cwt ($-.28 to $-.57)
      Southeast -        $-1.03 cwt ($-.82 to $-1.27)
      Northwest -        $+.22 ($-.02 to $.+49)

The estimates are based on complex econometric models, and slightly different regional definitions. Many dairy economists agree with the direction, if not the approximate magnitude of these changes. But a closer look at the dynamics of the adjustment process may be instructive and provide some food for thought.

Take the four orders below, based on 1995 annual statistics. Class I overorder premiums, Class II and Class IIIA are ignored for the sake of simplicity. Class I utilization has been rounded off to make the arithmetic easier:

	New York	Carolina	Florida	Upper Midwest
Class I value	$14.75 x .4	$14.70 x .8	$15.50 x .9	$12.80 x .2
Class III value	$11.60 x .6	$11.60 x .2	$11.60 x .1	$11.60 x .8
Blend =	$ 5.90	$11.76	$13.95	$ 2.56
	+ 6.96	+ 2.32	+ 1.16	+ 9.28
	$12.86	$14.08	$15.11	$11.84

Note that in the southeastern orders, Class I dominates the level of the blend price. In the UMW, Class III prices drive the blend price, and in NY value depends about equally on both classes. Southwest markets are similar to NY in terms of utilization, as is the all-market average.

Now let's take as a given that the national dairy market was at somewhat of an equilibrium in 1995. Farmers in any given region must receive approximately the same price or supply would fall. Most plants have contracts with cooperatives and/or local independent producers that presumably would remain in effect under deregulated pricing. Thus, fluid plants in any region must pay something close to the blend to attract sufficient supplies in the near term. Assuming cooperatives lack the bargaining power to hold the price line, fluid prices will fall toward the blend. Under flat pricing, if fluid prices fall, milk used for manufacturing must rise in price, though not necessarily by the same amount.

Now, let's take a closer look at the Upper Midwest order. The official FMMO data conceal more than they reveal. A more accurate picture is represented by the following:

The difference in the Class III minimum and actual is the sum of the Grade "A" premium and the average hauling subsidy -- about $.90. This is the major reason why mailbox prices in the upper midwest compare favorably with those of producers in other regions, despite low fluid utilization and lower Class I differentials. Class III premiums exist in other orders, but are nowhere near the levels of those in the upper Midwest.

If manufactured milk prices are to rise, the UMW price will certainly be no lower than the present $12.56. But since fluid prices must fall, it is unlikely to be above $12.80. So all plants in the UMW market, fluid or manufacturing, wind up paying a flat price of about $12.75, (probably with a continuing premium to attract supplies into metro areas for bottling).

Next, let's take New York. Cheese plants in the NY order cannot pay the old order blend of $12.86 and compete with Wisconsin plants paying $12.75. In fact, to retain the current $.90 raw product advantage they could pay no more than $11.85. This places pressure on New York prices to fall further. My estimate is that New York prices will fall by 50-70 cents from current blend price levels in the short run.

Turning to the two southern orders, which have in essence no manufacturing industry, the short term price pressure is less. Milk that is in excess of fluid requirements is still trucked north and sold at low prices even in the absence of a formal price classification scheme. Since this currently only represents 20 percent and 10 percent of sales in the Carolina and Florida orders respectively, my estimate is that short run price adjustments would approximate 35-55 cents below the current blend in the Carolina order and a 20-40 cent reduction in Florida.

But this is just the first stage of the adjustment process. Milk production will fall in New York, and by lesser amounts in the Southeast. This will move prices in those regions slightly higher. Conversely, production in the UMW will rise, dampening price increases there. Finally, the new price surface will encourage more milk movement from the northeast and southwest to the southeast, but make shipments from the UMW less likely. This will tend to raise the price in exporting orders and lower it in importing orders. This whole adjustment process is likely to take a couple of years to sort through.

Winners and Losers. Hopefully, this tracing through of the dynamic process of economic adjustment to the possible demise of classified pricing has been helpful. While the quantification of the new industry equilibrium is conjectural, the winners and losers under flat pricing are rather obvious:

.....milk producers in the upper midwest and probably, the northwest gain; producers in all other regions lose.

.....fluid milk consumers gain; consumers of cheese and other manufactured milk products lose.

.....fluid milk processors gain; manufacturing product processors lose, particularly those based in the northeast.

Final Thoughts. One of the interesting comments made at the recent Las Vegas conference, "Envisioning a Deregulated Dairy Industry," was that a lot of milk procurement managers in cooperatives and proprietary plants would be in jeopardy of losing their jobs for bad decisions if pricing regulations end.

An implication for cooperatives in the southeast is that balancing becomes an even more critical issue in the absence of differentials. Removal of the Class I cushion to absorb balancing costs will put great pressure on cooperatives to equate supply and demand on a seasonal basis. Alliances with cooperatives in the northeast and southwest will be important.

Nationally, total production is likely to be changed little. The increase in fluid consumption will be offset by a decline in consumption of manufactured dairy products. The structural consolidation of the industry into fewer production and processing units is likely to accelerate.

Geographic relocation of the industry from east to west would continue. However, the trend would shift more to the northwest. The upper Midwest would be in an improved competitive position and could regain some of its market share lost in the past decade. However, the Midwest still faces a major readjustment in producer numbers and average size.

Tools for vertical coordination of the industry would be developed. For example, production contracts for precise fixed volumes of milk might be the norm.

The leading dairy state, California, would be forced to make major changes in its state price regulations. Already faced with lower fluid milk prices in surrounding markets, its classified pricing system would probably fall too. This could eliminate the raw product price advantage that California cheese plants have held.

A final ironic twist to the decision if enforced, is that the U.S. will become less competitive in world dairy markets. The exception to this will be an improved competitive position for fluid exports to Mexico and Canada.

Benson, Geoff, Untitled Memorandum, N.C. State University, November 8, 1997.

Siebert, John, Mark Stephenson and David Anderson, "Milk Marketing Without Federal Orders", Choices, Third Quarter, 1997.

USDA, AMS, Dairy Market News, March 7, 1997.

Weimar, Mark and Don Blaney, "Landmarks in the U.S. Dairy Industry", USDA, ERS, Ag Info Bul. No. 694.

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updated 11/18/97