RECONSTITUTED MILK. Staff Report December 4, 1979 MARKET ADMINISTRATOR NEW YORK - NEW JERSEY MILK MARKETING AREA

Transcription

1 o MARKET ADMINISTRATOR NEW YORK - NEW JERSEY MILK MARKETING AREA 205 EAST 42ND STREET. NEW YORK. NEW YORK RECONSTITUTED MILK Staff Report December 4, 1979

2 lea! & in :_ )C.S 4! 4<t C _ \I _ pc 4ft ==-=- I. INTRODUCTION o Prior to July 1968, the accounting procedur~ used in the New York- Ne\v Jersey Harketing Area was the butterfat equivalent accounting method. This method accounted for only the butterfat in the various products an~ in effect, the skim milk portion as following the butterfat. To determine the producer milk allocated or classified in the various classes, the follmving procedure was followed: The butterfat was separately tabulated in fluid sales, and in the manufactured products, the total butterfat in the various classes was converted to producer milk by dividing it by the average test of the milk received from producers. During this period of time, the Order recognized the fact that when butterfat is disposed of as cream, the skim milk portion of the milk could be and often was disposed of in fluid skim milk, in half & half and in certain milk drinks. In these f~ '\ cases the pricing of the milk received from producers in the class to which the \ 1 "- butterfat was assigned would not return to producers the true use value for their milk. The application of the old fluid skim differential was intended to provide a price for skim milk approximately equivalent to the Class I value of skim milk disposed of in certain specified fluid uses, and was limited by formula to the so~called skim milk available. The butterfat accounting method coupled with the fluid skim differential worked reasoriably well in our market since, at that time, the states of New York and New Jersey did not allmv the standardization of milk for fluid use. Under those circumstances, the butterfat accounting procedure was considered to be appropriate. Later, however, the laws of the states of New York and New Jersey were changed to permit handlers to" st-andardize milk for fluid use. New Jersey changed (' their law in Hay 1964 and New York in November These new laws allowed handlers to change the average butterfat content of fluid milk by either the

3 - 2 - addition or removal of skim milk or the addition or removal of butterfat. In most cases, standardization was done to lower the butterfat content of the finished product. During that period of time when handlers were allowed by the states to standardize their milk, the Order provisions in effect did not and could not insure a full accounting and pricing in Class I of the total volume of milk and skim milk actually utilized for fluid purposes. When it became legal to standardize, more and more handlers engaged in that practice. The Order was limited on what it could price. At this point it may be helpful to explain how the fluid skim differential worked. A handler would tabulate his sales of fluid skim milk, the skim milk portion of half & half (computed by multiplying the butterfat content by 4.5), skim milk portion of certain milk drinks and skim milk used in standardization. He then would calculate the skim milk available for pricing by determining the total producer milk in the plant assigned to Class II.or III and reducing this amount by the result of multiplying the butterfat content by 2.5; the remainder would be the skim milk available for pricing. Example: Total Class II & III Milk Butterfat Content (4,000 lbs.) (4000 X 2.5 = 10,000) Skim Milk Available 100,000 lbs. - 10,000 lbs. 90,000 lbs. If the total of all of his skim milk uses listed above was the same or less than the skim milk available in Class II or"iii milk, then that total was priced under the fluid skim milk differential If the total of all of his skim milk uses listed above was greater then the skim milk available in Class II or III milk, then the skim milk subject to pricing under the fluid skim milk differential was limited to the skim milk available.

4 - 3 - During the period when the states permitted standardization and prior to the change in our Order, there was a great amount of skim milk utilized in fluid use that was not being priced under the fluid skim differential. This varied from month to month and handler to handler. When standardization became widespread, the butterfat accounting method did not achieve uniformity of product cost among handlers. This lack of uniformity in cost resulted from differences in butterfat content of milk received from producers and the difference in volumes of standardization. It became apparent that the butterfat equivalent method had to be changed to reflect the changes in the state laws which allowed handlers to standardize fluid milk. Skim milk and butterfat accounting was needed: 1) Because standardization allowed handlers to reduce their cost of products, thereby reducing the price received by producers. MC~ t'>---- <-vl-<- 2) To give a "true value of the skim milk and butterfat components of milk. A 3) To give equal product cost among handlers for standardized milk made from milk of varying butterfat test. 4) To give a more realistic picture of what actually occurs in a milk bottling plant. 5) To stop the reduction in the volume of Class I milk sales since in a great majority of cases the skim milk used in standardization of whole milk could not be classified or priced under the old method. 6) To return to producers the total value of milk and skim milk utilized for fluid purposes. Also, during that period of time when skim milk powder and/or skim condensed c were reconstituted and used in a fluid milk product or they,,,ere used to fortify a fluid milk product, they could not be classified or priced under the old butterfat equivalent method. It should be noted at that point in time there wasn't much, if any, reconstitution but there was some fortification of fluid milk products.

5 With the change to skim milk and butterfa~ for the first time the New York Order was able to classify and price all the skim milk and butterfat components of fluid ~ilk products. Reconstituted skim milk made from either skim powder or skim condensed was also included in this accountability. It was felt to omit it from the accounting and pricing provision of the new Order would allow handlers, who engaged in that practice, an unfair competitive advantage and also,vquld cause producers a loss of income, since it could be used as a substitute for fresh skim milk derived from producer milk. When any fluid milk products are fortified, with either skim powder or skim condensed, there is a volunetric increase in the product which was fortified. This volumetric increase finds its way into consumer packages. In effect, the handler has more fluid milk products in Class I than producer milk available. This results in the displacement of producer milk. It was felt that these increases, caused by fortification, should be subject to the classification and pricing provisions of the new Order for basically the same reasons as reconstituted skim milk. Now, the Order, in effect, takes into account all uses of skim powder and skim condensed and provides a mechanism to classify and price all volume increases caused by their use.. \fuen skim powder or skim condensed are used in reconstitution or fortification,. the volumetric increases that find its way into fluid milk products are classified as such. The Order has a specific assignment provision for skim powder and skim condensed (other source other than fluid milk products). Under the allocation provision, the Order assigns the skim powder or skim condensed first to any Class II then Class IB and then to Class IA. (It should be noted that all skim powder and skim condensed are handled under the Order at their fluid skim equivalents.) Any skim powder or skim condensed that is assigned to Class IA is subject to pricing.

6 - 5 - Such other source milk, other than fluid milk products assigned to Class la, is priced at the difference between Class la and Class II as adjusted by the transportation differentials. To the extent that any of the other source milk, other than fluid milk, prices is "down allocated" into Class II, producer milk is "up allocated" to Class la. If any producer milk is made into powder and used in reconstitution in the same month, the skim milk is treated as if it had been 'used directly in the fluid milk product.ll '. 1/ For specific order interpretation and examples of both current and proposed handling of reconstituted mil~ see Appendix A.

7 -6 - EFFECTS OF RECONSTITUTED MILK The potential for consumer acceptance of reconstituted milk products in a major metropolitan area such as the New York City area is unclear. There is little empirical evidence to support an answer to the acceptance question. In the long run, consumer acceptance will be determined by taste, product identification, and pricing. However, there are several examples of changed consumer buying patterns between close substitutes due to pricing and product identification. Prior to the advent of private label chain store brand milk, brand labels such as Bordens and Sealtest were identified by consumers as superior products to local labels. Large chains such as A & P eventually forced their own private label milk to be packaged. This product was sold for only pennies a unit less but, in time, ended the era of brand milk. The retail fluid orange juice market provides further insight into the consumer acceptance question. At one time, most of the ( -~ orange juice sold in fluid form was fresh. Today, properly labeled and identically packaged reconstituted orange juice occupies over half the orange juice case in the metropolitan New York supermarkets. There is a price difference between the fresh and reconstituted juice of about twenty to thirty cents per half gallon. A portion of this difference has to do with the cost of hauling the water for fresh juice. Tropicana, the only major fresh juice brand, maintains a strong brand identification at least partially through advertising. Not long ago, when fresh juice supplies ran short, Tropicana replaced its fresh juice with properly labeled reconstituted juice without a major price decrease or loss of sales. A cheese substitute product has recently entered the supermarket dairy case. The substitute product contains non-dairy ingredients but is identically packaged o. and nutritionally equivalent to processed cheese. Because of the difference in price between non-dairy and dairy ingredient costs, it has been estimated that in a few years as much as 25% of the real processed cheese market will be captured by the cheaper imitation product..p. '. z ~ ea:; _ $, C. ;, _$ ", <4. fy ' s.,:.. + ; -" - LQ = -

8 (\,., ( ) TABLE 1: ACTUAL CLASS I DIFfERENTIAL INFORMATION FOR THE FIVE NORTHEAST FEDERAL MILK MARKETING ORDERS, 1976 ($/cwt.) Federal Order Number Minimum Average. Actual ciass I Class I Over Order Class I Milk Usage Marketing Area Market Base Differential Payment Differential (1,000 pounds) New England Boston, MA/ ,972 Providence, RI New York-New Jersey New York City, NY ,668 r-uddle Atlantic Philad~lphia/ U 3,266 Baltimore-Washington 2.78 Eastern Ohio- Cleveland, OR !/ 2,133 Western Pennsylvania Pittsburgh, PA Ohio Valley Toledo, OR ~ / 1,894 Columbus, OR Charleston, W. VA Percent of Total Northeast Federal Class I Milk.Usage ~ Total Northeast Federal Milk Marketing Orders 2,. 68'};} 14, / Simple average of market base minimum Federal Order Class I differentials plus the average over order payment. 2/ Weighted average (Class i usage) for the Northeast. / / I.,

9 - 7 - o Although none of the examples can be used to accurately predict the consumer acce7ptance of a blended or fully reconstituted milk product, there are some interesting similarities. All of the substituting products were nutritionally ---- equal, identically packaged, properly labeled, lower in price, and captured or are expected to capture a large share of the market. Additionally, as in orange juice, there are transportation cost differences between fresh and reconstituted milk products. However, there is no- advertised brand, such as Tropicana, to differentiate them and prevent price decreases or sales declines. It would seem that all but one of the necessary conditions exists for the marketing and consumer acceptance of a reconstituted milk product. Current Federal Order pricing equalizes the price of reconstituted and fresh farm milk. If this equalization is removed, then a difference will exist. If all the necessary conditions are met, it appears probable that a fully or partially reconstituted.~ milk product caube effectively marketed. Economic Incentive to Reconstitute Under existing Federal Order No. 2 pricing provisions, reconstituted fluid milk products are essentially priced at or above the price of fresh fluid milk products. Because of such provisions, handlers have an economic disincentive to use reconstituted milk products. However, if these pricing provisions were altered to limit the pricing of pool milk used in reconstitution to the Class II I \ level, the disincentive would be eliminated and, in fact, an economic incentive for handlers would result. That economic incentive can best be shown by comparing the costs of using reconstituted skim under the altered pricing provisions with the costs of using fresh skim. Handlers must currently pay the Class I price at the mile zone plus transportation costs and an administrative assessment for fresh fluid skim milk. (, \~ In addition, handlers must incur the cost of fluid shrinkage and balancing and

10 - 8 - c services that must be pr6vided. For the ~onth of June 1979, the total costs to. 2/ handlers per hundredweight of fresh fluid skim in New York City was $ comparison, the costs to handlers of purchasing Class II priced skim milk at the mile zone, processing that. milk into nonfat dry milk powder, transporting the powder to the city and then reconstituting it back into fluid skim, was only $7.368 in June 19791/. Therefore, handlers would have saved $1.687 per cwt. by using reconstituted skim in June 1979 in place of fresh fluid skim~ Handlers could only take full advantage of the economic benefits ~esulting from the use of reconstituted skim milk if the final products made from reconstituted skim were as acceptable to consumers as the final products made from fresh fluid skim. If the final products were not equally acceptable to consumers,. the handlers would be forced to transfer some or all of the economic benefits to consumers. in order to increase the acceptability of reconstituted fluid products. Handlers could lower the price of reconstituted fluid products by as much as $.036 per quart before losing the economic incentive to reconstitute. All fluid milk handlers in Federal Order No. 2 do not presently have the capacity to process fluid skim milk into nonfat dry milk powder. Those handlers, as well as handlers with butter-powder facilities, have the option to purchase nonfat dry milk powder directly. If such powder was purchased at the market price in Chicago, transported to New York City, and reconstituted there, the cost ~ of fluid skim would have been $7.373 per hundredweight in June 1979~/.That cost is $1.682 less than the cost of using fresh fluid skim and is approximately the same as the cost to handlers of manufacturing their own powder. On a per quart basis, handlers could pass along as much as $.036 to consumers in the form of lower prices for reconstituted source fluid products.

11 .- 9- c '!:../ Fresh Skim Milk, June, 1979 Class I skim value ( mile zone) Hauling to city Administrative Assessment.5% shrinkage loss Balancing and Services Footnotes Per Cwt. $ $ / Reconstituted Skim from Locally Produced Powder, June, 1979 Per Cwt.. Class II skim value ( mile zone) $5.75 Processing cost for powder ~: 22 Transportation to city.084 Reconstitution (Os Administrative Assessment.035.5% shrinkage loss.029 Balancing and Services.200 $ / Reconstituted Skim from Chicago Spray Powder, June, 1979 Powder cost (Chicago Spray) ($.7892 X 9 lbs.) Transportation (1000 miles)- Reconstitution cost Per Cwt. $ $7.373

12 There will be a definite economic incentive for handlers to use reconstituted skim milk if Federal Order No. 2 provisions were amended to (1) remove reconstituted milk products from the definition of "other source milk" for the purpose of eliminating the "down allocation" of milk ingredients used in such products and (2) eliminate the requirement that processors of reconstituted milk products make a "compensatory payment" on such products assigned to Class LThepotential economic impacts of such a Federal Milk Marketing Order amendment are presently unknown. One would assume that the most immediate insight into the economic impacts might best be found in recent literature dealing with the subject. Recent Literature The most recent study dealing with the potential economic impacts of reconstituted milk was published by the University of Minnesota in r '''--,.' The publication, entitled "Potential Impacts of Reconstituted Milk on Regional Prices, Utilization, andproduction ll was written by Jerome W. HCl:mmond, Boyd M. Buxton, and Cameron S. Thraen. This study examines the federal and state use and price regulations that currently restrict the role that reconstituted milk can play in u.s. fluid milk markets. A model is constructed within the study which determines the economic impacts to individual and aggregate regions of the U.S. when Class I price differentials are changed. The direct use and pricing of reconstituted milk is not incorporated into the model. The only role that reconstituted milk plays in the model is as justification for changing current Class I price differentials throughout most regions of the United States. I The authors reckon that Class I price differentials must change in order for Class I fresh fluid milk to remain economically competitive \vith Class II-source reconstituted milk. They assume away the possibility c' that state restrictions and/or consumer preferences may playa major role in the competitive relationship between fresh and reconstituted fluid milk products.

13 The amounts that Class I differentials must change in order to keep fresh fluid milk competitive were determined in the study by calculating the actual Class I differentials which existed in 1976 and comparing them against the estimated maximum Class I differentials allowable given the availability of Class II-source reconstituted milk. This change in the Class I differential is a crucial factor in determining the economic impacts. Unfortunately, it appears as if the "actual" Class I differentials given in the study are substantially larger than the Class I differentials that truly existed in An ~xample of this exaggerated actual Class I differential can be seen for the Northeast region, one of nine regions in the analysis. The Northeast region, as defined by the study, includes the states of Maine, Vermont, New Hampshire, Massachusetts, Connecticut, Rhode Island, New York, New C region encompasses -five Federal Milk Marketing Areas: New England, New York-New Jersey, Pennsylvania, Ohio, West Virginia, Maryland, Delaware,. and Virginia. This I Jersey, Middle Atlantic, Eastern Ohio-\vestern Pennsylvania, and the Ohio Valley (Federal Order Nos. 1, 2, 4, 36 and 33 respectively). Of the nine regions forming the continental United States, the Northeast region was the largest in both milk production and population for In the study, a weighted "actual" Class I differential of $2.95 was given for the Northeast. This differential seems rather high, especially since the two Ohio~based federal marketing orders are included in the region.~1 51 The federal order Class I differential as well as the over order pa)~ents for 1976 are given in Table 1. The federal order Class I differential is given for the market base, which is,..ac:tually higher than the average Class I differential (.'-" for the entire order. Hhen actual Class I differentials are weighted by the volume of Class I milk in each federal order, the true average actual Class I J differential becomes $2.68. This is $.27 below the study's estimate. /

14 C ' " Using their exaggerated "actual" Class I differential along with their new maximum Class I differentials, a differential change was determined. That change was used in the model to determine economic impacts. Two scenarios concerning the new maximum Class I differentials were used in the study. For both scenarios, the allowable maximums were determined by adding a variety of costs to the Minnesota-Wisconsin manufacturing price. Those additional costs included the costs of maintaining Grade A production standards, the costs of processing fresh milk into ingredients, the costs of transporting thos~ ingredients to the appropriate region and the recombining costs. The first scenario.differed from the second by the additional cost of the Class I differential on milk at Eau Claire, Wisconsin. This cost, included in scenario 1, exists only when it is assumed that the current level of'class I prices in Eau Claire is maintained for milk supplied as ingredients. This cost implies the maintenance of identity of source for any milk solids used for reconstitution so that proper accounting to appropriate milk orders can be made. \{hile this cost is required in order to '\ maintain any level of price discrimination between fluid use and manufacturing use milk, one must agree with the authors' statement that identity maintenance would be difficult if not impossible to administer. Therefore, the results of the study for scenario 1 are essentially meaningless for practical purposes. Scenario 2 is the more practical assumption. Essentially, scenario 2 examines the case when Class I differentials are limited to the costs of processing fluid milk into butter and powder and then recombining the butter and pmvder back into fluid milk, as well as additional Grade A production costs. Allmvable Class I diff eren tials do not vary much be theen U. S. regions because the transportation costs for ingredients are much less than the same costs for fluid milk. Scenario 2 was also considered using two estimates of supply elasticity, one each for the short and long run cases.

15 According to the results of the model under scenario 2 assumptions, the fluid milk price in the Northeast would decrease by $1.08 in the short run. As.a result of the smaller Class I price, the uniform price in the Northeast would fall by $.42 and fluid milk use would increase by 302 million pounds. Because. of the lower uniform price, Northeast milk production in the short run would decrease by 278 million pounds. For the entire U.S., fluid milk use would increase by 610 million pounds. That resulted in substantially less manufacturing milk being available, thus causing the manufacturing milk price to rise by $.24. This $.24 increase in the manufacturing price kept the fluid milk price, which is determined using the manufacturing price, from falling the full $1.32 decrease in the Class I differential. According to the authors, the impacts under scenario 2 using long run supply elasticities did not differ substantially from the impacts under the same scenario (~ in the short run case. While that statement may be true for the average effect over the entire continental United States, it is definitely not true for individual regional impacts. In the long run, which is the most reasonable situation to consider, milk production changed substantially within regions 'vhen compared to the short run. Northeast milk production changed from -278 million pounds in the short run to -446 million pounds in the long run. In the Southwest region, milk production increased an additional 200 million pounds more in the long run than in the short run. Hhen examining the results of the model for each scenario,.it can be seen that the model does not appear to be in equilibrium~ One would presume that the change in aggregate U.S. milk supply would have to be equal to the change in the aggregate U.S. milk demand. In the model, the chan e in milk demand should be equivalent to the sum of the changes in fluid demand, manufacturing demand, and ~ government purchases. Unfortunately, in scenario 1, demand is greater than supply.

16 - 15- (, Eighteen million pounds more milk is used than is produced. Where did the 18 million pounds come from? Foreign trade is not considered in the model so the 18 million pounds were not imported. A reasonable conclusion might be that those 18 million pounds originated from government storage of milk purchases in previous years. If that is the case, then this model is certainly not in equilibrium, for the U.S. cannot draw upon its stored quantities of milk indefinitely. A similar disequilibrium condition occurs in the short and long run situations for scenario" 2. In both cases, the change in milk productipn is not equal to,the change in milk purchases. However, in these cases, too much milk is available. ' The decrease in purchases, or quantity demand, for the short run case is 240 million pounds. The corresponding decrease in production, or quantity supplied, is only 231 million pounds. Where did the extra nine million pounds of milk go? Once again, it is left unexplained and implies a condition of disequilibrium. Such a condition would affect the results of the model, since it implies that the model's supply and demand systems \Jere never adequately combin~d in the model. It was the conclusion of the authors that relaxing all price and use restrictions on reconstituted milk would not lead to its being a significant part of total fluid milk supply for any region of the U.S. "That is, if reconstituted milk would be freely traded and used and accepted by co~sumers in the U.S., very little would be used to supply fluid milk needs. Nevertheless, it [reconstitution] is a technology that can enable some consumers to obtain milk at lower cost, and it does not have economic consequences." The above conclusion of the study does not seem to agree with the basic premise and results of the analysis. The study is supposed to deal with the "potential impacts of reconstituted milk... " yet the major model in the study does ( not deal explicity with reconstituted milk nor do the results show any substantial

17 - 16 _. c increases in the use of reconstituted milk. The model appears to deal more directly with the impacts of changing Class I price differentials than with the impacts of reconstituted milk. Since reconstituted milk is not estimated to be extensively used in the U.S., it would seem that the increase in general +>ublic welfare, estimated at $22-25 million annually for scenario 2, is due not to the technology of reconstituted milk, but rather entirely to changing Class I differentials and the redistribution of income from farmers to consumers and between farmers. The statement that the technology of reconstituted milk does not have economic consequences seems contrary to the entire study. Reconstituted milk, used as justification for altering present Class I differentials, does have major economic consequences., if not on a national basis, then certainly on a regional one. ( \.. It is doubtful that, given the questionable analysis in the study, this publication can provide any specific insight into the economic effects of reconstituted milk. Currently, there is no alternative study or publication which can provide such insight. However, federal order data can be used to analyze some preliminary economic impacts for individual marketing areas. Such an anaylsis,vas done for the New York-New Jersey milk marketing area for June Economic Impacts of Reconstituted Milk on Federal Order No.2 The potential economic impacts of the proposed change in the Federal Order - pricing provisions dealing with reconstituted milk are highly dependent on the degree to which reconstituted milk can be substituted for fresh milk. In the, \ ::, previous study, Hammond, et. al. assumed that reconstituted milk can be completely substituted for fresh milk. State restrictions on the use of reconstituted milk as well as consumer preference for ~resh milk were assumed to be non-existent. However, in reality, state restrictions do exist which inhibit the use of reconstituted milk. Consumers also are believed to have a preference

18 for fresh milk. There are particular state restrictions concerning reconstituted milk in the two states included in the New York-New Jersey marketing area. While New Jersey has no restrictions against the use of reconstituted fluid milk products, the state does have labeling laws applying to such products. Any product containing reconstituted skim milk must be labeled "reconstituted" or "recombined" in letters not less than 1/16 of an inch high or half the height of the product name. New York State makes no provision for a milk product that may be legally labeled as reconstituted or recombined. "Flavored dairy drinks" may be made by adding reconstituted skim. Currently, any milk containing reconstituted skim is considered "adulterated" under New York State regulations. Consumers are believed to have a taste preference for fresh milk. However, r ' l it was suggested in the Hammond, et. al. study that milk blends made from skim, of which 50% has been reconstituted, cannot be distinguished from the totally fresh products by most consumers. Currently, such a blended product would not be legal in Ne\v York State,~/ but would be in New Jersey. Given the economic incentive Hhich would exist in reconstituted milk, it is possible that, in the long run, New York State laws might be changed to al1mv a blended product. 6/ Blended products of fresh and reconstituted milk cannot be labeled "reconstituted milk" because no legal definition of reconstituted milk presently exists in New (. "-- York State. If the blended product was labeled "milk" it would be considered adulterated and, therefore, illegal. In order to legalize the sales of a blended product, a legal definition of reconstituted milk needs to be established.

19 Given the above information concerning the potential degree of substitution of reconstituted skim for fresh skim, four cases involving different assumptions were used in estimating the economic impacts to Federal Order No.2. These cases are: Case 1: Assume the removal from pricing of milk currently reconstituted from powder and handled as "other source" milk. Case 2: Assume that all flavored milk drinks and buttermilk are made from reconstituted skim milk. All Class I skim displaced by reconstituted skim is priced as Class II. Case 3: Assume that milk, lm\7 test milk, and skim milk are standardized with reconstituted skim milk. All Class I skim displaced by reconstituted skim is priced as Class II. Case 4: Assume that all flavored milk drinks and buttermilk are made from reconstituted skim and also that 50 percent of the skim milk in - / Class I products of whole, 1m") fat, and skim milk is reconstituted skim milk. All Class I skim displaced by reconstituted skim is priced as Class II. In determining the economic impacts of the above four cases, it was also assumed that the current Class I differential would not be changed. This assumption is valid in the short run given the time-consuming process of initializing and conducting the necessary hearing required if the Class I differential was changed. In the long run, the.current Class I differential can be changed. The impacts of such a change are estimated in a later part of this analysis. A simple iterative model was developed which calculated the changes in uniform prices, total production, and total value of pooled milk for each case using selected estimates of supply and demand elasticity. Because of differing estimates in supply elasticity, four levels of supply elasticity were selected. The elasticity estimates for both supply and demand are given in Table 2. The

20 /""":", I. Table 2 Supply and Demand Elasticities for the Northeasternl/ United States Elasticity Supply Short Run Long Run Hammond!/ Jackso~/ Demand (fluid milk) -.168!/ From Hammond, Jerome W., "Regional Milk Supply Analysis," Department of Agricultural and Applied Economics, Staff Paper 74-12, University of Minnesota, 1974, p. 21. ( ]) From Jackson, Geoffrey, "Milk Supply Response and Some Regional Implications for Dairy Policy in the United States," Ph.D. Dissertation, Cornell Lniversity, 1973, p. 67. Jackson defines the Northeast region as all states north and east of, and including, Pennsyl vania, Maryland and Delaware. Hammond enlarges Jackson's Northeast region t o include the states of Ohio, Virginia and West Virginia..* &f9p ~!G' L!G W 4 _.i"x

21 r-, \,." supply elasticities from the 1974 Hammond study were -also used in the recent Hammond, et. al. report already discussed. One reason for 'the difference in supply elasticities between Hammond and Jackson is the difference in the area defined as the Northeast. Harmnond includes the states of Ohio, Virginia, and West Virginia in his Northeast region while Jackson excludes, the three states. Because this analysis uses the Northeast estimate as the estimate for Federal Order No.2, Jackson's smaller geographic area may better represent the New York- New Jersey marketing area. The empirical results of the model for all four cases as calculated for June , are given in Table 3. The uniform price, total production, and total value of pooled.milk did not change substantially in Case 1. This was due to the small amounts of milk currently reconstituted and used under present pricing provisions. The impact of Case 2 was greater than in Case 1 but nevertheless was still moderate. The uniform price decreased less than $.03 per hundredweight and the value of pooled milk decreased less than $500,000 for all supply elasticities. The impact was caused by the reclassification from Class I to Class II of over 11 ~illionpounds of skim milk used in flavored milk drinks and buttermilk. In case 3, the uniform price decreased between $.13 and $.14 per hundredweight depending upon the supply elasticity assumed. The use of reconstituted milk for standardization also changed the value of pooled milk over $2 million for June 1979 using Jackson's long run supply elasticity. The assumptions in Case 4 resulted in the largest impact to the order pool. In Case 4, uniform price decreased benveen $.44 and $.46 per hundredweight. Total Imilk production decreased substantially, ranging from -8 million pounds to -31 \ million pounds. and $7.2 million. The total value of pooled milk decreased between $5 million If the decrease calculated using the Jackson long run supply elasticity was the average monthly decrease in the total value of pooled milk,

22 TABLE 3 New York-Ne,ol Jersey Marketing Changes Due to Reclassification of Reconstituted Milk Using Selected Supply Elasticities and Reconstituted Milk Utilizations June 1979 Change in the Uniform Price Case Short Run Long Run Hammond Jackson Hammond Jackson ~~/cwt Change in Total Hilk Production Case Short Run Long Run Hammond Jackson Hammond Jackson ~11000 Eounds , 809-1, ,497-2,967-4,052-8, ,444-10,206-14,020-31,051 Change in Total Value of Producer Milk Case Short Run Long Run Hammond Jackson Hammond Jackson ~Dollars2 1 22,191 22,946 24,739 41, , , , , ,517,818 ' :'1,569,042-1,678,205-2,165,081, ( J 4-5,066,560-5,225,014-5,596,959-7,225,293

23 the annual decrease would be $86.7 million. Federal Order No. 2 dairy farmers would be losing over eighty-six million dollars annually as a result of allmving reconstituted milk to be priced at the Class II price. The impact on the total economy within the order would be greater than the total impact to dairy farmers alone. Secondary economic effects to the general economy must also be considered. Such secondary economic effects can be calculated using an income multiplier. This income multiplier represents not only the change in income to dairy farmers but also change in income to other sectors of the economy that are directly involved in the production, processing, or marketing of local dairy products. The income multiplier for the agricultural sector of Ne,,, York State is / If such an income multiplier was applied to Federal Order No. 2, it could be shown that the total loss to the economy in the Federal Order No. 2 milkshed would be in excess of a quarter of a billion dollars.,r That loss,"ould be felt most heavily in the rural sectors, which could least afford it. It can clearly be seen that dairy farmers and the entire rural economy,"ould be losing substantial income as a result of each of the various assumptions concerning reconstituted milk, regardless of the supply elasticity assumed. In order to determine the net impact on general welfare, one must estimate the benefits that would accrue to consumers as a result of lower fluid milk prices. Such benefits can be seen as an increase in consumer surplus. 2/ David L. Call, "The Role of Agriculture in the Economy of New York State," Cornell Agricultural Economics Staff Paper No , April,1977, p. 12.

24 c At this point in the analysis, one must make note of the difference between the Class I price and the fluid price. In current Federal Order provisions, the Class I price is the fluid price. However, if Class II-source reconstituted milk becomes part of the fluid supply, the ef fective fluid price is no longer the Class I price. Instead, the fluid price is a blend of the Class I price and the cost of reconstituted milk to the handler, weighted by the amount of fresh and reconstituted milk respectively in the fluid supply. The return to producers for fluid milk is also the Class I price under present Federal Order provisions. However, as Class II milk enters the fluid supply by way of reconstitution, the return to producers for fluid milk decreases. In fact, the return to producers is below the effective fluid price to consumers because the A effective fluid price to consumers must be equal to the return to farmers plus \ the costs involved in the reconstitution process. Figure 1 represents a graphic display of the change in consumer surplus due to a decrease in the price of fluid milk. ' The consumer surplus is approximated by the area POABP1. The total decrease in the value of producer milk represents the loss in income to producers. The loss in income can be broken down into two areas, the loss due to.the decrease in total production and the loss due to decrease in the value of fluid milk to producers. The loss due to the decrease in total production can be calculated as the change in total production multiplied by the marginal revenue lost by producers~ Since all milk in excess of Class I demand is priced as Class II, the marginal revenue per hundredweight is the Class II price. The decrease in the value of fluid milk represents the revenue lost by producers because of the inclusion of Class II milk in the fluid milk supply. Graphically, the decrease in the value of fluid milk to producers is represented ',_~ in Figure 1 as the area PoACP2less area CDFE. Area PoACP2 represents the revenue

25 - L4 - () FIGURE 1. CHANGE IN CONSU}lliR SURPLUS ~~D PRODUCER INCOME DUE TO SHIFTING FLUID MILK PRICES Price ($/cwt) Po (Class I) P l (Consumer) P 2 (producer) P 3 (Class II) 1-- r jc I i Demand (fluid milk) /~ (. ""' Where: Q l Q 2 Fluid milk use Ql is the quantity of fluid milk demanded at the original Class I price. Q2 is the quantity of fluid milk demanded at the new blended fluid price to consumers. Po is the Class I price (=12.88 in June 1979). P l is the new blended fluid cost to consumers. P 2 is the new blended fluid price to producers. P 3 is the Class II price (=10.65 in June 1979). Note: All prices and costs at the mile zone.., J2A. \ t'.=:;;;0.t. e. &,:... $

26 lost by producers on existing quantities of fluid milk. Area CDFE represents the increase in producer revenue because of the increase in the quantity demand of fluid products. The estimates of change in consumer surplus and producer inco~e as a result of changing fluid milk prices are given in Table 4. Also given in the table are the fluid prices paid by consumers and the fluid prices received by producers. Since fluid milk prices are unaffected by differing supply elasticities, the estimates are the same within each case considered. TABLE 4 New York-New Jersey Ma rket Order Changes in Fluid Milk Prices, Consumer Surplus and Producer Fluid Hilk Income Using Selected Reconstitute d Milk Utilizations June 1979 Case Fluid Price Paid by Fluid Price Change in Consumers Received by Producers Consumer SurElus ($!cht.) ($/cwt.) ($) , , , ,825,165 Change in Producer Income 7a/ ($) 14, ,711-1,267,185-4,202,279 7a/ Due to change in fluid milk prices only, this figure does not include the change in producer income due to decrease~ milk production.

27 The fluid price paid by consumers is above the fluid price received by. farmers by an amount equal to the processing costs involved,,,hen using recon-, stituted milk as part of the fluid miik supply. This difference in prices paid and received for fluid milk resul~in the gain in consumer surplus being substantially smaller than the loss in producer revenue from fluid sales. If the increase in cons umer surplus is compared with the decrease in the total value of producer milk (see Table 3), the benefit to cost ratio becomes even smaller. Consumers in the New York-New' Jersey milk marketing area do gain economically from the use of reconstituted milk. However, that gain is essentially a result of the transfer of money from dairy farmers to consumers. Even if such a transfer of money was desirable, the use of reconstituted milk as the transfer mechanism is extremely inefficient. Consumers are gaining only half the fluid income loss by dairy farmers. The remainder of the loss from fluid income is used to pay the processing and recombining costs of reconstituted ingredients. From a general economic perspective, the rural economy in the New York-Ne\" Jersey marketing area An alternative to maintaining the current Class I differential and allowing milkshed loses at least 10 times more income than consumers directly gain. reconstituted milk to become part of the fluid milk supply, is to lower the Class I differential and eliminate the economic incentives for handlers to use reconstituted milk. Since reconstituted milk would not become part of the fluid milk supply, it would not be necessary to assume any particular level of consumer acceptance of reconstituted milk. / The cost of obtaining fluid skim in June 1979 was approximately $7.37. The difference between that cost and the cost of using fresh fluid skim was approximately $1.68 in June If the Class I differential was to be reduced by $1.68, handlers would no longer have any economic incentive to use reconstituted skim over ( fresh skim. Since the Class I price in June 1979 was $12.88, the new adjusted price would be $11.20.

28 The previous iterative model was again used, this time to estimate the impacts of lowering the Class I differential. The four estimites of supply elasticity ~vere also used. The empirical results of the model can be seen in Table 5. As seen in the table, uniform price fell approximately $.67 per hundredweight for each supply elasticity assumption. This decrease in the uniform price is almost 50 percent larger than the decrease which occurred under the previous assumption of no Class I differential change for Case 4. Both the decreases in total milk production and total value of producer milk are also almost 50% more in this ca.se than in Case 4 of the previous assumption. Producers would be better off economically if the Class I differential was maintained at the current level and 53% of the fluid market was lost to reconstituted Class II products (Case 4) than if the Cla~s I differ~ntial was reduced to eliminate the use of reconstituted milk. However, the economic advantage to producers is dependent on how much of the fluid market ~.;ould be lost to reconstituted milk. It can be sho~/ that as long as at least 25% of fluid milk is used in a fresh state and is priced at the current Class I price, producers ~vould have an economic incentive not to reduce the Class I differential for the month of June / Recalling that the fluid price is no~.; a blend of the Class I and Class II prices, the level of utilization of Class I milk in the fluid supply can be determined by the following equation: (Class I Price x Class I Utilization in the Fluid Supply) + (Class II Price x Class II Utilization in the Fluid Supply) Fluid Price For June, 1979 the eqationwas (12.88 x XI) + (10.65 x XII) = where XI XII Class I utilization in the fluid supply Class II utilization in the fluid supply.. and XI + XII = 1.00 solving XI =.25 - Z< SQ...

29 TABLE 5 Nev York-Ne\.J' Jersey Market Order Changes Due to Altering the Class I Differential Under Selected Supply Elasticities June 1979 Short Run Long Run Hammond Jackson Hammond Jackson Change in the Uniform Price ($/cwt.) Change in Total }Iilk Produc tion (1,000 pounds) 12,599 14,934 20,434 44,659 Change in Total Value or Producer Milk ($) -7,469,755-7,711,400-8,263,023-10,710,704 TABLE 5A Ne~Y' York-New Jersey Market Order Changes Due to Eliminating the" Class I Differential Under Selected Supply Elasticities Short Ruri Long Hammond Jackson Hammond Change in the Uniform Price ($/ CtY't. ) Change in Total Hilk Production (1,000 pounds) 17,073 20,258 27,772 Change in Total Value of Producer Hilk ($). -10,011,932-10,334,201-11,094,563 Run Jackson ,944-14,451,235 ~

30 From the consumers' side, decreasing the Class I differential would result in a '), ~ threefold increase in the value of the consumer surplus. The consumer surplus would increase to $6.3 million. The drastic increase in consumer surplus resulted because consumers were now gaining the costs which formerly went to processing and reconstituting costs. Producer revenue attributed to fluid sales also decreased as a result of the decreased Class I differential. However, that revenue fell only $6.2 million. There was a net benefit of $.1 million dollars to general public welfare. However, that increase in general public welfare is rather insignificant in light of the fact that the total value of producer milk decreased $10.7 million. On an annual basis, this could amount to a $128 million decrease in producer revenue for the New York- New Jersey marketing area milkshed. When the multiplier effect is considered, the loss to the economy is calculated to be almost 400 million dollars. A possible alternative to decreasing the Class I differential by a fixed amount would be to eliminate the Class I differential entirely. Since the use of Class 11- source reconstituted fluid milk violates the requirements for a classified pricing system, eventual elimination of the Class I differential is not an unlikely prospect. If that situation does occur, essentially: the blend price would become the Class II. 8/ prlce.- The impacts of eliminating the Class I differential for Federal Order No. 2 are given in Table SA. As seen in the table, the uniform price ~ lould fall approximately $.91 in June Since the uniform price would no longer be a blend of class prices ~~eighted by the amounts of milk in each class, supply elasticity assumptions would have no effect on the uniform price. Total milk production and the value of producer milk would be dependent on the particular supply elasticity assumed. Under the Jackson long run supply elasticity, milk production decreased almost 61 million pounds for the 8a/, - Less any required deductions such as seasonai incentive deductions and transportational credits. ;;c

31 month. Under the same elasticity assumption, the total value of producer milk decreased over $14 million. Projected on an annual basis, the total value of producer milk, or total producer income, could change as much as $170 million annually. Because of the income multiplier, the impact on the rural economy of the milkshed, lould then be in excess of half a billion dollars annually. Clearly, from the viewpoint of Federal Order No.2 dairy farmers, altering present order pricing provisions could have drastic consequences, resulting'in severe personal loss to farmers and even greater loss to the rural economy. Since. it is doubtful that reconstituted milk could capture over 75% of the present fluid ' market, farmers would be better off in the long run by maintaining the present Class I differential. The greatest detrimental impact to both dairy farmers and the rural economy would occur if Class I differentials were eliminated entirely. The month of June 1979 was used in the previous analysis because it was the ( latest month for ~hich detailed Federal Order No.2 statistics were available. The question might be raised that perhaps the results from June 1979 are biased because of the milk production characteristics of that particular month and season of the I year. In order to examine the potential validity of portraying the economic impacts calculated for June as typical for each month, some simple economic impacts for the month of October 1979 were estimated. The price per hundredweight of fresh skim milk was approximately $9.24 in October The price per hundredweight of reconstituted skim was approximately $7.74 per hundredweight2..1 in the same month. The economic incentive to use reconstituted milk was, therefore, $1.50 per hundredweight, $.18 below the incentive in June. However, even though the incentive had been reduced almost eleven percent, the total economic impact between months will not vary substantially because fluid milk consumption was also eleven percent greater in October than in June. ~Vhen consumer.. surplus is approximated for October 1979, this estimate does not differ much from

32 June / The impact to dairy farmers also would be similar in both months. (~ As fluid milk consumption increases, the amount of reconstituted milk substituted for Class I sales also increases due to the assumption that reconstituted milk will maintain a fixed share of the fluid market for each of the four cases previously discussed. wnile the decrease in the fluid price received by farmers will be less in October than in June, the increase in the quantity of reconstituted milk used as fluid in October will act to make the total impact to dairy farmers similar in both months. In comparison with October 1979, June 1979 does not appear to have ' been a unique month. The impacts of the use of reconstituted milk will vary from month to month depending on such factors as total milk production, fluid milk demand, the reasonable to use June 1979 as a typical month and draw some general conclusions price of powder, and the effective Class I differential. However, it is not unf from it. ::::S.

33 Footnotes 2./ Fresh Skim Milk, October 1979 Class I skim value ( mile zone) Hauling to city Administrative Assessment.5% shrinkage loss Balancing and Services Per Cwt. $ $9.236 Reconstituted Skim from Locally Produced Powder, October ~ Class II skim value ( mile zone) Processing cost for powder Transportation to city Per Cwt. $ Reconstitution Administrative Assessment.5% shrinkage loss Balancing and Services $7.750 Reconstituted Skim from Chicago Spray Powder, October 1979 Powder cost (Chicago Spray) ($.8294 X 9 lbs.) Transportation (1000 miles) Reconstitution cost Per Cwt. $ $ / $6.2 million consumer surplus in October

34 In addition to the quantifiable impacts to Federal Order No.2, it is ( \. : ~ important to make note of many other less quantifiable, but equally important impacts to the Order. In the long run, dairy farmers would find it to their general economic advantage to maintain the present Class I differential instead of decreasing it. While the level of that advantage depends upon the assumption concerning the amounts of reconstituted milk in the fluid supply, it is unlikely that consumer preferences would allow reconstituted milk to capture 74% or more of the fluid market. 11./ However, in the short run situation, farmers may be forced to lower the Class I differential in order to find a market for their milk. If the Class I differential remained constant, there would be an immediate economic incentive for handlers to use reconstituted milk once Federal. Order pricing provisions were altered. Reconstituted milk could immediately be sold in (~ New Jersey so,long as the labeling requirements were met. Since the legai restrictions to the use of a blended product in Nev York. State result from the omission of a legal definition of reconstituted milk rather than a direct prohibition of its use, it would probably not be long before a blended product could legally be sold in New York State. Dairy farmers would feel the impact almost immediately, as handlers only are required to give 30 days notice in New York and Pennsylvania and 60 days notice in New Jersey vhen they decide to drop producers. Handlers would either manufac ture their mm ski8 powder or else buy pmvder in the midwest. The reconstituted milk will displace large quantities of milk formerly used for fluid use. While some of that milk may be converted into powder locally, the owners of most of the displaced milk ~vill be hard-pressed to,; 75% maximum for June 1979 and. 74% maximum for October =

35 find a market for it. In Case 4 of the previous analysis, which assumes that reconstituted milk would capture 53% of the fluid market, over 188 million pounds of milk would be displaced for the month of June alone. Most milk manufacturing operations are normally running near. the maximum level during the spring flush months. It is extremely unlikely that that quantity of milk,over 20% of the total pooled milk in the month and a potential 35% increase in Class II use, can be absorbed into the local marketplace. This displaced milk would cause major disruptions in the market, significantly contributing to the instability of local milk production; An alternative to lowering the Class I differential would be for farmers to ship their displaced milk to a more distant market. It is unlikely.that any market could handle that excess quantity of milk, especially considering that many other markets will also be having similar problems. However, if the milk. could be used in a distant market, perhaps in the mid'"est, the problem of excessive transport~ioncosts to producers would exist. The present hauling structure and supply patterns within the Order would be in chaos. An increased burden ' )Quld fallon coopera ti ves, because of their role in balancing and market ing milk supplies. Cooperatives currently receive service charges above the Federal Order No. 2 price in order to cover handling and transportation costs. Under the disrupted market caused by the incentives to use reconstituted milk, cooperatives will no longer be able to secure above-order prices. However, because of the possible need to ship milk to distant markets, the total transportation costs of cooperatives will increase drastically. Cooperatives would be forced to pass along the increased costs to producer members in the form of lower reblend prices. This would result in even greater stress on local milk producers.

36 - 35- One of the assumptions used in the previous analysis was that the manu- t " facturing price for milk would not increase as a result of the increase in demand for nonfat dry milk powder. Since the manufacturing price is related to the demand for manufactured products, such as powder, many people, including Hammond, Buxton, and Thraen in their recent paper, conclude that the manufacturing price would increase substantially. Since the Class II and Class I prices are linked to the manufacturing price, it would logically follow that these class prices would also rise. However, one might take exception with the initial assumption concerning the increase in the manufacturing price. It is not likely that the price of nonfat dry milk powder will increase much in the short run due to the Commodity Credit Corporation's current inventory of available powder. As of October 31, 1979, CCC had uncommitted inventories of 423 million pounds of nonfat dry milk powder. This is the equivalent of almost ( five billion pounds of. reconstituted skim milk. That powder can be released upon a 5% increase in price, thereby limiting the potential increase in market price. In the long run situation, additional butter-powder manufacturing facilities could be built in response to the increased demand and slightly higher price. A final observation which can be made concerning the economic impacts to the New York-New Jersey marketing area is that changing current pricing provisions would also change the relationship between the Class II and the blend price in certain months. When a blend of reconstituted- fresh milk was assumed with no decrease in the Class I differential (Case 4), the blend price 12 / for June 1979 decreased approximately $.45. The new blend price was then $10.58, seven cents below the Class II price. A similar situation ~ould have occurred if the Class I differential was dropped. In tnat case, the blend price for June fell approximately $.67, resulting in a new blend price of $ This blend price was 29 cents below the Class II price. This discrepancy was caused by the various deductions 12/ At mile zone.

37 - 36- c below the Class II price would not occur in all months, it could occur in the in June, including the seasonal incentive deduction. \{hile such a blend price months of spring. Such a relationship between the blend price and the Class II price could result in producer unrest within the Order. The difference between the Class II price and the price received by producers could be even greater if substantial cooperative reblends as a result of higher transportation costs occurred. Classified Pricing and Pricing Supports Classified. pricing, a form of price discriminatio~is authorized by the Agricultural }~rketing Agreement Act. The Secretary has used the inherent nature of dairy products and the resulting demand curves to raise and main~ain dairy income. The theory behind price discrimination is that, if the correct conditions exist, then charging a higher price in one market and a lower price in a second market will generate more revenue than charging the same price in both markets. In order to effectively price discriminate, there are certain necessary conditions. The two markets must be separable, i.e. buyers cannot divert product from the lower to the higher price market. Also, the demand elasticities must differ between \vith the more inelastic market having the higher price. additional condition of supply control is unnecessary because the Commodity The ( Credit Corporation, through the price support program, stands as the buyer of last resort.. The Federal Orders separate the markets through enforcement of its classification and pricing frame\vork. Milk is classified by the final form or purpose of its use, minimum use prices are established and charged to handlers on an equitable basis. The denand for fluid milk use is highly inelastic and receives the higher price \vhile demand for manufactured milk is less inelastic and priced lower. The current pricing of reconstituted milk under federal orders removes the price incentive for handlers to break the separate market condition because it is

38 effectively priced as a Class I fluid use. By allowing unpriced reconstituted milk, I a handler can buy nonfat dry milk at the lower Class II price and with the addition of water sell the product in the Class I market. If the reconstituted milk product was perceived as a close substitute of fresh fluid milk, this would make the demand for fresh milk more price elastic and have an additional adverse affect on classified pricing. Depending on the degree of consumer acceptability, exempting reconstituted milk from Federal Order pricing theoretically, if not practically, means the end of classified pricing. The Agricultural Act of 1949 requires the Secretary to support milk prices received by farmers at between 75 and 90 percent of their parity prices. Through the present support price calculation, only manufactured grade ~ilk and not all milk is supported at the announced percent of parity. If there is a $.50 per hundred,veight increase in the manufacturing milk support price, the $.50 per hundredweight increase will be reflected in the all milk,vholesale price. However, if this per hundredweight change brought about the announced percent of parity in lower priced manufacturing milk, it cannot achieve the same percentage in the higher all milk wholesale price. A major reason for this difference is that the Secretary has not further used his authority to price discriminate by either raising existing class price differentials or differentiating additional use classes. In 1969, the ten year ratio of the manufacturing grade milk price to the all milk wholesale price was 79.3%, by 1979 this ratio was 87.0%, and, if unpriced reconstitution destroys classified pricing, then this ratio will eventually approach 100%. In the interim, the loss of income by federal order dairy farmers would result in a percent of parity for all milk well below the congressionally mandated 80% and possibly below the legal minimum of 75%. The federal order system in 1978 paid producers $8,414,788,000 in their blend price. The use of price discrimination through classification accounted for over

39 nine percent of this total. If the result of allowing unpriced reconstitution.~ was taken to its extreme (the end of classified pricing), the United States dairy farmers would have lost almost three quarters of a billion dollars in If this loss \Vas to be made up in the support price, the percent of parity would have needed to be about 85% instead of 80%. This would have meant an additional 72i per cwt. increase in October 1, 1977 and 65i per cwt. in October 1, If dairy farm income were to be maintained at the current national level via the support program, consumers as a group are not likely to benefit at all. (). ~ Q, 2- ** II... g.,.

40 - 39- LEGAL COMNENTS Pricing Fluid Skim Milk Differently from Reconstituted Skim Milk 1. Section 608c(S) (A) requires that Orders issued with respect to milk and its products contain terms that prices shall be uniform as to all handlers subject to certain adjustments (including grade or quality of the milk purchased). Unless it can be successfully argued that classifying (pricing) reconstituted powder at a lesser price (Class II) than competing fluid skim (Class I) represents a permissible grade or quality adjustment, the CNI proposal may well run afoul of Section (S)(A). It seems that the greater the similarity of the product (Le. reconstituted skim vis-a-vis fluid skim) the greater the competition. If proponents urge the argument that presently packaged dry powder (priced at Class II) is unacceptable to the less affluent consumer because of taste, and that handlers can reconstitute /. "professionally".sotaste is like the fluid skim, then they must face the proposition that they are admitting inevitable competition based on the public's perception of substantial identity. Incidentally, if proponents deny that the taste is better, then this starkly exposes the.fact that so far as consumer economic benefit is urged as a reason for the p.roposal, it has no merit, since consumers can presently obtain packaged powdered milk (presently priced at Class II) at lower prices than fluid and reconstitute it themselves. 2. It can certainly be argued that the result of the above competition (the more so as the similarity of the products approaches identity) will be to erode the price uniformity requirement and ultimately to undermine the Act. 3. Al though the result of the CNI proposal "Till be to price reconstituted ( milk at Class II, it arrives at this result by removing it from the classification requirements of the Act. There is a solid argument that if classified pricing is

41 -40 - mandated by the Act, or even if classified pricing.is only a permissible alternative c. method of achieving uniform prices to handlers as mandated by the Act, then removing reconstituted milk from classification (and perhaps, despite CNI's contrary position, removing milk products from classification) is beyond the Secretary's power because it is not permitted by the Act. Comments on CNI Petition Section VI(c) - Alleged violation of 608c (5) (G) of the Act. The Act here prohibits barriers but the present pricing system for nonfat dry milk (po\\lder) doesn't bar the use of this product in terms or de facto because of economics. First of all, terming the payment a tax is inaccurate if only because any revenues derived from the classification system are not public revenues but are distributed amongst producers. Clearly, it is intended not to clarify but to inflame. The present system requires pa)~ent to be made at the Class I price for all powder used to the extent that the powder increases the volume of Class I sales. This system does not discriminate among or against different production areas. Powder produced and marketed in this production area is priced in precisely the same way as powder produced outside this production area, whether marketed in or out of this production area. Section VIed) - Secretary's Authority to regulate prices of powder. This petition admits that the Act gives the Secretary authori.ty to classify and establish prices for milk used to produce milk products. This, of course, is just what current regulations (the Marketing Order) do. They classify powder used to fortify or in other non-fluid-increasing ways as Class II and classify as Class I only so much of the powder as is associated with fluid milk volume increase. Thus, whatever the merits of CNIls contention that the Secretary doesnlt have the power to establish prices for milk products (which need not be reached), this is irrelevant to the issue they raise. ( ~. The issue is whether the Secretary has authority to establish prices for the milk (nonfat dry powdered milk) used to produce the milk product (reconstituted milk). The answer, by CNI's own admission, is clearly that he does.

42 SUMYiARY The.seriousness of changing reconstituted milk pricing in federal orders differs depending on the degree of consumer acceptance of the product. If consumers do not consider it a close substitute, there will be no impact. At the other extreme is the loss of millions of dollars of farm income and several times that amount to the already depressed rural economy. For the New York-New Jersey marketing area milkshed, substantial impacts to income would be felt. Under the assumption of close substitutability between reconstituted and fresh milk, the blend price in Federal Order No.2 was estimated to fall $.67 per hundredweight~ The loss in dairy farm income was projected to be in excess of $128 million annually. This was an average annual loss of over $7,000 per producer. Because of the secondary effects of a direct loss in income, the total loss to the rural economy of the New York-New Jersey milkshed was almost $400 ( million annually. It has been suggested that because of consumer taste preferences, reconstituted milk might be limited to replacing approximately 50% of current Class I usage. If such a limited degree of substitution did occur in Federal Order No.2, it would be to the economic advantage of farmers to maintain the current Class I differential instead of lowering the differential in order to eliminate the economic incentives to use reconstituted milk. While all producers would gain through a comparatively higher blend price, some producers would not be assured of finding a market for their milk. Almost 200 million pounds, or 20% of the total June 1979 pool, would be displaced as a result of the use of reconstituted milk. Manufacturing operations are normally running near their peak in the month of June and it is unlikely that that quantity of milk could be absorbed in the ( \.... manufacturing sector.

43 The use of reconstituted milk in Federal Order No. 2 was also seen to be an extremely inefficient means of increasing consumer surplus. Because of the costs of processing fluid milk into ingredients.and then reconstituting those ingredients back into fluid milk, consumers would be gaining substantially less than farmers would be losing. The economics and nature of a reconstituted milk product are such that successful marketing of the product is more likely than even consumer advocates suggest. This would pose a serious threat to federal orders because of the questionable viability of classified pricing. The use of classified pricing added about three-quarters of a billion dollars to dairy farm income in If this amount had been lost, it would have taken an increase of five percentage points in the parity price of manufacturing grade milk to offset it. If national dairy income was maintained at the current national level through the support program, it is r- unlikely that consumers on the whole would benefit from changing the federal order " " price structure.

44 APP~NDIX A c Reconstituting ~lilk Part 1: Current Conditions Under Order No.2 Reconstituted milk disposed of on routes in consumer packages under Order No. 2 is classified as Class I. The other source milk provisions are used to determine the basis of pricing. Sec Classes of utilization. Subject to the conditions set forth in Secs. ~ 'through , the of utilization shall be as follows: ~lasses (a) Class I-A milk shall be all skim milk and butterfat: (1) Disposed of as a fluid milk product: (i) inside the marketing area; (ii) As route disposition in an other order marketing area; (iii) To an other order plant and assigned under such other order to Class I;.1 (iv) (v) In packaged form to an other order plant if such product is not defined as a fluid milk product under such other order; and I i To a partially regulated plant under an other order and there, applied as an offset to Class I sales in any other order! market; (2) Contained in inventory of packaged fluid milk products on hand at the end of the month except as provided in paragraph (c) (3) of,this section; (3) In shrinkage assigned to Class I-A pursuant to paragraph (d) of this section; and (4) Not specifically accounted for as Class I-B or Class II milk. i I I! (b) Class I-B milk shall be all skim milk and butterfat: (1) Disposj~,d of~_a f.j\!t~lll}u.,k -J'!E.lli!.ct _ out:e.tde_~:,jl,g...j!l.er~etin8.jl,.rea. except as provided in paragraphs (a)(l)(i1) through (v) and (c)(3), (4) and (5) of this section; and. (2). In shrinkage assigned to Class I-B pursuant to paragraph (d) of this section. (c) ~ass II milk shall be all skim milk and butterfat: (Class II also includes items not being considered here.)

45 Sec Fluid milk product. "Fluid milk JZroduct" means all skim milk and butterfat in the form of milk, fluidlskim ~ilk, filled milk, cultured or flavored milk drinks (except eggnog and yogurt), concentrated fluid milk disposed of in consumer packages, and any mixture of cream, milk, or skim milk containing less than 10 percent butterfat (other than frozen desserts, frozen dessert mixes, whipped topping mixtures, evaporated milk, plain or s~veetened condensed milk or skim milk, sterilized milk or milk products in hermetically sealed containers, and any product which contains 6 percent or more nonmi1k fat (or oil)): Provided, That when any fluid milk product isf2.~tified with nonfat milk solids, the amount of skim milk to be included within this definition shall be only that amount equal to the weight of skim milk in an equal volume of an unmodified product of the same nature.. and butterfat content. The only changes in the definition of a fluid milk product since July 1, 1968 have pertained to the addition of filled milk and the changing of cream and half and half from Class I to Class II. Sec Milk. ' '-1 "~-1ilk" means (a) the product ~~livered t~ a plant or a tank truck by dairy i farmers as cow's ml}.k,. E (b) the product composed of sktm milk and of not I J.ess than 3 pe,rcent but less than 10 p.erce.nt. b,:!!=,~~~f~t., _ t:s>.. ~~~1) _. ~y- or"~!n~.y, I ~ot_ lav,e b~,e?_a ~,~d.. ingred:i.e~ts other than those deriv~d. fj;om m;i,lk,. s~ch I ingecli~.~~~j1_oj~_., t_o,exceed 4 percent ~ The addition of water as such at any I plant shall not be considered the addition of a.nonmi1v~~dient<.jor pur:pos~.2 : of this definition. This definition shall not be deemed to include products I that are included in other definitions. Sec Skim milk. "Skim milk!: means ill:!y part ~ar:~~.qf--.!q.ilk~ clef; ned in Sec (a) except butterfat and ~hal1 include wa!=~!, _Cl'!Lp.!..ovi4ed for in Sec Sec Fluid skim milk. "Fluid skim milk" means the product consisting principally of uncondensed skim or skim milk in an eguivalent form containing 0.5 percent butterfat or less. Sec Skim milk and butterfat to be classified..,. '-~ AlL skim milk and butterfat required to be reported by each handler pursuant to Sees and shall be classified each month pursuant to the. provisions of Sees through If any of the water contained in the mi;l'k...frqill.----rj;ri,.<;h.a_p.i.9_4~~j:.j.._l!lqg.. ~. _~~_rei!t9ved be(ore the product is utilized I E- disl?.q,~~d of by a h~jld1er 1-the poun_~s of skim milk used or disposeg...2..l.~?. s u_c:.~<!.l1 t sh~~lj?.~.-s2..lll?~c!~:e.~~ _tq.,.be. a.~,. l!;0un E., ~g~;!..y~;l,~p.j:.joth.~. p.9.~:fa!=. m,~.~1l solids contained in such products plus all the water originally associated with such solici.~. - --'-'. ~----~ ~... ~--'-.- \ {) As can be seen from the above, Class I is all the skim milk and butterfat disposed of as a fluid milk product. Skim milk includes all the water originally assoc'iated with the nonfat milk solids if the water was previously removed. Therefore,