OUR INDUSTRY TODAY. An Economic Evaluation of the Food Security Act of 1985: The Dairy Title

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1 OUR INDUSTRY TODAY An Economic Evaluation of the Food Security Act of 1985: The Dairy Title HARRY M. KAISER, DEBORAH H. STREETER, and DONALD J. LlU Department of Agricultural Economics Cornell University Ithaca, NY ABSTRACT This article examines the impact of the Food Security Act of 1985 on the nation's milk market. Market equilibrium variables for the duration of the Bill, 1986 through 1990, are simulated based on a previously estimated econometric model of the national dairy sector. Forecasts of cow numbers, production pcr cow, milk production, milk prices, commercial disappearance, and government removals and costs of the dairy price support program are presented and analyzed. The results provide quantitative evidence of the market impact of the Farm Bill, which should be useful to policy makers and industry leaders in shaping future dairy policies. INTRODUCTION On December 23, 1985, US President Reagan signed into law the Food Security Act of 1985, closing a chapter in a long and difficult process of shaping US agricultural policy for 1986 through The dairy title of the Farm Bill contained several new measures designed primarily to bring milk supply into balance with demand. Included in the Act were: an unprecedented voluntary supply control program aimed at removing 12 hillion lb of milk from the market ; a triggered adjustment mechanism for setting the dairy support price based on government net removals via the dairy price support program ; and mandatory producer assessments on milk marketings to cover some of the COStS of the dairy programs. Since its enactment, alternative views have been expressed on the effectiveness of the Food Security Act. Opionions have ranged from Received October 7, Accepted May 2, pessimistic to optimistic. On the pessimistic side, for example, a leaflet distributed by the Family Farm Coalition argued that as a result of the 1985 Bill : farm prices have been lowered, not stabilized; the US has become a net importer of agricultural products as the dollar volume of exports has plummeted; and real farm income is being replaced by direct payments from the government. On the more optimistic side, the positive impact of the 1985 Farm Bill in reducing production and increasing consumption has been recognized by dairy analysts; e.g., a recent article in the Milk Market News (4) expressed the following sentiment: The Dairy Termination Program with only three more months to go and the increase in commercial sales have gotten most of the attention for lower production and rightly so. Without the Dairy Termination Program we would have 12 billion pounds more milk to sell since last April and that would have eliminated the price in creases over the previous year.... Due to the limited number of empirical analyses of the impacts of this legislation on milk markets, the debate over the merits of the 1985 Farm Bill will likely continue. The purpose of this article is to offer some empirical insight on the impact of the Food Security Act on the nation's milk market. Annual market equilibrium variables for the remainder of the Bill, 1986 through 1990, are simulated based on a previously estimated econometric model of the national dairy sector (7). The forecasted variables include: cow numbers, production per cow, milk production, milk prices, commercial demand, and government removals of dairy products and COStS of the price support program. The results of this research may shed more light on the market consequences of the Farm Bill, which will help policy makers in shaping fu ture national policies for the dairy industry J Dairy Sci 71 :

2 2800 KAISER ET AL. LEGISLATIVE BACKGROUND Congress faced many difficult problems during the deliberation of the dairy title of the Farm Bill in the fall of The 1984 to 1985 Milk Diversion Program had Just expired and milk production was exploding, running above consumption at the highest levels in dairy history. On the one hand, Congress had to deal with the highly visible costs (well over $2 billion/yr) of removing dairy surpluses, projected at levels rangeing from 13 to 20 billion lb, raw milk equivalent (1). On the other hand, US agriculture was in turmoil; farmer prices and incomes were drastically lower than in recent years. Thus, difficult decisions had to be made between reducing the federal budget and assisting a financially weak agricultural sector. The House and Senate each drafted its own version of the Farm Bill, each version substantially different from the other. The Democrats, who controlled the House, proposed a voluntary supply control program without cuts in the milk support price to deal with excess milk supplies. The philosophy behind the House Bill was that reducing support prices to lower budgetary costs would cause more harm than good. The Republicans, the majority party In the Senate at the time called for gradual reductions in the milk support price to reduce milk production and government surpluses of dairy products. The Senate Farm Bill stressed market forces as the means to bring about a necessary restructuring of the farm sector. After much debate, a compromise Farm Bill was passed by both the House and the Senate. The compromise bill included the voluntary supply control program feature of the House bill and measures intended to lower milk support prices consistent with the intent of the Senate bill. The three major provisions of the Food Security Act were: the Dairy Termination Program, use of triggered adjustments in the dairy support price, and mandatory assessments on milk marketings. Market impacts of all three provisions are analyzed in this article. The Dairy Termination Program provided dairy farmers the opportunity to offer bids on the payment they would accept in return for ceasing milk production for 5 yr. The USDA had the discretion of either accepting or rejecting each bid. Farmers accepted into the Dairy Termination Program received a payment equal to the bid, on a dollar per hundred weight basis, times the farmer's assigned contrast base. The contract base was equal to milk marketings in the lower of two 12-mo periods (July 1984 to June 1985 or January to December 1985) and was further adjusted downward if the producer had any dairy cattle transactions between January 1, 1986 and the date of the bid. In return for these payments, participants were required to terminate milk production and to slaughter or export all their dairy cattle by the end of their assigned disposal period. Another unique feature of the Food Security Act was the procedures it established for setting the milk support price. The support price was frozen at its 1985 level for 1986 $11.60/cwt. Two mandatory $.25 cuts wer~ scheduled for 1987, one on January 1 and the other on October 1. Beginning on January 1 of 1988, 1989, and 1990, the Bill authorizes the Secretary of Agriculture to adjust support prices based on projected net removals for the calendar year under the dairy price support program. Specifically, the Secretary is required to either decrease or increase the support price by $.50 if net dairy product removals under the price support program are above 5 billion Ib or below 2.5 billion Ib milk equivalent, respectively. Finally, to reduce some of the budgetary costs of the price support and Dairy Termination programs, the Farm Bill set assessments on all milk sold in 1986 and An assessment of $.40/cwt on milk sales was set for April through December The assessment was reduced to $.25/cwt for January through September No other milk marketing assessments were included in the Farm Bill. I An additional $.l2/cwt marketing assessment was a?ded after the Food Security Act was passed to satlsfy the deficit reduction conditions of Gramm Rudman. The $.12 assessment was put in place in 1986 for April through September. METHODOLOGY The methodology used to project the market equilibrium variables is based on an econometric model of the nation's dairy sector (7) and on simulation procedures that incorporate the dairy provisions of the Farm Bill to forecast Journal of Dairy Science Vol. 71, No. 10, 1988

3 OUR INDUSTRY TODAY 2801 market impacts 1986 to The model was originally developed to compare current dairy policy with mandatory supply control programs (7). However. the model is general enough to be used to simulate the impacts of a wide range of alternative federal policies on the national milk market. In this article. the model is used for predictive purposes. The Econometric Model The technical details of the estimation procedures and equation parameters are presented in (7), and the data are presented in (6).2 The model assumes that the national dairy sector consists of three markets: a farm raw milk market, a retail fluid products market, and a retail manufactured product market. In the farm market, dairy farmers produce and sell raw milk to processors of fluid and manufactured dairy products. In the retail markets, processors purchase raw milk from farmers, process it into fluid and manufactured products, and sell it to consumers. Thus, it is assumed that all post-farmgate marketing functions are performed in the retail markets. The model reflects the economic regulations of the dairy industry through incorporation of the two federal dairy programs that affect producer prices: the dairy price support and federal milk marketing order programs. The price support program is designed to place a floor on farm prices and maintain producer incomes. The program attempts to accomplish these objectives by requiring the Commodity Credit Corporation (CCC) to buy unlimited quantities of cheese, butter, and nonfat dry milk at fixed purchase prices from dairy manufacturers. This offer by the government has the effect of increasing the farm level demand for milk and hence the price. The purposes of the federal order program are to regulate handlers of Grade A (fluid eligible) milk, to foster orderly market conditions, and to assure an adequate 1 Alternatively. a detailed description of the model is available from the authors upon request. 3 Federal marketing orders are voluntary and are only implemented in a marketing area after twothirds of all dairy farmers potentially effected by the order approve it in a special referendum. Although not all milk is regulated by federal orders. the remaining unregulated and state-regulated milk is priced comparably to federal order pricing. supply of fluid milk (5). Milk marketing orders legalize a weak form of price discrimination between the price inelastic fluid market and the relatively price elastic manufacturing markets through a system of classified pricing. In any marketing area, 3 handlers are required to pay minimum class prices. depending upon how the raw milk is utilized, including a fluid class (Class 1) and one or more manufacturing classes (Class 2 or 3). The Class 2 or 3 price is equal to the Minnesota-Wisconsin (M-W) average Grade B (Manufacturing) price and the Class 1 price is equal to the M-W price plus a fluid differential, which increases the farther the marketing order is from the Minnesota and Wisconsin area. Farmers receive a "blend" price, which is the average of the class prices weighted by utilization of the milk supply in the marketing area. Although independent, the two federal programs are indirectly related, since the support price strongly influences the M-W price, and in turn, the M-W price is the basic formula in determining class prices. The model is based on two simplifying, but plausible. assumptions. First, it is assumed that producers have "naive" price expectations, which means that they base their price expectations on actual realized prices in the preceding year(s). Due to this assumption, which has also been used in other models [e.g., (2)J, the farm milk supply equations can be estimated independently from the retail market system. Second, the model assumes that the milk support price is set outside of the system, i.e., is exogenously determined. Because the government sets the support price on the basis of parity rather than supply and demand conditions in the market place for the most of the period covered by the data, this assumption does not detract much from reality. This assumption facilitated using the support price as an instrumental variable to estimate the Class 1 and 2 minimum federal order prices, since the support price and class prices are highly positively correlated. With respect to the farm market, raw milk supply was calculated by estimating cow number and production per cow equations and taking their product. The cow number equation was specified as a function of the expected all milk price, which is a proxy for the national blend price, expected feed costs, expected cull Journal of Dairy Science Vol. 71. No

4 2802 KAISER ET AL. cow price, and cow numbers in preceding years. The production per cow equation was estimated as a function of the expected all milk price, expected feed costs, and technology. The previous year's all milk price was used as the expected price. To assure market equilibrium, the supply of raw milk was constrained to equal the demand for raw milk. Retail demand and supply functions in each of the retail markets were estimated simultaneously to determine equilibrium prices and quantities. The retail consumer demand functions for the fluid and the manufacturing markets were each estimated as a function of the retail price, lagged demand, price of substitutes, consumer income, and age population distributions. Retail supply functions for the fluid and manufacturing markets were specified as functions of retail price, class prices, lagged supply, technology, and labor costs. There are two linkages between markets specified in the model. The first requires that the quantity of raw milk supplied in the farm market is equal to the milk equivalent of retail fluid demand plus retail manufacturing demand plus government net removals. The second linkage concerns calculation of the all milk price (blend price), which depends upon the level of the Class 1 and 2 prices as well as utilization between fluid and manufacturing products. This price is calculated as the average of the two class prices weighted by their respective utilization rates. The model was.estimated using time series data (1949 to 1985) published by the US Department of Agriculture and the US Department of Labor. The statistical results of the estimated equations were excellent. For example, the lowest adjusted coefficient of determination was.951, all parameters were statistically significant at 10%, and all coefficients had the expected sign. The Simulation Several additional steps were required to simulate the market impacts of the Food 'The $11.29 support price is the weighted average of the 1987 support price. Recall that the Food Security Act set the support price at $ for J anuary through September 1987 and $11.10 for October through December Security Act for 1986 through First, forecasted values of the explanatory variables specified in the system of equations were necessary for the simulation period. All explanatory variables were forecasted using a first-order autoregressive model that included lagged variables and, in some cases, a time trend. The resulting forecasted values of the explanatory variables for 1986 through 1990 were substituted into the estimated system of equations to project a dynamic market equilibrium time path for selected farm and retail market variables. The reduction in cows due to the Dairy Termination Program was modeled in the following fashion. Monthly termination of milk cows began in April 1986 and continued for 18 mo until the end of August The model was first solved without the Dairy Termination Program to generate equilibrium cow numbers for Then, the actual number of cows terminated in each of the 9 mo of 1986 were used to calculate the annual average number of cows in the program. To reflect that a cow terminated in April had a larger impact on reducing milk production than a cow terminated later in the year, monthly weighted averages were used. Based on this annual weighted average, 318,100 cows were subtracted from simulated equilibrium cow numbers in The same procedures were used for 1987, where 141,300 cows were subtracted from simulated equilibrium cow numbers. Note tha t the dynamic nature of the econometric model causes these reductions in cows to have a carry-over effect on cow numbers in later years of the simulation period because the cow number equation includes lagged cow numbers as explanatory variables. The milk support price provisions of the Farm Bill were set as follows. In 1986 and 1987, the support price was set at $11.60 and $11.29,4 respectively, as established by the Food Security Act. To implement the triggered mechanism for setting the support price for 1988 to 1990, the model was solved iteratively for each remaining year. In 1988, the model was solved with the $11.10 and if net removals were above 5 billion lb, then the support price was reduced by $.50. However, if net removals were below 2.5 billion lb, then the $11.10 support price was raised by $.50. Finally, if net removals were between 2.5 and 5 billion lb, then the support price was held Journal of Dairy Science Vol. 71, No. 10, 1988

5 OUR INDUSTRY TODAY 2803 at $1l.10. The same procedures were used for 1989 and Assessments were treated separately from the simulation. That is, the average annual assessments for 1986 and 1987 were subtracted from the equilibrium farm prices generated by the model. In 1986, the annual average assessment was $.36, including the $.12 Gramm Rudman assessment. In 1987 and 1988, the average assessments were $.21 and $.02, respectively. This procedure more accurately depicts how assessments were implemented than the alternative approach of deducting the assessment from the support price because an equivalent decrease in the support price does not have the same effect on price as an assessment. THE RESULTS The simulated market impacts of the Food Security Act for 1986 to 1990 are displayed in Table 1. In comparison with realized 1986 values, the model performed quite well in its predictive capability. For example, the largest discrepancy between simulated and actual values for 1986 was a 2.3% difference in the all milk price. In general, the simulated values in Table 1 are within 1 % of the actual outcomes in As a result of the Dairy Termination Program and lower milk support prices, simulated cow numbers steadily decline from 1986 to By 1990, cow numbers are down to 9.76 million, which is over 9% less than the 1986 cow inventory. Production per cow, however, increases at a slightly higher annual rate during the simulation period (l.8%) compared with annual increases during the previous five year period (l.4%). The net result is fairly stable raw milk supplies for the entire simulation period, especially when compared with the previous 5 yr, where milk production increased steadily at an annual average rate of 1.6%. Note that although the majority of cows were terminated in 1986 under the Dairy Termination Program, the most significant impact does not occur until 1987, where production reaches a low of billion lb. This is primarily a result of the program not beginning early enough in 1986 to halt the very large spring flush production. Consequent Iy, record high spring production in 1986 partially offset the number of cows being terminated in the summer and fall resulting in a slight increase in 1986 milk production. Production increases modestly in 1988, but then decreases somewhat in 1989 and It is also interesting that the Dairy Termination Program indirectly reduces cow numbers, and hence production, in later years of the 5-yr period. This is due to the dynamic nature of the cow number equation, which reflects the realistic fact that there is a carry-over effect in cows from year to year. On the demand side, commercial disappearance continues to increase in the simulation period, but not at as high of rate as it increased between 1981 and The largest gains in commercial disappearance take place in 1988 through 1990 with an annual average increase of about 1.7%. These increases are due to decreases in the farm price, and hence, retail prices. Not surprisingly, almost all of this is attributable to increases in manufacturing dairy products rather than fluid products. This is because demand for fluid products is much more price inelastic (price insensitive) than that for manufactured products. Manufactured dairy products increase by 9.8%, whereas fluid dairy products increase by only 1.1% between 1986 and The provisions of the 1985 Farm Bill appear to be successful in reversing the trend of the huge stocks of surplus dairy products accumulated under the support program. However, it takes 2 to 3 yr for net CCC removals to decrease to a more politically acceptable range, e.g., 2 to 6 billion lb. In 1986, net CCC removals are about 13 billion lb, but they decrease steadily throughout the rest of the simulation falling to just over 3 billion lb in The simulation results pertaining to net removals and setting the support price are interesting. In 1988, net removals are simulated to be over 5 billion lb and, consequently, the support price is reduced to $10.60/cwt. Once again in 1989, simulated net removals are over 5 billion lb and hence, the support price is reduced to $10.10/cwt. At a $10.10 support price, net removals are simulated to be 3 billion lb in 1990, and therefore, no further adjustement is necessary. Government costs of dairy programs for 1986 to 1990 decline significantly due to the Food Security Act. With respect to the dairy Journal of Dairy Science Vol. 71, No. 10, 1988

6 ' o c: 3!'!. o ~ S' -< en ;;' " :l ::; TABLE 1. Simulated Impacts of the Food Security Act of 1985 on the National Milk Market, 1986 to <. -..J '" z o Variable Simulation N 00 o.j:>..0 -' Milk cows, million 10,782 10,464 Production per cow, Ib 13,450 13,803 Milk production, billion All milk price $/CWt' Class I price, $/cwt Class II price, $/ cwt ' Commercial disappearance: Fluid, billion Ib' Manuf. billion Ib' Total, billion Ib' ,215 14, , , ;0:: P Ui ttl ;:0 ttl..., P r Net CCC Removals (biooion Ib) SuppOrt price (3.67% milk fat) $/cwt Support program outlays billion $ 'All milk price is net of the milk marketing assessments for , and National average manufacturing grade milk price. 'Fluid and manufacturing commercial disappearance is expressed on a raw milk equivalent basis.

7 OUR INDUSTRY TODAY 2805 support program outlays, costs are down substantially from the previous 5-yr period. For instance, between 1981 and 1985, these costs averaged $2.2 billion annually. The costs of the support program for the five simulated years is projected to average about one-half of the previous figure, or $1.3 billion annually. This is due to lower acquisitions of dairy stocks by the CCC and lower support prices during this period. Of course, one must also add to this the costs of the Dairy Termination Program. The total COSt of this 5-yr program is $1.827 billion. However, the revenue from the $.36 and $.21/cwt assessments in 1986 and 1987 is projected to be $809.4 million. Thus, net costs of the Dairy Termination Program are $1.02 billion, or $203.5 million/yr. Consequently, the combined costs of the su pport program and Dairy Termination Program are still substantially lower than government COStS from 1981 to Milk prices are significantly lower in the simulation period than the previous 5 yr. For instance, the average effective all milk price for 1981 to 1985 was $13.211cwt. By comparison, the average effective all milk price for the simulation period was $11. 30/cwt. However, unlike 1981 to 1985, where the farm price decreased consecu tively from year to year, the milk price in the simulation period is more stable, with some slight increases as well as decreases. The federal order class prices follow the same pattern as the farm price, remaining quite stable over these 5 yr. CONCLUSIONS This article offers some empirical insights about the impact of the Food Security Act on the US milk market. An econometric model of the national dairy market (7) was used to simulate market equilibrium variables for the duration of the Bill, 1986 through The success of the Food Security Act can only be evaluated subjectively. Nevertheless, several general qualitative remarks can be made about the Farm Bill's impact on different segments of the industry. The simulation model results indicate that the Food Security Act will result in a more favorable bal:lnce between supply and demand than has been true in the previous 5 yr. The simulation also indicates a much more stable environment than the previous 5 yr. Production, consumption, prices, and government costs change somewhat during the first 2 yr, but then stabilize. The 1985 Farm Bill also appears much less expensive than the previous period, costing tax payers about half as much in budgetary outlays, including the costs of the Dairy Termination Program. Consequently, tax payers seem to benefit from the 1985 Farm Bill. At the same time, consumers and processors of dairy products appear to fare quite well under the Food Security Act compared with the previous period. With lower raw milk prices projected for 1986 to 1990 compared with 1981 to 1985, milk processors should find the Farm Bill appealing. Similarly, the Farm Bill appears to keep real (adjusted for inflation) retail prices for fluid and nonfluid dairy products at reasonable levels. It seems very likely that the retail prices of milk products will not increase as fast as the retail prices for all food and all goods and services in the general economy, which should make consumers' evaluation of the Farm Bill positive. Finally, dairy farmers appear to experience some costs as well as benefits of the Food Security Act. Milk prices are lower but more stable for the duration of the Bill than in the first half of the 1980's. However, milk production costs are also lower, which implies that looking only at the milk price is misleading. There are two intangible benefits of the Farm Bill to dairy producers. First, the amount of surplus milk production bought by the CCC is substantially reduced. This is important, because lower net removals, and hence lower government costs, means reduced political pressure to dismantle the dairy price support program. Elimination of this program would result in lower prices to dairy farmers. Second, the leading alternative to the dairy title of the Food Security Act was cuts in the support price, which could have meant even lower milk prices to farmers. If examined in this context, then farmers may also be viewed as beneficiaries of the 1985 Farm Act. ACKNOWLEDGMENTS The au thors wish to acknowledge L. Tauer for his comments on an earlier draft of this article. Journal of Dairy Science Vol. 71, No. 10, 1988

8 2806 KAISER ET AL. REFERENCES Carmon, c., W. Paddock, and C. Shaw US and World Outlook for Dairy. Annu. Agric. Outlook Conf., US Dep. Agric., Washington, DC. 2 Chavas, J. P., and R. M. Klemme Aggregate Milk Supply Response and Investment Behavior on US Dairy Farms. Am. J. Agric. Econ. 68(1). 3 Family Farm Coalition The Save the Family Farm Bill. Leaflet. 4 Jurchak, T Lots of reasons. Milk Marketing News, Coop. Ext. Serv., Penn. Stare. Univ., Universiry, Park. 5 Kaiser, H. M A Primer on Federal Milk Marketing Orders in the United States. Agric. Econ. Ext , Dep. Agric. Econ., Cornell Univ., Ithaca. 6 Kaiser, H. M., D. H. Streeter. and D. J. Liu A dynamic analysis of the Food Security Act and the Harkin-Gephardt Bill: the dairy secror. Agric. Econ. Res Dep. Agric. Econ., Corne ll Univ., Ithaca, NY. 7 Kaiser, H. M., D. H. Streerer, and D. J. Liu Welfare comparisons of US dairy policies with and without mandatory supply control. Am. J. Agric. Econ. Vol. 70(4). Journal of Dairy Science Vol. 71, No. 10, 1988