A Regional Economic Analysis of Dairy Compacts:
Implications for Missouri Dairy Producers

A dairy compact and how it works is described in this section. Also examined is the Northeast Interstate Dairy Compact (Northeast Compact) since it’s the only one in existence. Some of the impacts of the Northeast Compact on milk supply, consumption and farm-gate prices are discussed.

A dairy compact is an agreement among states to regulate the price of milk used for fluid purposes. It is an expression of states to have the right to regulate the price of milk for their dairy farmers. States rights, however, can compete with federal rights to run a national dairy pricing program (i.e. the federal order system). This is strue if such a program affects the interstate shipment of milk.

Dairy compacts can work with the federal government’s federal order milk pricing system as the basis for its pricing mechanism. Proceeds of the federal order system and that of dairy compacts, however, are separate. Compacts work by forming a commission that fixes a price that exceeds the minimum federal order price for fluid milk in the compact region. The difference between the compact price and the minimum federal order price for fluid milk--called the compact over-order premium--is then collected by the compact commission and is disbursed to farmers.

Compacts work within the borders of a group of states. The compact commission regulates all fluid milk sales within the borders of these states. They may use the federal order system to compute compact premiums and calculate farm-level prices, but the compact works within state borders, not federal order borders.

Interstate Compacts are authorized under the Compact Clause (Article 1, Section 10, Clause 3) of the United States Constitution as follows:

Compacts have been formed for ambulance services, disposal of radioactive waste, and for setting up Port Authorities. Until just recently, compacts were not used to regulate the regional pricing of an agricultural commodity.

States that want to create a compact must first seek the approval of Congress. In the case of the Northeast Compact, the Senate Joint Resolution that defines the Compact includes the provision that three or more states pass legislation authorizing a Compact, the consent of Congress be obtained (i.e. the 1996 Farm Bill), and that additional states could join if they are contiguous.

The Northeast Compact is the only dairy compact in existence today. The objective of the compact is outlined below and is listed in their web site,

The Northeast Interstate Dairy Compact was established to restore the regulatory authority of the six New England states over the New England dairy marketplace. The stated purpose of the compact is to recognize by constitutional prerequisite the interstate character of the northeast dairy industry and to form an interstate commission for the region. The compact serves several major functions including: assuring the region of an adequate supply of milk, recognizing the cultural and economic benefits of a viable dairy industry to the region, and recognizing the ability of the states to regulate milk prices collectively, rather than individually, is in the public interest. More specifically the stated objectives of the compact are:

1. Assuring an adequate milk supply for consumers:

   The express mission of the Compact commission is to take such steps as are necessary to assure the continued viability of dairy farming in the northeast and to assure consumers of an adequate, local supply of pure and wholesome milk.

   The participating states resolved that the dairy industry is the paramount agricultural activity of the northeast. Dairy farms, and associated suppliers, marketers, processors and retailers, are an integral component of the region's economy. Their ability to provide a stable local supply of pure, wholesome milk is a matter of great importance to the health and welfare of the region.

2. Preserving dairy farming provides cultural and economic benefits:

   States in the Compact region have found that dairy farming is essential to the region's rural communities and character. The farms preserve open spaces, sculpt the landscape and provide the land base for a diversity of recreational pursuits. In defining the rural character of our communities and landscape, dairy farms also provide a major draw for our tourist industries.

3. Recognizing the ability of states to regulate milk prices collectively is in the public interest:

   The participating states concluded that their ability to regulate the price which northeast dairy farmers receive for their product is essential to the public interest as defined by these twin goals. Assurance of a fair and equitable price for dairy farmers ensures their ability to provide milk to the market and the vitality of the northeast dairy industry, with all the associated benefits.

The 1996 Farm Bill (Federal Agriculture Improvement and Reform Act of 1996) contained language that created the Northeast Compact. Section 147 of the Act states:

1. Finding of compelling public interest:

Based upon a finding by the Secretary (of Agriculture) of a compelling public interest in the Compact region, the Secretary may grant the States that have ratified the Northeast Interstate Dairy Compact, as of the date of enactment of this title, the authority to implement the Northeast Interstate Dairy Compact.

2. Limitation on manufacturing price:

The Northeast Interstate Dairy Compact Commission shall not regulate Class II, Class III, or Class III-A milk used for manufacturing purposes or any other milk, other than Class I (fluid) milk, as defined by a Federal milk marketing order issued under section 8c of the Agricultural Adjustment Act (7 U.S.C. 608c) reenacted with amendments by the Agricultural Marketing Agreement Act of 1937.

3. Duration:

Consent for the Northeast Interstate Dairy Compact shall terminate concurrent with the Secretary's implementation of the dairy pricing and Federal milk marketing order consolidation and reforms under section 143.

4. Additional States:

Delaware, New Jersey, New York, Pennsylvania, Maryland, and Virginia are the only additional States that may join the Northeast Interstate Dairy Compact, individually or otherwise, if upon entry the State is contiguous to a participating State and if Congress consents to the entry of the State into the Compact after the date of enactment of this title.

5. Compensation of commodity credit corporation:

Before the end of each fiscal year that a Compact price regulation is in effect, the Northeast Interstate Dairy Compact Commission shall compensate the Commodity Credit Corporation for the cost of any purchases of milk and milk products by the Corporation that result from the projected rate of increase in milk production for the fiscal year within the Compact region in excess of the projected national average rate of the increase in milk production, as determined by the Secretary.

6. Milk Marketing Order Administrator:

At the request of the Northeast Interstate Dairy Compact Commission, the Administrator of the applicable Federal milk marketing order issued under section 8(c)5 of the Agricultural Adjustment Act (7 U.S.C. 608c), reenacted with amendments by the Agricultural Marketing Agreement Act of 1937, shall provide technical assistance to the Compact Commission and be compensated for that assistance.

7. Further conditions:

The Northeast Interstate Dairy Compact Commission shall not prohibit or in any way limit the marketing in the Compact region of any milk or milk product produced in any other production area in the United States. The Compact Commission shall respect and abide by the ongoing procedures between Federal milk marketing orders with respect to the sharing of proceeds from sales within the Compact region of bulk milk, packaged milk, or producer milk originating from outside of the Compact region. The Compact Commission shall not use compensatory payments under section 10(6) of the Compact as a barrier to the entry of milk into the Compact region or for any other purpose. Establishment of a Compact over-order price, in itself, shall not be considered a compensatory payment or a limitation or prohibition on the marketing of milk.

The Northeast Compact is operated by a Compact Commission which is authorized in Section 4 of the Senate Joint Resolution:

As stated earlier, the Northeast Compact works in conjunction with the New England Federal Milk Marketing Order. The Compact Commission sets a price floor, or compact price, for all fluid milk sales in the compact area. The Compact Commission then determines the over-order premium each month (difference between the compact price and minimum federal order Class 1 price) and collects this difference from fluid handlers. The Compact Commission then distributes the net proceeds to farmers that market milk in the Compact Region.

It is important to understand that the objective of the Compact Commission is to enforce a price floor on all fluid milk sales in the compact. No one can sell fluid milk in the compact region below the compact price. The Compact Commission must then ensure that the proceeds of these higher-priced fluid milk sales are returned to dairy farmers that market milk in the compact region.

Each month the Market Administrator publishes advance prices for Class I milk sales in New England. From that information the Compact Commission computes a compact over-order premium that all processors must pay. These funds go into a producer settlement fund. For example, the second month the Compact was in place the federal order Class 1 price was $13.98 per cwt and the Compact price was $16.94. The difference, the compact over-order premium, was $2.96.

The Compact Commission must now find a way to return the funds collected on only fluid milk sales to all dairy farmers that market milk in the Compact. The percent fluid utilization rate is the mechanism the Compact Commission uses. The Market Administrator’s office supplies the Compact Commission with the percentage of Class 1 milk that was sold in the region from the previous month. This utilization rate is the basis for how the Commission pays farmers the proceeds of the compact over-order premium. The percentage of milk used for fluid purposes was 47.29 percent the second month of the compact. So, the Compact Commission simply multiplied $2.96 by 47.29 percent. The result was $1.40. The idea then is to pay every dairy farmer that markets milk in the compact region the same uniform rate. So, even if a dairy farmer in the compact region sells milk to a manufacturing plant, that farmer will still get the uniform compact rate.

Other deductions were made from the $1.40 before a final farmer price was determined by the Compact Commission. Three percent of this money was set aside for WIC program payments, between four and five cents was set aside in a reserve fund in the event of audit adjustments or late payments by handlers. Additional funds were escrowed to cover potential refunds to the Commodity Credit Corporation in the event it was determined that the Compact resulted in surplus sales to the government. Table 3.1 shows the producer payments that have been made to northeast dairy farmers from the Compact Commission

There is an administrative cost to operating the Northern Compact. Fluid milk handlers must pay the Compact Commission 3.2 cents per cwt on all fluid milk sales in the

Table 3.1 Calculation of Producer Prices for the Northeast Interstate Dairy Compact

compact region as an administrative assessment to fund the Compact Commission. These funds are separate from the producer settlement fund.

It is interesting to note that the compact over-order premium (not including deductions) averaged $2.04 per cwt during January - December, 1997, and just $0.57 per cwt the first five months of 1998 when national market prices increased considerably.

What impact has the Northeast Compact had on regional milk production, fluid milk consumption and retail fluid milk prices? The Northeast Compact Commission has commissioned a study of these effects with the University of Vermont but has yet to publish any reports. The Office of Management and Budget completed a six-month study of the market impact of the Northeast Compact. And the General Accounting Office has finished a study on retail fluid milk pricing.

What impact has the Northeast Compact had on regional milk production? Has it created excess milk production that has resulted in excess purchases under the dairy price support program? This study focused on monthly milk production for Vermont, the largest milk producing state in the Northeast Compact region (Table 3.2).

The data compares Vermont to select top 20 dairy states on a monthly basis. It reveals that Vermont milk production increased during the first five months of 1998 relative to 1997 by an average 4.2 percent. However, 1997 was a year of low milk production in Vermont. Vermont milk production for the first five months of 1998 was only 2.7 percent ahead of 1996.

How does this data compare to the U.S. average? Data for the top 20 dairy states indicate that they were up 1.3 percent during the first five months of 1998 compared to the same period a year ago, and up 2.2 percent relative to 1996. Vermont has experienced a milk production increase in 1998 that is slightly above the national average. However, one state is not representative of the other Compact states, nor are the Compact states representative of the whole Northeast market. Also, one has to separate out the Compact from other factors that could have resulted in an expansion in milk production in these compact states (i.e. weather). This is difficult to do with just a few months of data. To really analyze this question, an economic simulation model is needed to disentangle the various market effects and isolate the compact effects.

Another concern is whether the Northeast Compact affected retail fluid milk sales. Has compact pricing adversely affected fluid milk consumption? Theoretically speaking, fluid milk consumption is expected to decline if the retail price of milk rises.

To address this concern, regional packaged sales of fluid milk in federal orders and in California were analyzed. This data is reported in "Dairy Market News." The months July through April were reported in Table 3.3. July was chosen because it reflects the

first month that the Northeast Compact was in place. April was chosen because it is the most recent month for fluid sales data.

The data reveals that fluid milk sales during the period July 1997 through April 1998 declined the most in the Northeast region relative to the same period a year ago. Fluid consumption declined 0.75 percent in the Northeast, 0.31 percent in the Midwest, and 0.35 percent in the Southwest. It remained unchanged in the Southeast and actually increased 0.25 percent in the Far West.

Table 3.3 Regional Packaged Fluid Milk Sales

There is not sufficient data to suggest that the Northeast Compact was the cause of reduced fluid sales in the Northeast region of the U.S. And, it should be noted, that the Northeast region depicted in Table 3.3 is much larger than the geographic region of the Northeast Interstate Dairy Compact since the former includes New York and Pennsylvania. However, with this in mind, one cannot refute that higher retail prices can reduce sales. Once again, an economic simulation model is needed to isolate what impact, if any, the Northeast Dairy Compact had on fluid milk sales in the region.

Another question is did the Northeast Compact result in higher retail prices for fluid milk in New England markets. That question was vaguely answered in the OMB study.

Table 3.4 below contains wholesale and retail prices for fluid milk in New England provided by the Market Administrator's office. The Class 1 price plus the Compact over-order premium represents the cost of raw milk to processors.¹

Table 3.4 Wholesale and Retail Fluid Milk Prices in New England

Table 3.4 also contains the retail price of a gallon of whole milk in Boston. The retail price along with the wholesale cost of raw milk (Class 1 price plus Compact over-order premium) can then be used to approximate the mark up and the gross percentage margin.

The mark up represents how much the wholesale price is raised to the retail price on a percentage basis. So if an item costs $1 and retails for $1.75, the mark up is 75 percent ($1.75/$1.00-1). The gross percentage margin is the percent of the retail price that reflects the gross margin (as opposed to the cost of the good). The gross margin is simply the retail price less the cost of the good. So, an item that costs $1 and retails for $1.75 has a gross percentage margin of 42.8 percent ($1.75-$1.00/$1.75).

The data in Table 3.4 indicates that packaged fluid milk in New England had a mark up of 65.8 percent in 1996. The gross percentage margin averaged 39.5 percent. The mark up then rose to 87.6 percent during the months of January through June 1997. The gross percentage margin averaged 46.7 percent this same time period.

The Compact then imposed an average over-order premium of $2.04 per cwt for the months of July through December 1997. That raised the retail price 19 cents per gallon. The mark up fell to 80.1 percent and the gross margin fell to 44.5 percent.

Then, during the months of January through June 1998, the mark up fell to 77.3 percent. This is lower than what prevailed in 1997, but higher than in 1996. The mark up fell to 43.6 percent.

It should be noted that 1996 was not a good year to use as a baseline for comparing 1997 and 1998. A drought prevailed that raised national Class 1 prices for fluid milk. In addition, these numbers don’t reflect market over-order premiums. Despite these concerns, some conclusions can be reached.

When compact pricing was enforced in July 1997, retailers faced higher costs for fluid milk. They responded by lowering their mark up and gross margins on a percentage basis. On a dollar basis, mark ups rose 3 cents per gallon between the January-July and July-December periods. Thus, on a percentage basis, some of the higher costs for fluid milk during the last half of 1997 were passed on to consumers and some absorbed by retailers.

The cost of fluid milk remained constant at $1.46 per gallon during the months of January through June 1998. The mark up and gross percent margin fell slightly when compared to the last half of 1997.

In any event, the key to deciding whether the Compact raised or lowered margins and retail mark ups is in choosing an appropriate baseline. In this case, 1996 was not a good year to use for this purpose since Class 1 costs were unusually high due to a milk shortage. The same could be said for 1998. Margins were likely squeezed in those years. Again, an economic simulation model is the only way to disentangle the various market forces that normally affect retail fluid milk prices.

Dairy Compacts work in conjunction with federal milk marketing orders. They do not replace them. In fact, the over-order premium that processors must pay to the Compact Commission is calculated as the difference between the Compact price and the federal order minimum Class I price.

According to the Northeast Compact legislation:

So, Compacts use current federal order Class I prices to set over-order premiums. And, they may contract with the Market Administrator to compute and distribute Compact premiums in order to lower the cost of operating the Compact. However, the Compact and Federal orders are separate and distinct.

The federal language that created the Northeast Compact allows for it to replace federal orders in the event that they are eliminated. That is the only way in which a compact can replace a federal order.

Therefore, in the Northeast Dairy Compact, there is a working relationship between the Compact and the New England Order even though the Northeast Dairy Compact is much larger than the New England Order. If a new compact is formed (i.e. a Southern Dairy Compact) the relationship between that order and existing federal orders would have to be specified in the compact legislation.