Economic Formula for Milk Price Discovery€¦ · Product Price Formulas ! Reverse engineering cost-plus pricing ! ... Most common version takes a starting point value and moves prices

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Economic Formula for Milk Price Discovery

Mark Stephenson, Ph.D. Director of Dairy Policy Analysis

What are Today’s Dairy Problems?

!   Milk & feed price volatility for the producer

!   Maybe milk price volatility for the processor

!   Dissatisfaction with product price formulas used in FMMOs and state orders

!   Are these issues related?

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Options for Setting Milk Prices

!   Regulated Grade A manufacturing price series

!   Deregulated Grade A manufacturing price series

!   Product price formula

!   Economic formula

!   Administratively determined

1989 Study

Options for Setting Milk Prices

!   Competitive Pay Price !   Gold standard, but almost impossible to achieve

!   Product Price Formulas !   Reverse engineering cost-plus pricing

!   Competitive Pay Price moving one step up the marketing chain

!   Economic Formulas !   Always discussed, seldom employed

!   Dairy Price Support Program

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Economic Formulas

!   Most common version takes a starting point value and moves prices with an index

!   They have been used before in milk pricing !   Dairy Price Support Program

!   California state order pricing for many years

!   Federal order class I pricing in the late 1940s-50s !   Boston, New York and other orders

!   All discontinued by the late 1960s

!   Major problem is price inflation over time

Economic Formulas

!   Usually include factors for the ability and willingness of consumers to pay

!   Often a measure of general economic conditions such as CPI or Consumer Sentiment

!   Always cost of production such as feed, etc.

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One Example…

!   During the 1990s debate, Wisconsin Farmer’s Union requested Ed Jesse to develop an economic formula price.

!   The devil is in the details…

!   His formula is resurrected after lying dormant for 15 years.

Cost of Production Sub-Index NASS Indices ’90-92

!   Feed

!   Fuels

!   Supplies & Repairs

!   Farm Machinery

!   Farm Services

!   Interest

!   Taxes

!   Wage Rates

!   Prices Paid

Weights

41%

3% 6% 10%

7%

12%

2%

15%

4%

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Consumption—Per Capita Disposable Income Sub-Indices

50#

100#

150#

200#

250#

300#

1995# 1996# 1997# 1998# 1999# 2000# 2001# 2002# 2003# 2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012#

Consumption—Product Price Sub-Indices

50#

100#

150#

200#

250#

300#

1995# 1996# 1997# 1998# 1999# 2000# 2001# 2002# 2003# 2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012#

CME#Bu1er#Index#(15.5%)#

CME#Cheese#Index#(69%)#

NFDMACentral#States#Index#(15.5%)#

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Composite Index

75.00%

95.00%

115.00%

135.00%

155.00%

175.00%

195.00%

215.00%

1995%1996%1997%1998%1999%2000%2001%2002%2003%2004%2005%2006%2007%2008%2009%2010%2011%2012%

Composite%Index%Equally%weighted%ProducEon,%Income%and%Product%Prices%

Productivity Deflated Composite Index

75.00%

95.00%

115.00%

135.00%

155.00%

175.00%

195.00%

215.00%

1995%1996%1997%1998%1999%2000%2001%2002%2003%2004%2005%2006%2007%2008%2009%2010%2011%2012%

Composite%Index% Adjusted%Composite%Index%

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Economic Formula for BFP

$8.00%

$10.00%

$12.00%

$14.00%

$16.00%

$18.00%

$20.00%

$22.00%

1995% 1996% 1997% 1998% 1999% 2000% 2001% 2002% 2003% 2004% 2005% 2006% 2007% 2008% 2009% 2010% 2011% 2012%

Economic Formula versus BFP

$8.00%

$10.00%

$12.00%

$14.00%

$16.00%

$18.00%

$20.00%

$22.00%

1995%1996%1997%1998%1999%2000%2001%2002%2003%2004%2005%2006%2007%2008%2009%2010%2011%2012%

BFP%

Adjusted%Formula%Price%

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Observations…

!   Economic formula captures all major turning points

!   Economic formula does not suffer greater lags than MW, BFP, or Product Price Formula

!   It is less volatile than current and previous Class III

!   It is transparent and can be readily calculated with current data

!   It is somewhat price inflationary (+$1.12)

Revenue Neutral Economic Formula

$8.00%

$10.00%

$12.00%

$14.00%

$16.00%

$18.00%

$20.00%

$22.00%

1995%1996%1997%1998%1999%2000%2001%2002%2003%2004%2005%2006%2007%2008%2009%2010%2011%2012%

BFP%

Adjusted%Formula%Price%

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In Summary…

!   Ed’s formula tracks demand changes well !   Look at 2007-08, 2009

!   The formula tracks producer cost of production quite well !   Look at 2011-12

!   The formula has a productivity governor that can dampen inflationary tendencies !   Might want to include indices for farm size and plant

size as other measures of increasing economies

!   We have learned from volatility modeling that if the highs aren’t as high, the lows don’t have to be as low.

One More Thing…

$8.00%

$10.00%

$12.00%

$14.00%

$16.00%

$18.00%

$20.00%

$22.00%

1995%1996%1997%1998%1999%2000%2001%2002%2003%2004%2005%2006%2007%2008%2009%2010%2011%2012%

BFP%

Adjusted%Formula%Price%

Adjusted%+%IrraAonality%Factor%

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Maybe I Was Too Hard on Ed

Nah…It doesn’t really fit.

Questions?