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November 9,2006No.24
 The U.S.dairy program,administeredthrough federal and state governments,subsidizes milk production and regulatesdairy prices.The current system costs tax-payers more than $4 billion per year in sub-sidies and adds millions of dollars to thegrocery bills of American consumers andto the costs of food product manufacturers.By boosting prices,the dairy programencourages overproduction.It also penal-izes more efficient farmers in the futileattempt to prop up smaller dairy farmersand stem the tide of decades of changes inthe dairy market.In order to preserve domestic pricesabove the world prices for dairy products,the U.S.government maintains prohibi-tively high tariffs on imported dairy prod-ucts.That invites scorn and retaliationfrom our trade partners and is one moreagricultural program that exposes theUnited States to charges of hypocrisy as itseeks to paint itself as a country in favor of free markets and opportunity for all.A better policy would be one thatallows farmers to make their living,likeother entrepreneurs,from markets ratherthan a government check.As Congressprepares to draft a new farm bill,worlddairy prices are unusually strong.Thus,this is the perfect time for the govern-ment to fundamentally reform dairy pol-icy in the United States with minimal“disruption”to dairy farmers.
 Milking the Customers
The High Cost ofU.S.Dairy Policies
 by Sallie James
Sallie James is a policy analyst with Cato’s Center for Trade Policy Studies.Her articles have been published in the 
Australian Journal of Agricultural andResource Economics
and the 
European Review of Agricultural Economics
.
Executive Summary 
   F   I   N   G    P   A   P   E   R  •   T   R   A   D   E   B   R   I   E   F   I   N   G    P   A   P   E   R  •   T   R   A   D   E   B   R   I   E   F   I   N   G    P   A   P   E   R  •   T   R   A   D   E   B   R
 
Introduction
 The American dairy industry operates underone of the most complicated programs in U.S.agricultural policy.Using a complex system of price supports,dairy market loss payments,fed-eral and state marketing orders,classified pric-ing,and export subsidies,the government sup-ports the dairy industry from behind a tariff walldesigned to insulate U.S.dairy producers frominternational competition and to prevent theentire house of cards from crashing down.By keeping prices artificially high,guaran-teeing income supports,and preventing importcompetition,U.S.dairy farmers produce dairy products regardless of market demand.Thatencourages overproduction,which puts furtherstrain on the price-support system and thestocks of dairy products the government mustbuy to maintain it.Consumers of dairy prod-ucts and food processors who use dairy prod-ucts as inputs pay above-market prices,whichcreates welfare losses.Taxpayers must foot thebill—to the tune of more than $4 billion per year—for dairy programs that provide over 40percent of dairy farmers’incomes and depress world prices through exports of subsidizeddairy products. The dairy program in the United States ispartly a reaction,and certainly a key contributor,to the gross distortions in world dairy markets. The global dairy trade is characterized by very high tariffs and restrictive tariff rate quotas,evenafter progressive liberalization from previousmultilateral trade negotiations.The global mar-ket for dairy products is,consequently,“thin,”inthat only 7 percent of global dairy production(measured in milk equivalent terms) is traded.
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Exports are dominated by a few main exporters,so fluctuating supplies from those countriescause volatile movements in prices. The Doha round of trade talks among World Trade Organization members,suspend-ed indefinitely,could have made inroads to cor-recting the inefficiencies in world agriculturalmarkets,including dairy.For example,WTOmembers had agreed at the Hong Kong minis-terial meeting in December 2005 that they  would cease all export subsidies by 2013.Thatagreement was meaningful because dairy export subsidies,especially from the EuropeanUnion,are a major contributor to global dairy market disarray.But that pledge may be aban-doned unless the Doha round can be revived.Congress is due to draft a new farm bill in2007.That presents an opportunity for policy-makers to play their part in correcting the dis-tortions in dairy markets at home and abroad.It is an opportunity that Congress can seizeregardless of what,if anything,eventually hap-pens in the Doha round.By significantly reforming the U.S.dairy program,the govern-ment could reduce the burden on taxpayers andconsumers,including downstream industries inthe food-processing sector.Current policy con-tributes to disarray in world markets for dairy prices,aggravates our trade partners,andinvites retaliation from them in the form of dispute settlement action.It also contributes tothe rancor over global trade liberalization andtherefore is a burden to U.S.consumers andindustries that would benefit from freer andmore open markets in other sectors.Almostone third of the amount that the United Statesis allowed to spend on trade-distorting supportis spent on dairy programs.The significantcosts of supporting dairy farmers demand fun-damental reform of the current policy. This study will provide a background on theU.S.dairy program:how it began,its objec-tives,and how its various elements contributeto market distortions.The costs to consumers,taxpayers,and trade partners will be explored. The study will conclude by suggesting changesto the dairy program that would better serveAmerica’s interests.
 A Dairy Program Designedfor Another Era 
Like many of the commodity programs inplace today,U.S.dairy policy originated in the1930s.The dairy price-support system wasauthorized by the New Deal–era AgriculturalAdjustments Act of 1933,which was part of abroad program to control supplies and prices
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 The significantcosts of supporting dairy farmersdemandfundamental reform of thecurrent policy.
 
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paid to producers.The depressing economicconditions of that time,combined with a lack of processing and storage capacity,led Congress tocreate the Federal Milk Marketing Order sys-tem (explained below) in 1937.In 1949,Congress made the milk price support programpermanent,with the ostensible purpose of assur-ing an adequate supply of milk and a level of farm income to maintain productive capacity sufficient to meet future needs. The 2002 Farm Bill (more formally,theFarm Security and Rural Investment Act of 2002) removed the permanent authority givenby the 1949 act,but did renew the programuntil the end of 2007.There have been changesin the milk price support program over the years,bringing it to a lower “safety net”level,and changes in the minimum prices of butterand skim milk powder (also called nonfat dry milk).Congress and the U.S.Department of Agriculture have regularly tinkered with thefederal milk marketing orders (which establishminimum prices that handlers must pay formilk).However,the type of support given tothe U.S.dairy industry is largely unchangedsince the early 1930s,and the market remainsextremely distorted. The Federal Agriculture Improvement andReform Act of 1996 reduced the dairy sup-ports and specified that they should be com-pletely eliminated in 1999.
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However,fallingdairy prices in the late 1990s saw Congressauthorize emergency dairy support in two stepsto the end of 2001,and then to the end of 2007through the 2002 Farm Bill.
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If the nature of government intervention islargely unchanged from the depression era,thedairy market itself is not.Shifts in consumptionpatterns,technology,and production methodshave made the price controls and other inter- ventions of the government increasingly damag-ing.On the demand side,consumption of dairy products has changed from primarily fluid milk to more cheese and processed products.In the1930s,fluid milk made up over 60 percent of thetotal amount of milk sold,whereas only 36 per-cent of milk was consumed in fluid form in2002.
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Additionally,consumption patterns haveshifted from retail (direct) sales to restaurant andfood processor use.
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 The federal milk-marketingorders impose higher costs on consumers wholive further from certain milk producing areas. The shift in consumption from highly perish-able,fluid milk to more processed products hasled to an increase in demand for ingredientssuch as milk solids and protein products.Thecurrent price support system,with its emphasison fluid milk products,discourages farmers fromproducing those niche products experiencinggrowing demand.
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On the production side,there has been anincrease in the average farm size and consoli-dation of the industry,with more of thenation’s milk being produced by fewer,butlarger,farms.Since 1980,the number of dairy farms has fallen by over 70 percent.There arefewer dairy farms overall,but the average sizeof dairy farms is increasing:from an averageherd size of about 30 cows in 1980 to morethan 100 milk cows today.Technologicalchange,economies of scale,and increased pro-ductivity have led to a large concentration of production:3 percent of all dairy farms (those with more than 500 cows) produce over 40percent of all milk in the United States.
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Asimilar trend can be seen in processing,manu-facturing,and distribution plants,where plantshave become larger and fewer. There has also been a regional shift in dairy production:less expensive land,larger access tolabor and feed,and a more favorable climatehave led to a shift to the west and southwest of the country.California has been the largestmilk-producing state since 1994,overtakingtraditional dairy areas in the Upper Midwestand Northeast.
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Improved processing,trans-portation,and storage techniques mean thatdairy markets are regional,if not national,inscope.In an effort to prop up the less productiveareas of the country,policies such as the feder-al milk-marketing order system stifle innova-tion and prevent the most efficient producersfrom growing.And the original goal of thedairy program—to ensure adequate supply of milk—is no longer relevant.Indeed,theUSDA states that “[the] market ...is growingmore slowly than milk production capacity.”
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Shifts inconsumptionpatterns,technology,and productionmethods havemade pricecontrols and other interventions of the governmentincreasingly damaging.
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