warren hall - dairy markets the direct payment per hundredweight for various usda reduction goals...

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MARKET ADMINISTRATOR NEW YORK - NEW JERSEY MILK MARKETING AREA 205 EAST 42ND STREET. NEW YORK, NEW YORK 10017 212 - 557-0330 Cornell University Dept . of Agricultural Economics Attn: Dr. Andrew Novakovic Warren Hall Ithaca, NY 14853 Dear Dr. Novakovic: February 18, 1983 The enclosed staff paper was developed while this office was researching the effect of the two 50¢ deductions and refund program. This paper is being sent to you in case the ideas might prove to be helpful in the course of your studies. If there are any comments or questions, please direct them to Robert Wellington of this office. Enclosure Very truly yours, Thomas A. Wilson Market Administrator

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MARKET ADMINISTRATOR

NEW YORK - NEW JERSEY MILK MARKETING AREA 205 EAST 42ND STREET. NEW YORK, NEW YORK 10017

212 - 557-0330

Cornell University Dept . of Agricultural Economics Attn: Dr. Andrew Novakovic Warren Hall Ithaca, NY 14853

Dear Dr. Novakovic:

February 18, 1983

The enclosed staff paper was developed while this office was researching the effect of the two 50¢ deductions and refund program.

This paper is being sent to you in case the ideas might prove to be helpful in the course of your studies.

If there are any comments or questions, please direct them to Robert Wellington of this office.

Enclosure

Very truly yours,

Thomas A. Wilson Market Administrator

MARKET ADMINISTRATOR

NEW YORK - NEW JERSEY MILK MARKETING AREA 205 EAST 42ND STREET. NEW YORK, NEW YORK 10017

212 - 557-0330

AN ANALYSIS OF THE IMPACT OF REFUNDABLE ASSESSMENTS

ON PRODUCERS' INCENTIVES TO DECREASE MILK PRODUCTION

February 1983

Staff Paper 83-4

The United States Department of Agriculture (USDA) is preparing to

implement the assessments authorized by the 1982 Omnibus Budget

Reconciliation Act. To date, two alternate methods for reducing the cost

of the dairy support program have been considered: 1) reducing the support

price and 2) instituting a direct payment plan by which farmers would

receive payments for not producing milk.

Two of the three plans, collecting the assessments or lowering the

current support price, will lower the price dairy farmers receive.

However, price reductions alone do not provide an adequate incentive to

reduce milk production immediately. Hany producers respond by increasing

production to maintain a sufficient income to meet payments on fixed assets

such as the farmstead, barn and silos. Although these increases are

limited by the capacity of existing assets, farmers could increase

production and maintain that higher volume for a period of time. When the

assets deteriorated, many dairy farmers would be forced out of business.

While this would eventually lead to a decline in milk production, it would

also cause major disruptions to the dairy industry and to rural

communities. Therefore, the U.S. government and the dairy industry cannot

be certain that either the USDA assessment program or a lower support price

would reduce support program costs in the near future. If farmers

increased production, the revenue collected from the assessments or the

lower unit support price paid by the Commodity Credit Corporation (CCC)

could be more than offset by increased purchases.

2

The other proposal under consideration is a government-funded direct

payment to the farmer for reducing milk production from a selected base

level. Unquestionably, this program offers a substantial incentive to

curtail excess production; however, it would be costly to the government.

Although the proposed $10.00 per hundredweight payment is lower than the

$17.00 cost of purchasing and storing the current excess production, 1/

government expenditures would still be unacceptably high.

Although the 1982 Budget Reconcilation Act does not explicitly provide

for "direct payments" to farmers for reducing milk production, refunding

the second 50<: assessment can be viewed as a direct payment for not

2/ producing milk to those producers who qualify for a refund. - The funds

for these payments would be generated by the assessments themselves.

Direct Payments

The implicit payment for not producing milk which would be made to

producers who qualified for a refund can be calculated as follows:

A P

D = G - A

where: PD

is the direct payment per hundredweight

A is the refundable assessment per hundredweight

G is the USDA "goal" (percentage reduction from base production)

(A mathematical proof of this formula is given in Appendix T.)

1/ Estimated CCC purchase, transportation and storage costs, cited in The Dairy Marketing Letter (ed. Jerry Dwyer) of January 21, 1983.

2/ The 1982 Omnibus Budget Reconcilation Act states that farmers must reduce "marketings" to receive refunds. For the sake of simplicity, in this presentation "production" and "marketings" are assumed to be equivalent.

Table 1. Direct Payment for Selected Levels of USDA Production Reduction Goals

Direct Payment USDA Goal SOc;: refundable (percent) ($/cwt.)

5 9.50

6 7.83

7 6.64

8 5.75

9 5.06

10 4.50

10.3 4.35

11 4.05

12 3.67

13 3.35

14 3.07

15 2.83

20 2.00

25 1. 50

3

4

The direct payment per hundredweight for various USDA reduction goals

can be seen in Table 1. The Secretary of Agriculture recently proposed

that a 10.3 percent reduction in production from a 1981-1982 base level

would be required to qualify for a refund of SOc;:. However, pro rata

(partial) refund s will not be made for partial volume reductions from

base production. In other words, a producer must produce at or below his

target volume--his base marketings less the USDA goal--to receive a SOc;:

refund. With a 10.3 percent goal, the direct payment would be only $4.35

per hundredweight; this would give farmers little incentive to reduce

production for a number of reasons.

First, a farmer must curtail at least 10.3% of his milk production to

receive a payment of $4.35 for each hundredweight he no longer produced.

On the other hand, if a farmer continued to produce that milk and was paid

approximately $13.00 per hundredweight, was assessed $1.00 and incurred

variable production costs of about $7.00, that would leave $5.00 available

3/ to meet fixed expenses. Therefore, producers do not have an incentive

to reduce production if the implicit direct payment for curtailed

production is only $4.35.

Second, the USDA's current implementation plan only offers an "all or

nothing" refund. Because no pro rata refunds would be made, producers

cannot be certain that they will receive any payment for curtailing

p r oduction. Farmers who attempt to qualify for a refund and reduce

3/ The national all-milk price averaged $13.54 per hundredweight for 1982; therefore, for illustration we have assumed that the price farmers received net of standard deductions for hauling, cooperative and ADA dues, and the like would be approximately $13.00. Similarly, variable costs range from $5.00 to $10.00 per hundredweight but $7.00 was assumed for this illustration.

5

production will not receive any direct payment for not producing that milk

if they do not reach the USDA goal. Few producers would be likely to

attempt to qualify because of this risk. However, the 1982 Omnibus Budget

Reconcilation Act explicitly allows the Secretary to make partial refunds

for partial volume reductions from the base level. If the USDA

implementation proposal were amended to allow pro rata refunds, the

uncertainty about receiving a direct payment would be eliminated.

Partial Refunds. If partial refunds were given for partial volume

reductions from base marketings, a producer would still receive a refund of

his entire assessment if his production is below his base level by at least

the entire USDA goal set by the Secretary (i.e., at or below his target

volume) . However, if a farmer's actual production exceeds his target

volume, but is less than his base, he would receive no refund for

production above his target volume, but he would receive a partial refund

on his target volume. The partial refund would be based upon his actual

reduction from the base as a proportion of the USDA goal. In other words,

if the Secretary requires a 10% reduction but the producer reduces

production only 6% below his base, 60% percent (6% divided by 10%) of the

assessment on his target volume would be refunded. The refunds paid on

target volume implicitly translate to a direct payment for each

· hundredweight below base volume that is no longer produced. However, even

though the payment would be guaranteed, the $4.35 per hundredweight payment

discussed above is not a large enough incentive. (The formula given

previously would be used to calculate the direct payment implied by either

partial or lIall or nothing ll refunds.)

If the direct payment were more than $5.00, producers would be more

likely to reduce production. The direct payment could be incr e ased in

6

various ways: 1) by augmenting the producer-generated assessment refunds

with additional government funds; 2) by reducing the USDA goal (see Table

1); 3) by increasing the refundable portion of the assessment; or 4) by

using a combination of these means. Because the government would be averse

to increasing its expenditures and because a 10.3% reduction goal is

consistent with the level of overproduction, the least costly and most

practical alternative would be to refund the entire $1.00 assessment on a

pro rata basis.

As shown in Table 2, refunding the entire assessment increases the (

implicit direct payment. At the USDA goal of 10.3%, the direct payment

would be $8.71 per hundredweight. With the opportunity to receive an $8.71

direct payment for not producing milk, the producer has significantly more

incentive to curtail production.

Contribution of Excess Production to Income

From another point of view, the current assessment program also

provides a disincentive to continuing to produce milk in excess of the

target volume. With production in excess of target volume, a producer

loses the refundable assessment. Therefore, an alternative approach would

be to calculate the contribution to income from each hundredweight a farmer

produces in excess of his target volume and determine whether or not he has

any incentive to continue producing that milk.

To simplify this approach, the "all or nothing" refund qualification

for a SOC refund is assumed temporarily. Therefore, only producers whose

actual volume is at or below target volume will receive a refund. The

first hundredweight in excess of target volume causes the farmer's income

to decline substantially. Assuming a $12.50 net pay price (i.e., net of

both standard deductions and the SOC non-refundable assessment) and a

Table 2. Direct Payment for Selected Levels of USDA Reduction Goals

Direct Payments USDA Goal 50¢ refundable $1.00 refundable (percent) ($ / cwt.)

5 9.50 19.00

6 7.83 15.66

7 6.64 13.29

8 5.75 11.50

9 5.06 10.11

10 4.50 9.00

10.3 4.35 8.71

11 4.05 8.09

12 3.67 7.33

13 3.35 6.69

14 3.07 6.14

15 2.83 5.67

20 2.00 4.00

25 1. 50 3.00

7

8

target volume of 500,000 pounds, the first excess hundredweight decreases

income by $2,488. That is, the farmer earns $12.00 for the first excess

hundredweight but loses 50C per hundredweight on the 5,000 others--$2,500.

Although the second excess hundredweight would also earn $12.00 without a

further decline in income, the cost of losing the refundable SOC on the

entire target volume should not be allocated only to the first excess

hundredweight. Ra ther, the loss should be "borne" by all of the excess

milk. The per hundredweight contribution to income from the excess

production is, therefore, calculated as the change in total income divided

by the production in excess of the target volume.

Sample calculations for selected levels of actual production are shown

in the top portion of Table 3. It can be seen that the contribution

to income is negative when the farmer's actual production volume is less

than 20,000 pounds above his target volume.

The bot tom half of Table 3 shows the contribution to income if the

entire $1.00 assessment is refundable. In this case, the net uniform price

(before assessments) is $13.00, but it is clear that the farmer has less

incentive to continue excess production with a $1.00 refundable assessment

than with a 50C refund. For example, if actual production is 550,000

pounds, the producer is 10% above his target volume. 4/

With a 50C

refund program, excess production contributes $7.00 per hundredweight to

the farmer's income; this probably compensates him for feed costs and makes

him indifferent to a choice between reducing or maintaining his production.

However, if the entire $1.00 is refundable, the contribution to income is

only $2.00 per hundredweight which would not cover feed costs; therefore,

he would prefer to reduce production if he indeed qualified for a refund.

4/ With 10% excess volume, a producer would be near the base level implied by the USDA 10.3% goal.

Table 3: Calculation of Contribution From Excess Production

Net Lost Production Pay Refundable

a/ Price Total Excess Contribution

Level Price Assessment Received Income Production to Income lbs. $7cwt. $ lbs. $ $/cwt.

Target Volume 500,000 12.50 0.00 12.50 62,500

Actual Volumes 510,000 12.50 0.50 12.00 61,200 10,000 -1,300 -13.00

520,000 12.50 0.50 12.00 62,400 20,000 100 .50

530,000 12.50 0.50 12.00 63,600 30,000 +1,100 + 3.67

540,000 12.50 0.50 12.00 64,800 40,000 +2,300 + 5.75

550,000 12.50 0.50 12.00 66,000 50,000 +3,500 + 7.00

-----------------------------------------------------------------------------------------------------------------

Target Volume 500,000 13.00 0.00 13.00 65,000

Actual Volumes 510,000 13.00 1. 00 12.00 61,200 10,000 -3,800 -38.00

520,000 13.00 1. 00 12.00 62,400 20,000 -2,600 -13.00

530,000 13.00 1. 00 12.00 63,600 30,000 -1,400 - 4.67

540,000 13.00 1. 00 12.00 64,800 40,000 200 .50

550,000 13.00 1. 00 12.00 66,000 50,000 +1,000 + 2.00

a/ No partial refunds allowed.

10

The contribution to income of production in excess of target volume as

shown in Table 3 would vary with the assumed price paid to the producer,

his assumed target volume and his assumed actual production. However, if

the excess production is expressed as a percentage of target volume,

the general formula for calculating contribution to income from excess

production would be:

where:

c = P - A - ~

C is the per hundredweight contribution to income of production in excess of target volume

P is the net price paid to the producer (net of standard deductions and non-refundable assessment).

A is the refundable assessment

R is excess volume as a percentage target volume.

(The mathematical proof of this formula is given in Appendix II.)

The contribution per hundredweight for selected pay prices and excess

production percentages is given in Tables 4 and 5. A graphic

representation which assumes a $1.00 refundable assessment, a $13.00 pay

price and various levels of excess production is shown in Figure 1.

Table 5 and Figure 1 show that the producer faces the risk of being

caught in an extremely adverse income position if he reduces production,

bu t fails to reach the USDA goal (i. e., his target volume). That risk

\.;Tould be eliminated if the "all or nothing" qualification \.;Tere dropped and

producers received partial refunds for partial declines from the base

level.

If pro rata refunds are made for partial reductions from the base

level, the contribution per hundredweight from excess production is the

same for all production up to the base. However, the level of that

contribution varies with the price received, the amount of the refundable

II

Table 4. Per Hundredweight Contribution to Income From Milk Marketed in Excess of Target Volume for Selected Milk Prices and

Percentages of Excess Production

Note: Assumes SOC Non-refundable Assessment and SOC Refundable Assessment "Allor nothing" Refund Qualification, 10% USDA Goal

Price Received Less Standard Deductions ($ / cwt.) 12.50 13.00 13.50 14.00 14.50 15.00

Less Non-Refundable Assessment of 50C/cwt. 12.00 12.50 13.00 13.50 14.00 14.50

Percentage Over Target

Volume Contribution To Income At Above Prices ($/ cwt.)

1 -38.50 -38.00 -37.50 -37.00 -36.50 -36.00

2 -13.50 -13.00 -12.50 -12.00 -11. 50 -11. 00

3 - 5.17 - 4.67 - 4.17 - 3.67 - 3.17 - 2.67

4 - 1.00 .50 0.00 .50 1. 00 1. 50

5 1. 50 2.00 2.50 3.00 3.50 4.00

6 3. 17 3.67 4. 17 4.67 5. 17 5.67

7 4.36 4.86 5.36 5.86 6.36 6.86

8 5.25 5.75 6.25 6.75 7.25 7.75

9 6.19 6.44 7. 19 7.44 8.19 8.44

10 6.50 7.00 7.50 8.00 8.50 9.00

11 6.95 7.45 7.95 8.45 8.95 9.45

12 7.33 7.83 8.33 8.83 9.33 9.83

13 7.65 8.15 8.65 9.15 9.65 10.15

14 7.93 8.43 8.93 9.43 9.93 10.43

15 8.17 8.67 9. 17 9.67 10.17 10.67

20 9.00 9.50 10.00 10.50 11.00 11. 50

25 9.50 10.00 10.50 11. 00 11. 50 12.00

30 9.83 10.33 10.83 11.33 11.83 12.33

12

Table 5. Per Hundredweight Contribution to Income From Milk Marketed in Excess of Target Volume for Selected Milk Prices and

Percentages of Excess Production

Note: Assumes $1. 00 Refundable Assessment with an 11AII or Nothing11

Refund Qualification, 10% USDA Goal

Percentage Over Target

Volume

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

20

25

30

Price Received Less Standard Deductions ($/cwt.) 12.50 13.00 13.50 14.00 14.50 15.00

Contribution To Income At Above Prices ($/cwt.)

-88.50 -88.00 -87.50 -87.00 -86.50 -86.00

-38.50 -38.00 -37.50 -37.00 -26.50 -36.00

-21.83 -21. 33 -20.83 -20.33 -19.83 -19.33

-13.50 -13.00 -12.50 -12.00 -11.50 -11. 00

- 8.50 - 8.00 - 7.50 - 7.00 - 6.50 - 6.00

- 5.17 - 4.67 - 4.17 - 3.67 - 3.17 - 2.67

- 2.79 - 2.29 - 1. 79 - 1. 29 .79 .29

- 1.00 .50 0.00 + .50 + 1.00 + 1.50

.39 .89 1. 39 1. 89 2.39 2.89

1. 50 2.00 2.50 3.00 3.50 4.00

2.41 2.91 3.41 3.91 4.41 4.91

3.17 3.67 4. 17 4.67 5.17 5.67

3.81 4.31 4.81 5.31 5.81 6.31

4.36 4.86 5.36 5.86 6.36 6.86

4.83 5.33 5.83 6.33 6.83 7.33

6.50 7.00 7.50 8.00 8.50 9.00

7.50 8.00 8.50 9.00 9.50 10.00

8.17 8.67 9.17 9.67 10.17 10.67

Figure 1. Per Hundredweight Contribution to Income from Milk Production., .

$/ewt.

13 .010-------

8 .00

6.00

4 .00

2.0 -

I .,

" ,

Assuming an "Allor Hothing" Refund

Production Qobr-~~----r-----r--~L--r--~-~-~--~~---T-~ ___ _

-2.00

-4.00-

-6.00

-8.00

-10.00

-12.00

-14.00

-16.00

-18.00-

-20.00

Target . Level

Base Level

15% 20 % 25%

13

assessment and the USDA goal. The contribution formula becomes: 5/

A CF = P - G

where: CF

is the per hundredweight contribution to income

P is the net price paid to the producer

A is the refundable assessment

G is the USDA goal

(A mathematical proof of the above formula is given in Appendix II.)

14

Table 6 shows the per hundredweight contribution to income assuming a

reduction goal of 10% and a $1.00 partially refundable assessment, for

selected pay prices and actual production levels. Figure 2 is a graphical

depiction of the contribution to income for the $13.00 net pay price shown

in Table 6. As mentioned above, with a pro rata refund of the entire $1.00

assessment, the contribution to income is constant for all excess

production between the target and base levels. At an assumed pay price of

$13.00, continuing to produce milk in excess of the target volume

contributes only $2.00 per hundredweight to the producer's income. Feed

costs alone are higher than $2.00 per hundredweight, therefore producers

would have a significant disincentive for continuing to produce milk in

excess of the target volume.

Methods To Increase Producers' Incentives

Any program designed to reduce the excessive cost of the dairy support

program will be successful only if producers respond to it by reducing milk

production; therefore, producers must have an adequate incentive to

participate in the plan. The incentive to reduce production provided by

the assessment refund program has been presented from two viewpoints:

5/ For actual production levels in excess of the base level, the previous formula still applies.

15

Table 6. Per Hundredweight Contribution to Income From Milk Marketed in Excess of Target Volume for Selected Milk Prices and

Percentages of Excess Production

Note: Assumes $1.00 Refundable Assessment and Partial Refunds for Partial Production Declines, 10% USDA Goal

Percentage Over Target

Volume

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

20

25

30

Price Received Less Standard Deductions ($/cwt.) 12.50 13.00 13.50 14.00 14.50 15.00

Contribution To Income At Above Prices ($/cwt.)

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

1. 50 2.00 2.50 3.00 3.50 4.00

2.41 2.91 3.41 3.91 4.41 4.91

3.17 3.67 4.17 4.67 5.17 5.67

3.81 4.31 4.81 5.31 5.81 6.31

4.36 4.86 5.36 5.86 6.36 6.86

4.83 5.33 5.83 6.33 6.83 7.33

6.50 7.00 7.50 8.00 8.50 9.00

7.50 8.00 8.50 9.00 9.50 10.00

8.17 8.67 9.17 9.67 10.17 10.67

16

Figure 2. Per Hundredweight Contribution to Income from Milk Production, Assuming a Partial Refund tor Partial Production Decline

S/ewt.

6.00

4.00

I

2.0 - I

Production 0.06

5% 10% 15% 20% 25%

Target Base -2.00 Level Level

-4,.00

17

1) as a producer-funded direct payment for milk not produced below the

base level and 2) as the contribution to income from milk still produced

above the target level. In either case, the risk inherent in the currently

proposed "all or nothing" refund qualification will discourage producers

from even attempting to qualify for the refunds, in spite of the incentive

level provided by the refunds. If we, therefore, assume that pro rata

refunds will be made, we can re-examine the formulas to discover the

. factors which could increase a producer's incentive to participate. The

two formulas are:

1) Implicit Direct Payment

where: PD

is the direct payment per hundredweight

A is the refundable assessment

G is the USDA "goal"

2) Contribution to Income

where: in addition to the above,

CF

is the per hundredweight contribution to income

P is the net price paid to producers.

These formulas have two common variables which affect their values:

the USDA reduction goal (G) and the amount of the refundable assessment

(A) .

The lower the USDA reduction percentage is, the greater is the

incentive to reduce production. If the USDA selected a 10% goal, the

farmer would have a smaller target volume and, therefore, a larger required

production decrease for a full refund than if 8% were selected. However,

as the goal declines, the per hundredweight contribution to income from

excess production also declines but the direct payment for not producing

increases; this increases the incentive not to produce. Although this

18

suggests that the USDA should choose a smaller goal to increase the

incentive, a low goal might not reduce the current level of CCC

expenditures sufficiently. In other words, a lower goal would induce more

producer participation, but the higher target level production would

continue to generate an unacceptably high surplus. The Secretary of

Agriculture, therefore, does not have much flexibility and should choose a

fairly high percentage.

The second variable affecting a producer's incentive to reduce

production is the amount of the refundable assessment. With the current

50<; refundable assessment, producers \.;rould be likely to continue excess

production because the direct payment associated with a 50<; refund is too

small and the contribution to income from excess production would cover

variable costs. As the amount of the refundable assessment increases,

producers' incentives to participate in order to obtain that larger refund

also increase. Under current legislation, the maximum assessment is $1.00

per hundredweight. If the entire $1.00 now mandated were refunded,

producers would receive an implicit direct payment of $8.71 per

hundredweight (or a $2.29 contribution from excess production) with the

USDA's proposed reduction goal of 10.3% (see Table 2)~ this would provide

an adequate . . 6/ lncentlve. - Although a refundable assessment in excess of

$1.00 would further increase a producer's incentive to reduce production,

it would also put an undue burden on him. A larger assessment would be

unfair both to those who do decrease production and to those who do not. A

larger assessment obviously has a larger negative impact on the revenue of

6/ Congressman James M. Jeffords of Vermont has proposed refunding 85<; per hundredweight and using the remaining 15¢ for promoting dairy product consumption. If 85<; were refunded the direct payment would be $7.40 and the contribution to income from excess volume would be $4.60 (with a 10.3 percent USDA goal).

19

producers who do not decrease produc tion. However, the larger assessment

also affects those producers who decrease production and obtain the larger

refund. All producers would be assessed but those who qualify would not

receive the refund until months later, significantly reducing cash flows.

Therefore, increasing the current assessment, without compensating for the

impact on cash for operations, does not appear to be advisable.

In addition to the two variables discussed above, the base marketing

period selected also affects the producer's incentives to participate. If

the current USDA goal of 10.3% is required, a producer might simply refer

to Table 6 to find the income contribution per hundredweight for actual

production at 10% above target volume. However, if the selected base

period is not recent (currently an average 1981-82 base is proposed rather

than 1982 itself), the producer may have increased production since the

base period. In October 1982, more than 37% of the farmers with deliveries

under the New York-New Jersey Milk Marketing Order had increased production

at least 10% above the average of their October 1980 and October 1981

levels. If production is 10% above the base level, it is approximately 20%

above target volume and the income contribution is $7.00 per hundredweight

rather than $2.00. In addition, a producer would not receive implicit

payments for curtailing production above the base level. Therefore, he has

less incentive to reduce production. Choosing a more recent base period

would also reduce the number of "new" producers (those who would not have

established a base during an older marketing period).

Summary of the Possible Incentives from an Assessment Program

The only permanent solution to excessive CCC expenditures is reducing

U.S. milk production. Milk price reductions alone, however, are not likely

to result in such a reduction. If both SOC producer assessments are made

20

refundable on a partial basis, the assessment program can offer sufficient

economic incentive to reduce milk production and can give farmers an

alternative to their present choices: increasing production to pay bills or

going out of business.

The economic incentive to reduce production could also be increased if

the refundable assessment is higher than $1.00. But, as has been

discussed, assessing farmers more than $1.00 would severely strain cash

flows. However, an increased refundable assessment would be more

acceptable to producers if it were accompanied by an increase in the

support price. Although an increase in the support price would seem to be

an anathema to consumers, handlers and the government, the combination of a

higher support price with a larger refundable assessment would offer

substantially higher incentives to decrease production and would reduce eee

expenditures more than either a $1.00 refundable or a SOc;.

non-refundable/SOc;. refundable assessment program. In addition, if both the

assessment and the support price were increased, U. S. consumers would be

assured of a stable and healthy dairy industry.

If the support price were increased by SOc;. per hundredweight and the

refundable assessment were raised to $1.25, the net impact on farmers who

did not reduce production would be a price reduction ranging from 7sc;. to

$1.00 per hundredweight (depending on how much of the support price

increase actually reached farmers). Farmers who decreased production,

however, would clearly benefit. With a 10% USDA goal, farmers who reduced

production to target levels would be refunded the entire $1.25 assessment

and would receive approximately SOc;. more for their actual production

volume (again, depending on the impact of the higher support price on pay

prices). If pay prices rose to $13.50 as a result of the increased support

21

price, the implicit direct payment for not producing would be $11.25 per

hundredweight.

The eee would benefit whether or not producers decrease production.

If they do decrease production, the eee would make fewer purchases. And if

producers do not decrease production, the eee would purchase products at

50C more per hundredweight. The eee is now purchasing approx imately 10%

of U. S. production; therefore, the additional cost would average 5C per

hundredweight of all U. S. production. However, under this program, the

assessment would rise by 25C on all U.S. production.

would have a net gain of 20C.

Therefore, the eee

A 50c increase in the support price would represent a 4% increase

since October 1980 (or an annual increase of less than 2%), which is a much

smaller increase in income than most U.S. workers have received during the

same period. Because raw milk costs are only approximately half of total

retail costs, a 4% increase in raw milk costs may result in only a 2%

increase in retail dairy product costs. Therefore, a 50c increase in

the support price should not be unacceptable to consumers, especially if it

contributes to a stable dairy industry and eliminates the excessive costs

in the price support program.

Impact on Price Support Program Net eosts

Viewing the 50c refundable assessment as a direct payment for milk

not produced does not change the impact of the current program on the eee.

And whether the farmer views the refund as a direct payment or views the

lack of a refund as lost income attributable to excess production, the

proposed assessments are currently allowed under the 1982 Act. Although

the pro rata refunds would result in more refunds actually being made than

"all or nothing" refunds, partial refunds are more likely to induce farmers

22

to reduce milk production. And the funds for pro rata refunds are still

generated by the producer assessments, not the U.S. treasury. In addition.

every hundredweight of milk that farmers do not produce would save the U.S.

treasury approximately $17.00.

eee net expenditures could be significantly lower with a $1.00 refund

plan than with the current SOC non-refundable/SOC refundable proposal.

There are three possible production responses to both plans: (1) neither

plan offers a sufficient incentive to reduce production; (2) both plans

provide a sufficient incentive; or (3) the $1.00 refund will be sufficient

incentive but the SOC/SOC plan will not.

If producers do not respond to either plan and do not reduce

production, the eee collects the $1.00 per hundredweight assessment on all

producer milk, none of which is refunded.

If producers respond to either plan and do reduce production, the

SOC/SOC plan would generate more revenue to offset support program costs,

because all producers would lose (and the ~ee would keep) the SOC

non-refundable assessment. In light of this. the non-refundable assessment

appears to be unfair to those producers who do decrease production and are

no longer contributing to program costs.

The third response is the one most likely to occur. As has been

shown, the SOC/SOC plan will not induce participation because it does not

offer an adequate incentive to decrease production. With a $1.00 refund,

however, the producer is much more likely to decrease produc tion. In

addition. if producers do not decrease production under the SOC/SOC plan.

total dairy price support program expenditures would initially decline by

$1.00 per hundredweight. Based on fiscal 1982 data. the assessment would

generate $1.4 billion for the eee. However, since program costs have been

23

$2.4 billion, net costs would be approximately $1.0 billion. If producers

respond to the 50~/50~ assessment by increasing production six percent or

more, any net saving would be eliminated and total program costs would

again exceed $2.0 billion. On the other hand, if producers decrease

production under a $1.00 refund plan, program costs would decline and the

excessive purchases could perhaps be eliminated in the long run.

Conclusion

Dairy farmers should be made aware of the impact of refundable

assessments on their income. Presenting the refunds as implicit direct

payments for not producing or as per hundredweight contributions to income

from continuing excess production are two methods of showing the impact.

In addition, dairy leaders, legislators and USDA officials should also be

made aware of the assessment plan's impact on farmers and on government

costs. An understanding of how the various components of an assessment

program affect a farmer's incentives to decrease production will help all

parties to formulate a program that will, in fact, solve the problem of

surplus supply.

APPENDIX 1

MATHEMATICAL PROOF OF THE DIRECT PAYMENT FORMULA WITH A REFUNDABLE ASSESSMENT PLAN

Note: This formula only holds when actual production is between target volume and base volume.

24

The direct payment per hundredweight is defined as the total value of

a producer's assessment refund divided by the number of hundredweight by

which actual production is below base volume (i.e., the number of

hundredweight no longer produced). Thus, the formula is:

~ A"'~xT

~)C B

where: PD

direct payment ($/cwt.)

A refundable assessment ($/cwt.)

~ percentage by which base production has been reduced

G USDA reduction goal (%)

T target volume (cwt.)

B base volume (cwt.)

That is, ~ G

is the proportion of the full assessment which will be

refunded, and A)(~ is the per hundredweight value of that refund. Since a G

refund will be made only on the target volume, the numerator represents the

total dollar value of the refund. The denominator, ~)C B, represents the

producer's volume reduction (i.e., the number of hundredweight he no longer

produced).

Note that target volume (T) can also be expressed as:

T or T

B- (B )( G) B (l-G)

If we substitute this expression for T into the original direct payment

formula, it becomes:

p = D

RB A~ G~BX(l-G)

RBXB

AXRBX B~ (I-G) - -----)(

G

The B and ~ terms cancel, leaving:

p = Al\.(l-G) D G

or p = A --' .. A D G

25

APPENDIX 2

MATHEMATICAL PROOF OF THE PER HUNDREDWEIGHT CONTRIBUTION TO INCOME FROM EXCESS PRODUCTION, UNDER TWO ASSUMPTIONS

26

The per hundredweight contribution to income that results from excess

production is defined as the change in total income due to production above

target volume divided by the number of hundredweight above target volume

that are actually produced.

Assumption 1: Producer will not receive a refund unless actual production

is at or below target volume--the "all or nothing" refund policy.

The formula is:

C=P_A_A~T R oX T

where: C contribution to income resulting from excess volume ($/cwt.)

P net uniform price less non-refundable assessment ($/cwt.)

A refundable assessment ($/cwt.)

T target volume (cwt.)

R percentage by which actual volume exceeds target volume

Each hundredweight above target volume earns the net uniform price less the

full assessment, but because he has excess production, the producer does

not qualify for any assessment refund on his target production. The last

term, A ~ T allocates the total value of the lost refund (A ~ T) to the R " T

actual production in excess of target volume (R ~ T).

Simplified, the formula is:

C P - A - ~

27

Assumption 2: A partial refund will be given if the producer's actual

production is above the target volume but lower than the base volume.

Under such a plan, the producer would lose a proportional amount of the

assessment refund on target volume. Therefore, the formula is:

where: CF

p

A

G

~ T

R

C F

G -RB P - A - A x G x T

R x T

contribution to income of excess volume ($/cwt.)

net uniform price less non-refundable assessment ($/cwt.)

refundable assessment ($/cwt.)

USDA reduction goal (%)

percentage by which base production has been reduced

target volume (cwt.)

percentage by which actual volume exceeds target volume

Again, the last term allocates the total value of the lost portion of the

refund (numerator) to the excess volume (denominator).

If B is defined as the base volume in hundredweight, we can express

actual production in two ways:

a) T (1 + R)

b) B(l - ~)

This creates the identity:

T(l + R) = B(l - RB)

Target volume (T) can also be expressed as:

T = EO - G)

(See Appendix I.)

28

Substituting for T and solving for (G - ~) in the identity:

B)((l-G) (l+R) BX(l-RB

)

(i-G) (l+R) l-RB

l+R-G-(RlCG) 1-RB

G-R+(RlC.G) RB

G-RB R-(RxG)

G-RB R"-(l-G)

If we substitute for (G - ~) in the contribution formula above and

simplify:

CF

AX R(l~G) . G . X

P - A -Rx T

A R(l-G)

>< G P - A -

R

Ax R(~ - 1) P - A -

R

1 P - A - A (G" - 1)

A P-A-C+A

P A G

T