Our food system is composed of highly independent levels. Production of basic farm commodities, such as corn, soybeans, wheat, livestock, and poultry, is one critical part. Equally important, however, is the food processing industry which converts these commodities into food products for retail markets. Today, there is growing concern about how product movement between these two levels of the system is coordinated. Grain producers wonder whether specialty crops, with their associated production certification methods, will grow in importance. Hog producers worry about a trend toward contract hog production with ties to processing which may exclude their farm or at least change the ownership structure of farm assets. At the same time, poultry producers pore over the details of their production contracts.

All of these concerns are justified, and therefore it is our intent to help readers better understand potential coordinating mechanisms, to discuss their advantages and problems, and to explore some of the implications for Indiana agriculture.

Coordination refers to the process by which successive stages of the production and marketing of a commodity interact in order to deliver products when, where, and in the form that they are most desired. A stage is any of the individual processes occurring in the production- marketing chain that is able to produce a salable product or service (Mighell and Jones). Coordination methods include open market transactions, integration, and contracting in several forms.

 

Open Markets

 

The benchmark by which other coordination methods are compared is an open or cash market between stages in which goods of homogeneous and known quality are offered by a number of small sellers to a number of small buyers. Open markers are possible between every pair of stages in a market economy. Also known as spot markets, present-day examples that approach this definition of an open market include livestock sale barns, local grain elevators, and terminal livestock markets. Buying or selling a product on a spot market is known as an external transaction, because the coordination between the states occurs outside a single firms normal operations (Mighell and Jones, 10). Competition amounf several buyers and sellers produces a unique price that clears the market. Producers and consumers make adjustments in their output and consumption based on the price signals generated in the market. A purely market coordinated system would have a market between every stage, and no firm’s activity would include more than one stage.

Spot markets provide easy access to potential buyers and sellers, and prices are visible to all participants. If an individual had money he can be a buyer; if he has goods available he can be a seller (Schrader, 67). No previous agreements or commitments are required. Typically, this means produce first and then sell. At worst, a seller’s receipts will not cover costs, or a buyer will find the good too expensive, but a market will be available.

Spot markets provide a means of price discovery, through a bidding process, a market clearing price is established and made public. Knowledge of process at each accessible market is desirable to allow all participants to compare their market alternatives (Schrader, 67). Also, other market coordinating mechanisms may use the spot market price as a basis for determining payment. It is important to recognize that the value of a spot market for price discovery or as a basis for other pricing formulas depends highly on the volume and quality of products going through the particular market in which the prices and quan­tities are simultaneously negotiated.

Spot markets provide a method of rewarding buyers and sellers of goods for differences in quality, location, and timing. Ideally, such markets serve to promote efficient allocation of resources through competitive pricing (Schrader, 64-65). Prices will be high enough to obtain the volume of production required to satisfy all who wish to buy at that price, but low enough to entice buyers to purchase all that is available at that price. Only low-cost, efficient producers and processors will remain in business in the long run, which will lead to the lowest possible prices for goods in the grocery store. As the forces of supply and demand bid commodity prices down to the efficient producer’s minimum average cost, individuals who for reasons of location, climate, management, and so on, are unable to produce at that price will begin to operate at a loss, and will be forced to cease production and exit the industry.

The primary disadvantage of spot markets is their high transaction costs. For example, it is costly to transport goods to or from a central place where buyers and sellers gather. The negotiating/haggling over prices can be quite time-consuming. In addition, there are costs associated with uncertainty regarding the quality of purchased goods. Spot markets, while resembling perfect competition, often do not meet the condition of perfect information. For example, a hog buyer with a trained eye can closely estimate the yield and cut-out of live hogs, but because value may also depend on the genetics, feed, or production practices used, it may be impossible for open market prices to provide a complete quality signal. The quality message may be difficult to communicate through price alone. Buyers desiring a specific quality may have difficulty in satisfying their needs in a spot market.

The stability of product supply and price is another relevant measure of market performance. Spot markets are good at allocating the supply of products already produced, but because of the biological lag inherent in agricul­tural production and the emotions of market participants, spot markets often result in cycles in commodity prices and supplies.

 

Vertical Integration

 

Vertical integration and spot markets are at opposite ends of the spectrum of coordination methods. In the vertically integrated case, a firm owns and inter­nalizes the coordination of two or more stages in a commodity system. Generally, vertical integration occurs in response to market characteristics that make it more economical to carry out the transaction within the firm rather than across markets (Martin, 234). Economic advantages of vertical integration may arise from the physical relationship between stages (technol­ogy), transaction costs (including risk), or market power.

Technology has encouraged integra­tion of egg production and packing. The capability to connect large production units directly to grading and packing equipment eliminates a product move and reduces product loss. Livestock slaughter and further processing may offer similar economies for meat processors. Modern processing tech­nology, in general, is less tolerant of quantity and quality variation than ear­lier, less capital-intensive systems.

Transaction costs are also an impor­tant stimulant for integration. There are many costs associated with market transactions. Some are easily observed, such as transportation to a central market, brokerage, and yardage. Others are less visible but may be substantial, such as the assurance of adequate supplies, quality assurance, credit checks, and costs of information. A number of risks are inherent in reliance on open markets. Buyers may have to offer prices well over production costs to obtain the quality and quantity needed at a given time. Likewise, sellers may be forced to accept a price well below costs when a market is glutted. These problems are more serious for perishable products than for storable products. The more unique the product, the greater the risk for both buyers and sellers in an open market. Consumers’ desires for an increasing diversity of quality-controlled foods presented in attractive, convenient-to-use forms impose more exacting specifications on acceptable agricultural raw materials. The more exacting the requirements, the more difficult it is for price alone to carry the appropriate message to producers.

Integration may reduce some types of risk, but it also concentrates all remaining risk in one firm. It also limits the ability of a firm with limited capital to exploit size economics that might be available through specialization at one stage of the system. In addition, a market which is dominated by integrated fim1s will not, in general, reveal prices for the intermediate goods.

The market power argument for integration is more complex. If both sides of a market are less than competitive, each will take a margin over their marginal cost in maximizing their separate profits. If both operations (one producing and the other using the product) are combined, the profit for the single remaining firm would exceed the sum of their separate profits. Jn agricul­ture, the motive for farmers to integrate downstream into processing tl1rough cooperatives is often the perception that other marketing firms are taking larger margins than necessary because of market power. Cooperative purchasing and marketing are forms of vertical integration.

 

Contract Coordination

 

Open markets and vertical integration represent the extreme positions. Con­tracting spans the continuum from a simple sale of grain for future delivery to arrangements approaching integra­tion into production by food processing firms. Generally speaking, contracting refers to an agreement in which one firm produces goods for another firm, but both maintain separate identities and long-term profit objectives (Mighell & Jones, 24).

Contracts of many types exist in agriculture. They differ by: (1) the share of management, resources, and risk bearing provided by each party involved, and (2) the method of payment and/or profit sharing used.

Contracts fall into three primary categories. The first type is called a market specification contract, some­times referred to as a forward contract. This type of contract is the closest to market coordination. Market specifica­tion contracts could in principle be made in an open market for contracts. Some agreements specify the exact price to be paid upon delivery, while others may specify only the delivery conditions with prices based on market quotes at the time of delivery. The price or specific formula for price calculation is guaranteed by the contractor in return for delivery by the producer of a specific quality and quantity of com­modity at a predetermined place and time. Forward pricing and basis con­tracts with elevators for grain are examples of this type of contract. The strictness of the standards agreed upon will vary with the commodity and con­tractor involved. The contractor provides no physical production inputs in the market specification contract. Basically, contracts provide assurance of a supply or outlet and may involve a shift in price risk.

Production management contracts represent a second classification of contracts. Similar to market specification contracts, these contracts call for more direct managerial participation by the contracting firm. Cultural practices and type of inputs to be used often are specified in the contract agreement. For example, popcorn grower contracts may specify the variety of seed to be planted and cultural practices to be followed or avoided. Pricing can be fixed or based on market quotes at the time of delivery with a production management contract. Special corn for processing is often produced under this form of contract.

The third type, resource-providing contracts, involves the greatest amount of managerial control by the contractor. In addition to providing the guaranteed price or price formula and strict production guidelines, this contract includes contribution of major production inputs by the contractor. Well-known examples include: (1) broiler contracts in which the contractor provides feed and chicks, and (2) hog contracts in which the contractor provides the breeding stock or feeder pigs and feed. In both examples, the farmer provides the buildings, equipment, utilities, and labor. Payment to the farmer often comes on a per head or per pound basis, with monetary incentives for desired performance such as high feed efficiency and low mortality rates. Resource­providing contracts differ from the first two in that the contractor retains ownership of the commodity.

 

Why Contract?

 

Contracts span the continuum from almost spot markets to almost integration. They can be varied to achieve almost any desired sharing of control or risk to suit the parties involved and the situation. One might ask, if market coordination is not performing well in a given situation, why isn’t vertical integration the logical answer.

Financing provides an interesting case. Consider the broiler processor. Hatching, growing, and processing must be closely coordinated to use capacity efficiently and to produce the product valued by the users. The capital required for a processor to produce all the birds needed to supply an efficient processing plant would be very high. Contracting for production lowers the capital required by the processor and at the same time makes capital more available to the contracting grower. The typi­cal contract transfers much of the risk from the grower to the processor. The simple market specification contract to arrange for matching production and slaughter schedules would leave much more of the production and price risk with the producer.

A further advantage of contract production over integration is that the self-motivated contract producer may be a more efficient worker than a processor employee in the same position. Avoidance of fringe benefits and other employer obligations may also be a significant factor encouraging con­tracting rather than integration by a processor. Much productive family labor can be used by a contract producer that would be difficult or impossible for a large processor to employ. Both producer and processor may gain financially from a contract arrangement.

A cooperative processing operation that would be classified as a form of vertical integration may also use con­tracts with member growers. Contrac­tual commitments with members are usually required to coordinate production and processing.

The continued trend in the U.S. towards larger, specialized farms has led to some acceptance of contracting in areas typically characterized by inde­pendent production. Specialization tends to increase income variation, and contracts may help reduce some of the corresponding uncertainty (Schrader, 1165). Farmers have investments in facilities and goods in process and are therefore “long” in the market. The processor also faces market risk. The manufacturer of a branded item is “short” in the market, because the product must be on the shelf when the consumer wants it or else all the resources used in advertising and promotion to create brand image have been wasted. Thus, contracting can reduce risk for both farmer and processor. Contract payments typically reflect the amount of risk involved in the enterprise and how it is shared between the producer and the contractor.

Many contracts rely on spot market prices to establish payments to producers. As the proportion of production under contract (or integration) increases, the volume traded in spot markets diminishes. This impairs the price discovery function of the spot market and renders its use for contract settlement questionable when the proportion under contract dominates. Egg trading is dominated by long-term arrangements between producers and packers and between packers and retailers with prices based on market quotes. With 90% or more of the trans­fers integrated or contracted, price discovery falls to the very small share for which prices are negotiated daily and the judgement of the market reporters. Pricing of eggs and meat have been the subject of controversy for many years. Even so, few would argue that a spot market for cartoned eggs to retailers would be better.

Similarly, the growth of contracting and integration may limit the access to market for the produce-and-then-sell producer, or access to supplies for the processor not having made prior arrangements. The point of access changes where contracts dominate and the cost of entry may be prohibitive where integration is the norm.

 

Issues and Implications

 

The two issues associated with con­tracting and integration that generate controversy are the feeling that resource-providing contracts reduce the scope for decision at the producer level and diminish access to markets at the traditional farm level. The latter is closely associated with the problem of price discovery in a thin market.

The vertical structure of commodity systems has changed a great deal and continues to evolve. Fifty years ago, agricultural production and some processing were integrated within the farm. Power was often homegrown as was fuel. Seed was produced where used and pest control was internal. Processing such as mi 1k separation, butter making, and poultry slaughter was done on the farm. Specialization on the farm has created more markets than integration has replaced.

Change in vertical structure is not new. The trend to reducing integration in traditional production has been replaced by recombination of some of the same stages, but at a much larger scale and with a nonfarm firm as the coordinating agent.

The relevant question for firm planning and for policymakers is the balance of costs and benefits and whether the costs are borne by those who benefit from nonmarket coordination. Some cases are relatively clear. A daily spot market for raw milk would be a high-cost alternative to a stable buyer/seller relationship with fixed routes for assembly. It is equally clear that the transfer of cartoned eggs to retailers benefits from a standing arrangement rather than a daily or even weekly auction. The cost advantage of a closely coordinated system to produce, process, and market poultry is not seriously questioned.

Quality and flow control are central to the issue. Integration or contract coordination achieve control to lower processing costs, provide final products to match consumer preferences, and lower transaction costs. The question is whether these benefits offset diminished accuracy of price discovery and the possibility of exclusion of some who might have entered the system. It must be recognized that al I market par­ticipants lose from inaccurate prices, not only those who benefit from the integration and contracting.

Quality control is not necessarily achieved to a greater degree with production owned or contracted by a processor. Agricultural production, a biological process, is subject to quality variation. A group of pigs with similar genetics grown in the same facility on the same feed will not all be alike. If the variation under controlled conditions remains larger than that desired by a processor, using the market process to sort for the quality that each processor desires may result in lower cost than internalizing coordination.

The institutions of exchange could be tuned to function more efficiently. The price signal could be more effective in transmitting consumers’ desires upstream to producers. For example, the value of soybeans is derived from only two components, oil and protein. Quick tests are available to determine both, yet no beans are bought based on oil or protein content. Furthermore, an allowance for a percentage of foreign material results in worthless material purchase at the soybean price. Computerized trading that could enhance price discovery, lower transaction costs, and accomplish a more thorough sort is feasible but unused. Traditional ways of doing things may increase transaction costs and encourage non­market coordination.

Biotechnology holds the promise of agricultural products designed or genetically engineered for specific uses. Methods exist for changing the composition of animals and plants. Interactions between genetics and husbandry or cultural practices are likely to be better understood in the near future. These factors will achieve greater diversity of products and a greater need for quality control. There will be greater incentives for coordination by means other than spot markets. Closer relationships between agricultural production and processing are likely in the future. The form these take will be influenced by regulation and/or institutional innovation.

Regulation which serves to assure that all costs enter the market decision would enhance the efficiency of the system. Direct regulation of transactions between stages or the stages that may be combined in a firm will most likely result in costs higher than without regulation to the disadvantage of consumers and very likely also for producers.

Regulation of vertical structure in one state or area of a larger market will encourage the affected activities to increase more rapidly elsewhere. A refusal to accept cost-reducing organizational innovation in traditional areas of production will also encourage expansion in new, less inhibited areas.

The challenge for producers in any commodity system is to recognize the common interests of producers and marketers and to find a relationship which allows both to benefit from a cooperative rather than an adversarial relationship.

 

 

REFERENCES

Martin, Stephen. Industrial Organization. New York, NY: Macmillan Publishing Company, 1988.

Mighell, R. L., and L.A. Jones. Vertical Coordination in Agriculture. Washington, D.C: U.S. Department of Agriculture, Econ. Res. Serv. AER No. 19. Feb. 1963.

Schrader, Lee. “Pricing and Vertical Coordination in the Food System,” The Organization and Pe1formance of the U.S. Food System. ed. B.W. Marion, pp. 59-110. Lexington. MA: Lexington Books, 1986.

Schrader. Lee. “Responses to Forces Shaping Agricultural Marketing: Contracting.” American Journal of Agricultural Economics. (68:5) 1161-66, 1986.