Analysis of Changing Methods of Vertical Coordination in the Pork Industry

Journal of Agricultural and Applied Economics, 30,2(December 1998):301–3110 1998 Southern Agricultural Economics Association

Analysis of Changing Methods of VerticalCoordination in the Pork Industry

Steve W. Martinez, Kevin E. Smith, and Kelly D. Zering

ABSTRACT

This study examines the motivation behind contracts and vertical integration in the porkindustry, and simulates the effects of potential improvements in coordination. Incentivesrelated to lowering costs of measuring and sorting hogs, and protecting against opportu-nistic behavior associated with specific assets, can result in hog quality improvements. Aframework for simulating the effects of increased coordination through contracts and ver-tical integration was developed and used to evaluate potential improvements in leanness.Although simulations suggest only modest changes in pork prices and supplies, gains inconsumers’ surplus could be substantial for larger demand shifts due to quality improve-ments.

Key Words: contracts, hogs, lean pork, simulation model, vertical coordination, verticalintegration.

Significant changes underway in the pork in-dustry illustrate the industrialization of agri-culture (Hurt; Boehlje; Rhodes). The trend to-ward larger, more specialized hog productionand processing operations is accelerating(Hurt). Potential size economies and newhealth-enhancing technologies encouragegreater concentration of animals. Changingmethods of vertical coordination in the porkindustry are also evident. The proportion ofslaughter hogs obtained by large packersthrough long-term contracts or integrated op-

Martinez is an agricultural economist with the Eco-nomic Research Service, U.S. Department of Agricul-ture. Smith is a Ph.D. candidate and Zering is an as-sociate professor/extension specialist, both at NorthCarolina State University.

The authors would like to thank an anonymous re-viewer for many helpful comments. Support for thisresearch was provided by the U.S. Department of Ag-riculture under Agreement No. 43-3 AEM-5-80122.The views expressed here are those of the authors anddo not necessarily represent those of the U.S. Depart-ment of Agriculture.

erations is expected to increase from approx-imately 1370 in 1993 to 3470 in 1998 (Hay-enga et al.).

Greater use of contracting and integrationhas led to complaints by smaller hog produc-ers and packers about market power. Marketpower through price discrimination, or barriersto entry, may result in welfare losses to societybecause of misallocated resources. Contractingand integration also reduce the amount and ac-curacy of publicly available market informa-

tion, which may distort production and mar-keting decisions of producers.

However, contracting and integration mayalso result in improved food quality for con-sumers. As households have become smallerand the value of their time has increased, con-sumers place a greater value on convenienceand quality assurances in their food purchases.Information linking diet to health has in-creased consumer interest in the nutritionalquality of food products. Trends toward moreaway-from-home food consumption and in-

302 Journal of Agricultural and Applied Economics, December 1998

creased sales by large restaurant chains indi-cate that food suppliers must be able to pro-vide large amounts of consistently highquality, uniform products. Pork producers andprocessors also are introducing branded prod-ucts, thereby increasing the need for qualitycontrol. Contractual arrangements and verticalintegration presumably are leading to a highlycoordinated pork marketing system which ismore responsive to consumer preferences. Ina 1993 survey, large packers ranked ‘ ‘im-proved quality” as the most important reasonfor market contracts (Hayenga et al.). By tyingpremiums and discounts paid to the quality ofhogs produced, or by directly controlling qual-ity, packers may receive a more consistentsupply of high quality hogs. Hence, it is im-portant to consider benefits of changing co-ordinating arrangements, as well as potentialharmful effects related to market power.

Unfortunately, there is very little empiricalwork that examines the market effects ofchanging methods of vertical coordination. 1Yet, limited empirical evidence suggests thatthese effects could be substantial. For exam-ple, Kinnucan and Nelson use a farm-retailprice margin model of the egg industry to ex-amine the effect of increased vertical controlon marketing costs. They estimated that con-tract production reduced egg marketing costsby 25% between 1973 and 1983. In a com-petitive egg marketing system, this translatesinto lower egg prices on retail shelves for agiven level of demand. Similar results havebeen documented for nonfood industries aswell. Kwoka estimated that vertical integrationof the generation and distribution stages of theU.S. electric utility industry led to cost savingsof 27?i0. Hence, consumers and producers havean interest in the type of coordinating arrange-ments that develop.

In this analysis, we focus on the reductionof transactions costs associated with qualityimprovements as incentives for contracts orvertical integration between hog producers and

~Formal empirical modeling of non-spot coordi-nating arrangements has focused on higher profits asincentives for vertical integration of imperfectly com-petitive stages (e.g., Azzam; Azzam and Wellman).

packers. We present a modeling framework forsimulating the impact on the pork industry ofa hog market characterized by a combinationof open market exchange, contract coordina-tion, and vertical integration. We then evaluatethe potential effects of quality enhancements(i.e., increased leanness) via contracts and ver-tical integration.

Motivating Forces for Changes inCoordination Between Producers andPackers

We focus on transactional economies as mo-tivation for contracts and vertical integration,specifically those that relate to improvementsin quality. Transactions costs are expenses as-sociated with carrying out transactions, suchas measuring performance, creating incen-tives, and enforcing agreements to ensure de-sired performance. Transactions cost theorysuggests that economic activity is organized tominimize these costs (Milgrom and Roberts).Hence, the move to contracting or vertical in-tegration may be occurring to reduce the costsof trading on the open market. By reducingtransactions costs associated with obtaininghigher quality hogs, the quality of hogs maybe improved.

Measuring and Sorting Costs

One way that non-spot coordinating arrange-ments can improve the quality of hogs slaugh-tered is by reducing transactions costs asso-ciated with asymmetric information andmonitoring between packers and producers. Abuyer of an intermediate product (input) mayhave difficulty in assessing the quality of theproduct. For example, the PSE (pale, soft, ex-udative) pork quality problem in some porkcarcasses is not easy to identify in carcassesat the time of grading. Barzel argues that tojudge the value of a good, its attributes mustbe measured. The cost of measuring these at-tributes may be expensive and mistakes inmeasurement may result in wealth transfers. Inaddition, if there exists some variability in de-sirable attributes of the intermediate product,it may require costly sorting to determine its

Martinez, Smith, and Zering: Vertical Coordination in the Pork Zndustzy 303

value. The total cost of the good to the buyeris the price paid plus the cost of attribute mea-surement. If the quality attributes can be con-trolled in the production process, the buyer ofan intermediate product may reduce the costsof measuring and sorting by using new meth-ods of coordination with the producer.

In the pork industry, the characteristics ofthe hogs used by the packer and processor canhave an important influence on productioncosts and the value of the final output pro-duced. These characteristics include leanness,PSE, and hog size. For example, Forrest founda 53 $ZOlean hog to be worth approximately $13more than a 45~o lean hog.

Since the value of hogs is largely deter-mined by genetics and weight of hogs re-ceived, the use of long-term contracts by thepacker, which specify these characteristics,may help reduce measurement and sortingcosts. As the costs of measuring quality attri-butes of hogs increase, the cost of monitoringcontractual performance in long-term con-tracts also increases. This increases the incen-tive for vertical integration, as opposed tolong-term contracts.

Hennessy presents a model demonstratingthat inaccuracies in measuring the quality ofan intermediate agricultural product create in-centives for contracts or vertical integration. Ifinformation asymmetries exist between pro-ducers and processors regarding the quality ofthe intermediate product, testing is required bythe processor to determine the appropriate pre-mium. Inaccuracies in testing of product qual-ity reduce the incentive for producers to investin assets that improve quality (e.g., geneticstock, technical education, harvesting andstorage equipment, etc.). Contracts and verti-cal integration and production contracts solvethe problem by removing the need to test forquality, thereby improving the quality of theintermediate input.

Asset Specificity

Another incentive for vertical contracting andvertical integration may be created by the use ofspecific assets in the production process of in-termediate goods (KIein, Crawford, and AIchi-

an). Specific assets are assets whose value ismuch greater in a particular use compared to thenext-best alternative (Milgrom and Roberts). Aspecific asset may be physical (unique physicalcharacteristics), human (unique skills), or site(unique location) specific capital.

Klein, Crawford, and Alchian suggest thatspecific assets may generate quasi-rentstreams, where quasi-rents are defined as thevalue of the asset in excess of the salvage val-ue (i.e., next-best alternative use). These qua-si-rents may be appropriated through the op-portunistic behavior of others. For example, anindividual contemplating investment in a spe-cific asset may agree to exchange with anotherparty at prices that will ensure the owner re-ceives some level of quasi-rent from the spe-cific asset. Once the investment is made, thesecond party may then renege on the agree-ment by offering a lower price. The ownermay be forced to accept the offer, as long asthe price is more favorable than could be ob-tained in the next-best alternative use.

Long-term contracts and vertical integra-tion serve to protect individuals from oppor-tunism by trading partners. A large number ofstudies have found that as the level of appro-priable quasi-rents increases, the use of long-term contracts and vertical integration increas-es (see Shelanski and Klein for a review of theliterature).

The use of long-term marketing agree-ments may serve to reduce the potential foropportunism in the development of pork prod-ucts with unique quality characteristics. Forexample, PSE pork is lower in quality andhighly related to the “stress gene.” The Na-tional Pork Producers Council (NPPC) esti-mates that PSE costs packers $3.29 per hog,with PSE affecting over 10% of U.S. hogs(Morgan et al.). Packers may reduce thesecosts by offering premiums to hog producerswho use genetic lines that are free of the“stress gene. ” Carcass merit pricing schemesused in spot markets offer no premiums forhogs bred from genetic lines that are free ofthe “stress gene. ” In order to receive premi-ums, hog producers may need to make sub-stantial investments in “stress gene” freebreeding stock (physical specific assets). Once


I I I

Q, Q,Quantity

Figure 1. Net effect at the retail stage of in-creased vertical coordination of the pork pro-

duction and packing stages

the investment is in place, the premium overthe spot market price becomes a quasi-rentthat can be appropriated to the packer. If thepacker lowers the premium offered, the pro-ducer is left with the alternative of acceptingthe reduced premium or selling in the spotmarket for no premium at all. A legally en-forceable long-term contract with specificquality provisions provides protection againstshort-term opportunism. As the level of appro-priable quasi-rents increases, the likelihood ofvertical integration increases because there isa greater one-time benefit of reneging on along-term contract.2

Price, Quanti@, and Economic Surplus

Changes

The expected market impact of reducing trans-

actions costs associated with quality improve-

ments is illustrated in figure 1. At the initial

equilibrium, the retail price is PO and retail

quantity is QO.Now consider packers and pro-

2Other examples of specific assets in the pork in-dustry include substantial investments necessary totake advantage of economies of size in hog production(e.g., feed mills, confinement housing, etc.) and hogprocessing (e.g., packing plants, storage facilities, etc.).

ducers who establish contracts for delivery offinished hogs, or vertically integrate. Higherquality hogs, manifested in quality improve-ments of pork products, shift out the demandfor pork from DOto D, (Unnevehr). Improvingthe quality of hogs also reduces slaughter andprocessing costs by increasing the productivityof the hogs. This shifts the retail supply curvefrom So to S1. The shifts in supply and demandresult in a new equilibrium at Q~ and PL. The

new equilibrium quantity is unambiguouslylarger. The net effect on the retail price is in-determinant, depending on the elasticities ofsupply and demand and on the extent of thehorizontal shift-out in supply and demand. Infigure 1, the shift-out in supply exceeds thatof demand, so that the retail price falls. As-suming parallel shifts in supply and demand,there is a consumer surplus gain equal to thearea ABCP1, and a gain to producers equal tothe area P, CDE (Lemieux and Wohlgenant).3

Modeling the Effects of IncreasedCoordination

Kilmer and Ward have offered one of the fewframeworks for simulating the effects of in-creased coordination of the vertical stages ofa competitive marketing system. They hypoth-esize that when a firm contracts or integratesto obtain inputs, parameters of the productionfunction may be altered because of increasedinput productivity. This occurs because the in-put is usable only within a narrow band ofcharacteristics, such as quality, quantities, andtiming of deliveries, which can be controlledwith greater precision by using non-spot co-ordinating arrangements. To obtain an aggre-gate market supply curve in a market consist-ing of firms that use non-spot exchangemethods and firms that exchange on the open

YThe equivalence of these areas to changes in con-sumer and producer surplus can be derived using ge-ometry, assuming parallel shifts in supply and demand.Producer surplus represents net benefits because theformula aggregates over alt producers, when only afraction of pork may be affected by non-spot coordi-nating arrangements. Therefore, winners and losersfrom non-spot coordinating arrangementsare not sort-ed out.

Martinez, Smith, and Zering: Vertical Coordination inthe Pork Industry 305

market [i.e., multiple exchange mechanism(MEM) market], firm supply curves for themore productive firms and less productivefirms were summed. The importance of con-tracting and integration is reflected by the pro-portion of firms using these methods of coor-dination. Equilibrium prices and quantities inthe MEM market are then compared to equi-librium in a market consisting only of spotmarket exchanges.

A major weakness of the Kilmer and Wardframework relates to estimation of parametersof the production function for firms that con-tract or integrate. According to Kilmer andWard, parameters can be directly estimated inindustries that have undergone changes in ver-tical coordination, or they can be approximat-ed using managerial judgment. However, di-rect estimation would be difficult because it isunlikely that changing methods of coordina-tion in the pork industry have been significantenough to warrant direct estimation. To the ex-tent that such changes have occurred, it wouldbe difficult to attribute differences in param-eter estimates to changing methods of coor-dination. It is also unlikely that “managerialjudgment” can be used to indicate how a pa-rameter in a production function changes withnew methods of vertical coordination.

The framework used here differs from thatof Kilmer and Ward in several ways. First, weaccount for demand shifts at the retail leveldue to food quality improvements. Second,Kilmer and Ward focused on farm-stage ef-fects, whereas we additionally examine effectsat the retail level, since changing methods ofcoordination can have important implicationsfor consumers as well. Finally, we use per-centage of hog sales through contract produc-tion or vertical integration to reflect their im-portance in the pork industry, instead of theproportion of firms that use these arrange-ments. This is because firms can use severalmethods of coordination at the same time.

To evaluate the price and quantity effectsof increases in vertical coordination betweenthe hog production and packing stages, we usethe modeling framework developed by the Na-tional Pork Producers Council, AgriculturalEducation and Consulting Team (Sonka,

Doehring, and Hofing). The NPPC model is acomparative statics model with two inputs(hogs and marketing services) and one product(pork), consisting of three competitive stages(retail, marketing, and farm). Hog quality im-provements resulting from increased coordi-nation are represented in the modeling frame-work as a shift in supply and demand. Wefollow the methodology used by Sonka,Doehring, and Hofing for estimating supplyand demand shifts related to improved pork

quality. We estimated shifts in retail demandrelated to increased leanness, and shifts in re-tail supply related to increased leanness, andlower hog acquisition costs. Reduction in the“fatness” attribute was examined becausemore information exists regarding consumerpreferences for leaner pork compared to otherquality attributes, such as PSE (Sonka, Doehr-ing, and Hofing).

Vertical Coordination and Improved

Leanness

The relationship between non-spot coordinat-ing arrangements (i.e, contracts and verticalintegration) and reductions in fat is inferredusing survey results and firm-level cases. In a1993 survey of the 19 largest pork packers,each was asked to give primary reasons forusing long-term contracts (Hayenga et al,).Seven of the 10 respondents ranked improvedquality as the most significant reason. In ad-dition, half of all long-term contracts betweenthe large packers and large hog producers in-cluded minimum quality or genetics require-ments.

Smithfield Foods, a leading packer in thepork industry, emphasizes the importance oflong-term contracts and vertical integration inobtaining consistent supplies of lean, highquality hogs (Smithfield Foods, Inc.). In fiscalyear 1996, it obtained approximately 61% ofits hogs through long-term agreements and in-tegrated operations. Smithfield Foods touts itsNational Pig Development (NPD) program asthe best demonstration of the effects of a high-ly coordinated operation. Through Srnithfield-Carroll’s, a joint hog production operationwith a major North Carolina hog producer,


Table 1. Packer Costs Associated with Lean-ness Problems

Control- Costlable Controlledcosts by Farmer

Packer Defect ($/head) (%)

Backfat thickness 2.80 100Degree of ham and

butt trimming 1.87 100Excessive seam fat 0.63 100Bellies too fat or

too thin 0.14 100Weight problems 0.88 100Total packer costs 6.32

Source: Sonka, Doehring, and Hofing.

Carroll’s Foods, Smithfield Foods has long-term contracts with Carroll’s and its affiliatesto raise hogs. Smithfield-Carroll’s also ob-tained exclusive rights to develop and marketthe NPD breed of hog. This breed producesthe leanest hog in U.S. commercial productionand one of the leanest meats of any kind, in-cluding chicken. Nutritional studies in 1996indicated that NPD pork is 34~o to 6190 leanerthan that of non-NPD pork, depending on thecut. Other packers using non-spot coordinatingarrangements include Farmland Foods and Ex-cel, who offer contracts with specific require-ments regarding leanness (Freese, Fee, andLooker).

Supply Shifis

Sonka, Doehring, and Hofing estimated thatpackers could save $6.32 per head by slaugh-tering a hog that is approximately 199Z0leanerthan average (table 1).4 Because packer costsassociated with leanness problems were re-ported to be controlled at the farm stage (e.g.,through genetics), these cost savings could berealized by increased coordination between the

4Thispercentagereductionwas calculatedby com-paringa weightedaverageof backfatdepthfor packersin the survey and comparing it to the mid-point of theoptimal backfat depth range of 0,8 to 1.0 inch. Specificassumptions regarding the weight of the leaner hogsare not necessary to estimate the shifts in supply dueto packer cost savings.

producer and packer. Coordination via con-tracts or integration can serve to improve thequality of hogs slaughtered by reducing mea-suring and sorting costs or by reducing op-portunism associated with investments in spe-cific breeding stock. Smithfield Foods’ NPDprogram suggests that a 199Z0reduction in fatfrom increasing vertical control through con-tracting or integration is realistic.

To estimate the shift in the retail supplycurve associated with the production of leanerhogs, the $6.32 per head cost reduction is firstmultiplied by the average number of U.S. fed-erally inspected barrows and gilts slaughteredfrom 1993–95 (89.7 million head) [U.S. De-partment of Agriculture (USDA), Livestock

Slaughter]. Dividing this cost of excess fat($567 million) by average total marketingcosts of $19.8 billion5—which include costssuch as slaughtering and processing, transpor-tation, and cutting and merchandising—givespotential marketing cost savings of 2.86%.

Assuming that increased leanness isachieved through contracting and integration,another potential source of cost savings is hogacquisition costs. These costs include operat-ing buying stations, paying salaried or com-missioned buying agents, and transportinghogs to packing facilities. Recently, ThornApple Valley entered into an agreement withthe Michigan Livestock Exchange (MLE) tomanage the company’s buying stations and tosupply the quantity and quality of hogs spec-ified by Thorn Apple Valley. Thorn AppleValley pays MLE $83,333 a month plusMLE’s hog costs to supply approximately 2.1

5The average of total marketing costs from 1993–95 was calculated by first estimating average farm rev-enue over the same period. Average farm revenue($1O.3 billion) was calculated by multiplying averagequantity of pork sold (liveweight billion pounds;USDA, Meat Animals—Production, Disposition, andIncome) by average farm price ($/pound; USDA, HogOutlook). Average consumer expenditures ($30. 1 bil-lion) were then estimated by dividing average farmrevenue by the average cost share of farm inputs (0.34,net farm value as a percent of retail price; USDA, HogOutlook). That is, consumer expenditures are 1/0.34times higher than farm revenue. Average marketingcosts ($19.8 billion) are then calculated by subtractingaverage farm revenue from average consumption ex-penditures.

Martinez, Smith, and Zering: Vertical Coordination in the pork Industry 307

million hogs per year (Martinez, Smith, andZering). This results in a cost of $.48 per hogfor acquisitions (not including transportationor buying station facilities costs). Packers pro-ducing their own hogs, or using long-termcontracts, do not incur this buying stationmanagement fee.

U.S. hog slaughter of 89.7 million head,together with a $.48 per hog reduction in buy-ing agent costs, suggests that hog acquisitioncost savings ($.48 X 89.7 million head = $43million) as a percentage of total marketingcosts ($19.8 billion) are 0,22%.6 Adding thisto packer cost reductions due to increasedleanness, the net percentage change in margin-al cost is – (2.86 + 0.22)a = –3.08a, wherea is the percentage of market hog salesthrough long-term contracting and verticallyintegrated operations. Percentage shifts are ad-justed down to reflect the degree of contract-ing and integration in the hog industry. A sim-ilar approach was used by Lernieux andWohlgenant to reflect adoption rates of agrowth hormone.

Demand Shi#s

The shift in the demand for pork arising froma 19% reduction in fat is calculated using con-sumer premiums placed on leaner pork. Be-cause an estimate of consumers’ value of lea-ner pork could not be located,’ the premiumplaced on 19% leaner pork was derived usingconsumers’ willingness to pay for 1O% leanerpork. Lemieux and Wohlgenant used surveydata to estimate consumers’ willingness to payfor 10% leaner pork that is produced by agrowth hormone. They found that mean will-ingness to pay for this 10% leaner pork was4.3% of the retail price. Using a linear inter-polation of consumers’ willingness to pay for1096 leaner pork, we estimate that consumers’

6Although moves to contracting or integrationmaynot benefit Thorn Apple Valley specifically, these costsdo provide documentable evidence of acquisition costsfor open market purchases.

7Although available evidence suggests a negativerelationship between fat (backfat and seam fat) in beefcuts and prices at retail (Unnevehr and Bard), similardetailed studies for pork could not be located.

willingness to pay for 19?lo leaner pork is 8.2%

of the retail price of pork.8 Assuming that the

willingness to pay for leaner pork applies only

to fresh pork, which comprises 25% of total

pork consumption (Sonka, Doehring, and Hof-

ing), the percentage demand shift is estimated

to be 2.OW(i.e., 8.2 X 0.25a), where a reflects

the degree of contracting and integration.We use three estimates of the degree of

contracting and integration in the pork indus-

try. Hayenga et al. surveyed 19 large packers

in 1994, accounting for 8670 of U.S. hog

slaughter in 1993. Their results indicated that

contracting and integration accounted for

about 13% of their market hog transactions in

1993, and were projected to increase to 3490

by 1998. Assuming that packers who were ex-cluded from the survey (14% of U.S. slaugh-

ter) did not procure their hogs using these ar-

rangements, then on a national basis these

arrangements accounted for about 11% (0.86x O.13) of U.S. packers’ supply, with 1998

projections to 29% (0.86 X 0.34). For com-

parison, simulations also are provided for the

case where 1009o of hogs are transferred

through contracts and integrated operations.

Results

Changes in prices and quantities from in-creased coordination considered in our analy-sis are presented for nine scenarios. Given the

uncertainty underlying consumers’ willingness

to pay for leaner pork, we assume three values

for the demand shift. First, we assume thatthere is no quality-induced demand shift dueto increased coordination. Second, the willing-

ness-to-pay estimate is applied only to freshpork. Third, we assume that the premium

placed on leaner pork applies to both fresh and

8This estimate is based on consumers’ willingnessto pay for leaner pork produced from a growth hor-mone at a particukw point in time. Consumers’ will-ingness to pay for leaner pork may vary for leannessobtained through genetic advances, or over time asconsumer preferences change.


Table 2. Changes in Pork Prices and Quantities from Increased Coordination of Productionand Packing Stages

11% Contracting 29910Contracting 100% Contracting

Lengthor Integration or Integration or Integration

of No Low High No Low High No Low HighVariable Run Value Value Value Value Value Value Value Value Value

Retail Pork Price SRIRLR

Pork Consumption SRIRLR

Hog Price SRIRLR

Hog Production SRIRLR

-------------------------- Percent ---------------------------–0.2 –0.1 o –0.5 –0.4–0.2 –0.2 –0.1 –0.6 –0.05

–0.2 –0.2 –0.2 –0.6 –0.6

0.1 0.2 0.6 0.3 0.6

0.1 0.3 0.7 0.4 0.70.1 0.3 0.7 0.4 0.8

0.1 0.3 0.7 0.2 0.70 0.1 0.3 0.1 0.30 0 0 00

0 0.1 0.3 0.1 0.30.1 0.2 0.5 0.1 0.50.1 0.2 0.7 0.2 0.6

0.1 –1.8 –1.2 0,4–0.3 –1,9 –1.7 –1,1–0.6 –2.0 –2.0 –2.0

1.5 1.2 2.1 5.11.8 1.3 2.5 6.11.9 1.3 2.6 6.6

2.0 0.7 2.3 7.00.8 0.3 0.9 2.60 0 0 0

0.8 0.3 0.9 2.81.4 0.5 1.6 4.71.7 0.6 1.9 5.9

Notes: SR refers to the short run (one-year adjustment),IR refers to the intermediate run (five-year adjustment), andLR refers to the long run (when supply elasticity of hogs is infinite). For the “no value” scenario, no demand shift isassumed. For the “low value” scenario, consumer willingness to pay for leaner pork is applied only to fresh pork,which implies a shift in consumer demand of 270. For the “high value” scenario, consumer willingness to pay forlearrer pork is applied to all pork, implying an 8.2% shift in consumer demand for pork. In each scenario, supply anddemand shifts are applied only tothe percentage of slaughter hogs procured through long-term contracts or integratedoperations.

processed pork. 9 For each of the demandshifts, we generate results for three degrees ofcontracting and integration. Parameter valuesused in the simulations are presented in ap-pendix table Al.

Effects of increases in coordination that re-sult in improved leanness are presented in table2 for three lengths of run, depending on the elas-ticity of hog supply. There is a tendency forretail prices to fall, hog prices to rise, and pro-duction and consumption quantities to rise.Changes in prices and quantities are magnifiedas the percentage of hogs obtained through con-tracts and vertical integration increases. Theshift in demand due to leaner pork moderatesthe reduction in retail price that results from

gAccounting for other quality attributes, such asreduction in PSE, would have the same directional ef-fect on the size of the demand shift as applying thepremium to a larger proportion of pork. In this way,applying the premium to both processed and fresh porkcan be used to represent a higher willingness to payfor higher quality pork.

marketing cost reductions. The greater the valueplaced on leaner pork, the less the reduction inretail price and the greater the increase in hogprice. Over a one-year period, the retail priceincreases when the demand shift is greatest.Price changes, however, become less sensitiveto demand shifts over time as hog productionand consumption rise.

These results suggest that significant ben-efits to producers and consumers occurthrough increased coordination between hogproducers and packers. Changes in consumers’and producers’ surplus are presented in table3. Consumers’ surplus increases over time,while producers’ surplus declines. Increases inconsumers’ surplus range from $60 million to

$3.2 billion because of increases in coordina-tion to improve leanness. Producers’ surplusis estimated to increase from $8 million to

$706 million in the first year, and between $3million and $270 million within a five-yearperiod. These surplus changes compare to $30billion in average total consumer expenditures

Martinez, Smith, and Zering: Vertical Coordination in the Pork Industry 309

Table 3. Changes in Consumers’ Surplus (as a percentage of pork expenditures) and Producers’Surplus (as a percentage of farm revenue) from Increased Coordination of Production andPacking Stages

1170 Contracting 29% Contracting 100?40Contracting

Lengthor Integration or Integration or Integration

of No Low High No Low High NO Low HighVariable Run Value Vahte Value Value Value Value Value Value Value

------------------------- Percent -------------------------Consumers’ Surplus SR 0.2 0.4 0.9 0,5 1.0 2.3 1.8 3,3 8.0

IR 0.2 0.4 1,0 0.6 1.1 2.8 1.9 3.8 9.6LR 0.2 0.5 1,1 0.6 1,2 3.0 2.0 4,1 10.6

Producers’ Surplus SR 0.1 0.3 0.8 0.2 0.7 2.0 0.7 2.3 7.1IR O 0.1 0.3 0,1 0.3 0.8 0.3 0,9 2,7LR O 0 0 000 00 0

Note: See footnote to table 2,

on pork from 1993–95, and $10 billion in av-erage farm revenue from hog production overthe same period. Resulting changes in con-sumers’ and producers’ surplus appear to besensitive to both the percentage of hogs ob-tained through contracts and vertical integra-tion, and the shift in demand due to the pro-duction of leaner pork.

Limitations

Our ability to formally test the hypotheses re-garding motives for contracting and integra-tion was limited by a dearth of published in-formation in several areas. Publishedfirm-level data on contracting and integration,quality of plant slaughter output, and unifor-mity of hogs and pork products are sporadic,at best. The authors also are not aware of pub-lished output quality information for packers.Costs associated with contracting and integra-tion were excluded because of the difficulty inobtaining this information, Including thesecosts would moderate the downward shift inthe retail supply curve. 10 In addition, infor-mation on consistency of size and quality, andits effect on slaughter costs and returns wouldprovide more accurate assessments.

10Because contracts are long term and betweenlarger producers and packers, costs of negotiating andrenegotiating contracts are reduced.

Estimating pork price and consumption ef-fects of higher quality products is further com-plicated by the considerable uncertainty sur-rounding consumer valuation of pork qualityattributes. For example, there is still little knownabout how consumers value leaner pork. Thisinformation can be assessed in several ways,Detailed price, quantity, and quality data are re-quired to estimate hedonic demand functions forproducts of various levels of quality. Unnevehrand Bard directly estimated values of varioustypes of fat in several cuts of beef using datafrom the National Beef Market Basket Survey.They found that external fat reduced value,while the effect of marbling was positive insome cuts and negative in others. In the absenceof such data, researchers have used willingness-to-pay data to estimate the relative value ofproducts of various levels of quality. Willing-ness-to-pay data usually are elicited by offeringvarious qualities of similar products to individ-uals and asking them to state how much theywould pay for one versus another. Estimationproblems are exacerbated by the fact that “qual-ity” may be defined by several traits rather thanjust one. Collection of willingness-to-pay data isexpensive, and the cost increases rapidly withthe number of variables being evaluated. Wlll-ingness-to-pay data are useful in estimating thedirection and scale of consumers’ preference,but extrapolation and assumptions are requiredto predict overall demand shifts.


Conclusions

The effects of contracting and integration onconsumers and producers ultimately will de-pend on the motives for these arrangements.Transactions costs economics suggests thatcontracts and integration may serve to im-prove product quality in two ways. First, mea-suring and sorting costs associated with ob-taining a uniform supply of high quality hogsfor slaughter may be reduced. Second, oppor-tunism associated with breeding stock for pro-ducing high quality hogs may be alleviated.

A framework was developed for assessingthe effects of quality improvements due tonew coordinating methods. It was then appliedusing the quality attribute “leanness.” Signif-icant benefits to producers and consumers canbe obtained by increases in coordination be-tween producers and packers that result inleaner hogs and pork products. Consideringother attributes besides leanness could resultin even greater benefits.

Potential benefits of contractual arrange-ments and integration, motivated by efforts toimprove product quality, should be consideredin legislative decisions regarding market pow-er. Pork price increases at retail are not nec-essarily indicative of anticompetitive behavior.Demand shifts due to food quality improve-ments can result in higher retail prices, de-pending on the extent of quality improvementsand the value placed on quality attributes.

Additional information is needed to moreformally link changing methods of coordi-nation to hog quality improvements, and linkhog quality improvements to cost reductionsthroughout the marketing system. Possibili-ties for measuring quality effects of in-creased coordination include: a multi-firmstudy for a single industry, where quality ofproduct is compared to degree of coordina-tion; and a multi-industry study wherechange in product price and quality overtime are compared to the degree of coordi-nation in each industry.

Data and methodological problems includefinding an appropriate definition of quality andobtaining cost and quality information that isproprietary in nature. One possibility is to un-

dertake research projects with cooperatives,such as Farmland, or private firms, withoutidentifying participants. Another alternative isto conduct industry-sponsored studies wherefirms may be more willing to participate withthe intent of improving overall standards andcompetitiveness in the industry. Packer sur-veys, such as that conducted for the NationalPork Producers Council (Morgan et al.), aresteps in the right direction for developing abetter understanding of the cost effects ofquality improvements that result from increas-es in vertical coordination. For multi-industrystudies, the challenge is to obtain comparablemeasures of quality and costs.

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Table Al. Parameter Values for the U.S. Pork Industry

Parameters Values

Elasticity of demand at retail –0.65’Elasticity of supply of hogs 0.40, 1.8, WIElasticity of substitution 0.35’Farm operator’s cost share o.34bCost share of marketing input o.66bDecrease in marketing costs’ –0.34, –0.90, –3.08Increase in retail demand priced 0,0,0.0, 0.0; or 0.23,0.60, 2.0; or 0.91, 2.39, 8.2Consumer expenditures $30.1 billion’

“ Source: Lemieux and Wohlgenant.bSource: USDA, Hog Outlook.c Percentagechange in costs of – 3.08’% is multipliedby 0.11, 0.29, and 1.0, which correspond to three percentages ofmarket hogs procured through non-spot arrangements.dFor the first three values, no demand shift is assumed. For the next three values, percentage change in consumerdemand for pork of 2% is multiplied by 0.11, 0.29, and 1,0, which correspond to three percentages of market hogsprocured through non-spot arrangements. For the final three values, percentage change in consumer demand for porkof 8.2% is multiplied by 0.11, 0.29, and 1.0.e See text footnote 5 for derivation.

Documents

Analysis of Changing Methods of Vertical Coordination in the Pork Industry