Structural Change and Market Performance in Agriculture:

Critical Issues and Concerns about Concentration in the Pork Industry

Testimony of

Ken Foster, Associate Professor, Purdue University

before the Senate Committee on Agriculture, Nutrition, and Forestry

February 1, 2000

Chairman Lugar and Members of the Committee:

Dr. Paarlberg has shown that greater consolidation in the meat packing and processing industry could lead to lower live animal prices paid to farmers. Likewise, increased captured supplies, via vertical integration and/or contracting, have the potential to lower prices on average and increase the variability of prices. This is especially true for producers who are not a part of the captured supply chain. Estimates from 1999 tell us that only about 36 percent of the hogs were purchased on the spot market. However, another 44 percent were purchased on formula contracts that depend on spot markets for pricing.⁽¹⁾

Packers are motivated to coordinate their supply of live animals by the large fixed costs associated with a slaughter plant, and the large transactions cost of purchasing thousands of animals on a daily basis. In order to reduce their cost per unit of wholesale meat, packers need to slaughter as many animals as possible. For modern plants, this means thousands of animals each day. The risk of "coming up short" motivates the use of company owned animals and contracted purchases to ensure that the appropriate quantity and quality of animals arrive as needed. With captured supplies, transaction costs are also reduced by not having to haggle over the price of each load of animals.

Logically, packers attempt to capture the highest quality animals via contracts and vertical alliances. This can leave the lower quality animals to establish prices in the open market. Because payment schemes for most of the packer contracted animals are based on either a spot market price or the Chicago Mercantile Futures price, substantial vertical coordination may create a downward bias in the prices received by many livestock producers.

Offsetting the consolidation and integration effects

Mitigating these downward biases in live animal prices will not be an easy task. The strongest public policy instrument is anti-trust. Clearly, breaking up the larger packers would help mitigate markdown pricing due to consolidation if it exists. However, sound economic rationale, unassociated with market power, could be motivating contracting, vertical integration, and consolidation. If the societal benefits of these rationale exceed the costs of markdown pricing then the anti-trust approach would not be justified.

It is my opinion that alternative public policies do exist that could offset the price impacts of these business structures without completely foregoing their benefits. The focus of these policies would be on increasing the bargaining power of pork producers. Unfortunately, the livestock producing community has little experience and expertise in using these alternatives and will likely need public policies and assistance to get them functioning.

Cooperative Production and Marketing

Cooperative production and marketing appear to be one possible way to offset the impacts of consolidation and integration in today's pork industry. Any strategy that places livestock producers in a more symmetric bargaining position with packers will make it more difficult for packers to exploit prices or contract terms. It should also be more difficult for a packer to terminate a contract or to force less favorable terms on the producer community. The packer, in need of animals to fill a daily kill, will be compelled to negotiate a more competitive price if producer power is increased.

How many high quality hogs must a single supplier (or allied group of suppliers) control in order to maintain bargaining power with a packer? At present, it appears that 300 thousand to 500 thousand head per year, or approximately the single day double-shift kill for a moderate sized slaughter plant each week would be sufficient. This is a large number of animals and would require a sizable network of today's large independent producers. Forming such networks or cooperatives must be nurtured by public policy. Our research at Purdue has demonstrated that there are a variety of ways to structure these entities that may also allow the producers to capture cost reductions and gain access to new (and possibly proprietary) technologies that individual farms would not be capable of obtaining by themselves.

Tax incentives or deductions for members of production and marketing networks, corporations, cooperatives and alliances could provide incentives not only for producers to enter such arrangements, but such policies could also be fashioned to provide disincentives for producers to break away from the group in an effort to capture short term gains as a "free rider". Current exemption from anti-trust constraints provides some benefit for cooperative formation. However, undercapitalization is the most common cause of failure among new cooperative ventures. A serious commitment of technical and financial support above that currently available will be needed to develop and encourage new production systems and marketing strategies that facilitate greater bargaining power for producers.

The approach needed by such groups is fundamentally different from the traditional livestock marketing cooperatives of the past. In the past, farmers independently produced the animal type of their choice and marketed them on the day of their choice to various markets. If the cooperative alliances of the future are to increase the bargaining power of producers, then the production systems of the cooperating farmers must be coordinated. Coordinated production will allow the group to provide a steady supply of hogs of uniform quality to a single packer. This supply chain must be closely managed to deliver a large number of animals on a daily basis because fluctuation in supply is not attractive to a packer and reduces producer leverage. Managing the supply chain in this way will take innovative production practices that may require greater specialization of activities by farm and standardization of mating systems, feeding strategies, genetics and so forth.

Marketing Orders

Marketing orders provide another possible policy avenue. Marketing orders are used in several agricultural markets where lack of producer bargaining power is a concern. These orders may set base prices at a particular location with premiums and discounts for other locales and involve pooling of all marketings in a given locale. Typically, they also establish quantity and quality restrictions.

If such a marketing orders were adopted for pork, it would be essential to incorporate quality premiums. Otherwise, there would be little incentive to produce high quality animals. The resulting lack of quality hogs would encourage packers to increase vertical integration and effectively exclude independent producers from the market. Furthermore, some of my own research has found that a market failure may occur if a geographical discount structure is not market driven⁽²⁾. This market failure may lead to a geographical distribution of production that is not socially optimal.

Summary

In summary, two major policy options are anti-trust activity on the one hand and nurturing increased market power of pork producers on the other. With current knowledge, we cannot recommend breaking up existing packer concentration. Such actions can be extremely contentious, and may be contrary to society's best interest. However, public policy can assist producers in gaining countervailing market power. This can happen by encouraging the formation and survival of highly structured cooperative production and marketing systems. However, many of today's independent pork producers are not familiar with these new strategies and public assistance may be necessary to get them off the ground. Finally, caution should be exercised against blanket condemnation of strategies adopted by packers or producers that enable them to compete successfully in an increasingly international marketplace.

1. Source: Grimes, G., J. Lawarence, and M. Hayenga

2. Source: Foster, K. and A. Havenner. "Cointegration and Settlement of Commodity Futures Contracts," Macroeconomic Dynamics, 1999.