Lecture 11 Vertical Coordination along the Food Supply Chain

1. Lecture 11Vertical Coordination along the Food Supply Chain

2. The Food Marketing Channel • Each sector adds value to food. • Each sectors depends on others.

3. The Food Marketing ChannelRelative Importance in Terms of Value added • Value added by different sectors in food marketing channel

4. The Food Marketing ChannelVertical Coordination • Vertical Coordination: The act of coordinating activities between sectors along the food marketing channel. • Commodities change hands many times on its way up to the food marketing channel before reaching consumers. • Typically, consumers prefer a consistent eating experience. • The consistency depends on how the vertical sectors coordinate their activities to supply the final product. • At each point in the channel, firm’s actions are dictated by price incentives – as price goes up, more is produced and vice versa. • Price conveys the signal about consumer preferences – thus works as a coordination mechanism. • Unfortunately, market prices can be imperfect signals and imperfect forms of communication • Firms along the food marketing channel may seek alternatives to coordinate their activities.

5. The Food Marketing ChannelVertical Coordination Problem • Consider a vertical coordination problem in the hog industry: Hogs can exhibit carcass defects that impose cost on the pork processors • Pork processors have a harder time processing hogs that are too heavy, have bruises in carcass, and some hogs have genes causing PSE (pale, soft, and watery) meat problems. • Quality problems cost packers around $10.08 for each head of hog processed – 80% of the costs is inflicted by the activities of the producers. • To avoid this cost the pork packers must convince the producers to employ efficient production practices • Overweight hogs can be avoided through proper management • Carcass bruises can be avoided by properly administering vaccination and antibiotics • PSE problems can be completely eradicated by improving genetics • All of these activities cost farmers money

6. The Food Marketing ChannelVertical Coordination Problem • Consider a vertical coordination problem in the hog industry: Hogs can exhibit carcass defects that impose cost on the pork processors • Pork processors have a harder time processing hogs that are too heavy, have bruises in carcass, and some hogs have genes causing PSE (pale, soft, and watery) meat problems. • Quality problems cost packers around $10.08 for each head of hog processed – 80% of the costs is inflicted by the activities of the producers. • To avoid this cost the pork packers must convince the producers to employ efficient production practices • Overweight hogs can be avoided through proper management • Carcass bruises can be avoided by properly administering vaccination and antibiotics • PSE problems can be completely eradicated by improving genetics

7. The Food Marketing ChannelVertical Coordination Problem • Consider a vertical coordination problem in the hog industry: • The carcass quality improving activities cost farmers money. • Evidence suggests that the increase in carcass value outweighs the extra costs. • While processors receive the benefit, they can more than compensate the farmers for the extra cost. • If processors can find a way to compensate the farmers and provide an incentive, both can make more money in the process. • Thus, processors and farmers should coordinate to reap higher profits. • But how, exactly, should they coordinate? • Average pricing • Value-based pricing • Production and marketing contracts • Vertical integration

8. Vertical Coordination • Coordination through the Market - Average Pricing: • Prices are often efficient signals of information – vertical sectors tend to rely on prices as information signals. • Higher prices for superior quality beef signal that consumers are willing to pay more for superior quality beef. • The problem is that retailers receive the premium for superior quality while the processors procure beef cattle in lots (groups) at an average price for all animals (with varying quality) in the lot, and actual carcass quality is revealed only after slaughter. • This average price may depend on many factors – perceived carcass quality of each animal in the lot, as well as supply and demand conditions. • If producers receive a higher price, it is difficult for them to determine exactly why they have received a higher price. • Average pricing of live animals, as opposed to assigning a unique price to each animal, reduces the information contained in price signals and makes it impossible to send certain signals.

9. Vertical Coordination • Coordination through Value-Based Pricing: • Value-based Grid Pricing – pricing each carcass according to its quality • Instead of pricing for live animals, the producer and packer agree on a formula for the animal’s price based on certain carcass characteristics. • Carcass quality is determined by various characteristics, such as quality and yield grades, weights, dark cutters, etc. • USDA quality grades: Premium, Certified Angus Beef (CAB), Choice, Select, and Standard • USDA yield grades: 1, 2, 3, 4, and 5 – larger number reflecting lower yield grade. • Typical grids determine a base price for “choice” quality carcass with yield grade 3 based on an agreed formula. • Formula: Previous week’s average cash/futures price plus $1/cwt. • Carcasses with higher (lower) quality and yield grade receive pre-specified premiums (discounts) • Carcasses weight beyond 600-900 lbs also receive discounts

10. Vertical Coordination • Cattle Pricing Grid: Each carcass is assigned a unique price based on the supply and demand of individual carcass traits. • Grid pricing has become popular within a short period of time – only 16% of cattle were sold on grids in 1996, and 62% in 2006.

11. Vertical Coordination • Coordination through Production Contracts: • Production Contract – formal or informal contract between food processor and producers for producing a certain volume of a commodity with agreed quality characteristics. • In some production contracts, processors supply all or some inputs (except for labor) • Hog production contracts – Hog processors supply the young animals, feed and other inputs. Growers supply labor, farm facilities, and are responsible for animal growth. The processor pays a flat fee per animal per day or a flat fee based on animal performance. • Broiler production contracts – • Cattle Feeding Contracts – Ranchers or beef packers supply the feeder animals. Cattle feeders supply feed, labor, farm facilities, and are responsible for animal growth. The owner of the cattle pays a flat fee per animal per day or a flat fee based on animal performance.

12. Vertical Coordination • Coordination through Production Contracts: Motivation and risk sharing • Processors • Greater control over the production process • Supply assurance • Assumes all the risks but receives all potential benefits • Growers • Market assurance • Eliminate price risk

13. Vertical Coordination • Coordination through Marketing Contracts: • Marketing Contract – A contract specifying the amount, price, and type of good to be exchanged in advance. • Dairy, sugar beet, fruits, vegetables, and cotton industries rely on marketing contracts. • Fruits – 57% • Sugar beet – 94% • Livestock – 17% • The pork industry uses a mix of production and marketing contracts • 7% of hogs are produced under marketing contracts • 53% of hogs are produced under production contracts • 60% of fed cattle are marketed through marketing contracts – grid and dressed weight pricing

14. Vertical Coordination • Coordination through Vertical Integration: • Vertical Integration – the process by which two or more successive stages of the production process are under the same ownership • Turkey – 56% production contract and 32% integration • Broilers – 80% production contracts and 18% integration • Reasons for vertical integration • Reduce Transaction costs • Risk sharing • Efficiency gains