Contracting and Market Power in Meat Production

Over at Twitter, I read the following from ‏@michaelpollan:

Obama's aborted effort to restore fairness to ag markets: Best piece of ag journalism in years: don't miss this one.

I had to check it out.  The link leads to Washington Monthly Magazine where there is a long and well written piece by Lina Khan on fight over new proposed USDA-GIPSA rules that were introduced a couple years ago.  This is old news to a lot of us in the ag community as many of us had friends or colleagues working with GIPSA or DOJ or knew farmers or industry groups that staked out positions on one side of the issue or the other (for some perspective, here is a piece in BEEF Magazine written in the heat of the battle).  But, apparently the story seemed to have gone unnoticed by a lot of the mainstream press. 

Although many issues were raised in the Washington Monthly piece, Khan’s key complaint seems to center on the production contracts signed by poultry (and to a lesser extent hog) producers.  At issue is the fact that many farmers have to make major capital investments in buildings, feed, etc. to raise poultry for integrators, who offer only short-term contracts.  The trouble comes when a farmer takes out a loan and spends $1 million or more on a barn, with payments amortized over 10+ years.  Yet, the farmer only get a short term contract from Tyson’s, Pilgrim’s Pride, etc. that is far shorter than the payback period for the barn.  Thus, the farmer finds themselves at the mercy of the large poultry processors. 

On the surface of it, the set-up seems entirely unfair, cruel, and manipulative.  But, I wonder why the farmers would enter in such agreements in the first place if they’re so bad?  The terms of the contract aren’t secret.  If the processors are reneging on terms of the contract or being secretive in payment schemes, why do business with people like this? That said, one important thing to realize is that these kinds of contracts aren’t at all unique to agriculture.  I’ll give a couple personal examples. 

When I took my first job out of grad school, I bought a house by taking out an adjustable rate mortgage.  In retrospect (and given the subsequent housing market crash), this was a really stupid decision.  Still, I had a short-term contract for a job and yet took out a large mortgaged amortized over 30 years with the rate re-setting after five years.  Was I being manipulated by the University?  The bank?  No, I made this decision on my own.  Let’s dig a little deeper.  Even though I had a tenure-track job, the University only offered me a 1 year contract – to be renewed at the end of the year if my progress was satisfactory and budget conditions were good.  Based on this 1-year contract, I undertook huge costs by packing up my family, moving half-way across the US, took out a long-term mortgage, and made many social investments in the community.  My point is that all of us routinely make long-term investments even when there are a lot of short-term risks that threaten our ability to meet our long-term obligations.  This is not something that is insidiously unique to poultry and hog farming.

None of this is to say that the poultry farmers aren’t getting the raw end of the stick.  That’s why it’s useful to turn to the academic research on the effects of these contracts.  The Washington Monthly is long on anecdote and short on citing research from key scholars in the area. 

So, I’ll turn to the very research commissioned by GIPSA – the agency raising the new rules.  I should note that I was an external reviewer on one of the chapters of this report.  The entire report is here.  Looking at the report on hogs, the authors find some evidence of market power exhibited by hog processors and more contracting does seem to relate to lower cash pork prices.  However, contracting is also associated with an increase in pork quality.  Moreover, contracts help producers reduce risk, with more risk averse producers opting for contracting.  And, most importantly, the simulations show that a forced reduction of contracting would lead to economic losses to both farmers and consumers.

By the way, here are some relevant academic papers on concentration in the meat sector. 

This paper by Azzam and Schroeter shows that increasing concentration in beef packing has led to increased market power.  However, larger size has conveyed efficiency gains that way more than offset any adverse effects caused by anti-competitive behavior.

My colleagues at Oklahoma State, Zhang and Brorsen, showed that market power issues can be studied using a new method called agent-based modeling (where one creates an economy of programmed agents, who bargain and learn based on prior gains/losses).  They show less market power in cattle procurement than observed in papers that had make a number of assumptions to utilize their cattle data.

Here is a really nice experimental paper by Wu and Roe that tackles one of the main issues raised in the Washington Monthly article. Namely, they compare fixed-performance contracts to tournament contracts.  As they show, there is no unambiguous ranking of which type of contract is better from the perspective of the producer and packer.  It depends on the relative size of the uncertainty associated with individual famer performance to the size of the uncertainty associated with issues that affect the whole industry.

Finally, in his AAEA presidential address this year, Richard Sexton from UC Davis presented a provocative paper (which I can’t seem to find online yet – but it will be published in the AJAE within the year).  In it, he argued that agricultural industries that appear to have all the hallmark signs of market power may in fact be playing a different game altogether than the one assumed in many of our industrial organization models. In particular (and if I remember correctly), the business model requires large processors need to operate a near full capacity, which encourages contracting, packer-ownership, and other activities - not to pursue market power per se but rather to keep their through-put costs to a minimum.  If I’ve misinterpreted Sexton’s model, feel free to let me know!