1. Production and Marketing Contracts in Agriculture  Production contracts  Marketing contracts  Trends in use by commodity  Advantages and disadvantages

2. Contacts in Agriculture   Production and marketing contracts governed about 36% of the value of U.S. agricultural production in 2001, compared with 28% in 1991.   Prominent in broilers, hogs, sugar beets, processing tomatoes, and tobacco   Small share in corn, soybeans, and wheat.

3. Contracts in Agriculture  Common in some parts of ag »Land and equipment purchase or lease »Processing vegetables »Broiler production  Increasing use in other areas »Hogs, specialty grain, tobacco  More common with large farmers

4. Marketing Contracts   Usually set a price (or pricing mechanism) and an outlet for the commodity, before harvest/delivery.   Often limit a farmer’s exposure to wide price fluctuations and often specify product quantities and delivery schedules.   The farmer retains substantial control over major management decisions since the farmer maintains ownership of the commodity and provides all inputs used during production, with limited direction from the contractor.

5. Production Contracts   Resource-providing contracts   Define specific farmer and contractor responsibilities regarding production inputs and practices. » »specify particular inputs and set production guidelines » »allow for contractor technical advice and field visits, leaving the farm operator with less control over input choices.   Contractor owns the commodity » »Grower is paid a fee for inputs provided

6. CONTRACTS

7. Why Contracts are Used   Contracts offer potential benefits to both buyers and sellers of agricultural commodities. » »Farmers can obtain a guaranteed market for their production with a known price or pricing system. » »Buyers can obtain an assured and timely supply of product with desired attributes.

8. Why Contracts are Used »New technologies: Relationship-specific investments provide incentives for “opportunistic” behavior. »Perishability: Timely delivery to processing plant very important (e.g., eggs, poultry). »Control of Inputs/Output: Facilitates “branding” to attract consumers.

9. Contracts may Share Risks  May reduce or remove input and output price risk and production risk for farmer  May increase strategic risk if contractor fails or production is out of compliance.

10. Contract Reduce Buyer Risk  Known supply and schedule »Identity preserved products  Greater quality control and uniformity

11. Cattle Production Contracts  Different from other commodities because the “grower” provides the management inputs and most decisions not the owner of the cattle »Commercial feedlots »Custom grazing

12. Hog Production Contracts  Farmer is paid to provide building and labor  Hog owner provides inputs and management  Limited production risk, no price risk  Accounted for 40% of hogs produced in mid 2005

13. Forward Contracts  Contract for delivery »Defines time, place, form  Tied to the futures market »Buyer offering the contract must lay off the market risk elsewhere »The buyer does the hedging for you

14. Forward contract advantages  No margin account or margin call  Working with local people  Flexible sizes  Known basis  Tangible  Simple

15. Forward contract disadvantage  Inflexible »Replace price risk with production risk »Difficult to offset »Must deliver commodity  Buyer “takes protection” »The known basis may be wider

16. Cattle Marketing Contracts  Forward contract for delivery »Futures and basis fixed »Single group  Basis contract »Only basis is fixed »Single group  Formula contract »Price base on another related market »Ongoing agreement

17. Hog marketing contracts  Relatively new - growth since 1993 »Open market was 87-89% in 1993 »Open market was about 11% in 2005  Product specification important »Genetics, inputs, food safety  Delivery scheduling  Types of contracts »Formula price »Share price risk »Forward contract for delivery

19. Risk Sharing Contracts  Window contract »Set upper and lower bound »Share the “pain and gain” outside  Cost based price floor “Ledger” »Minimum price tied to feed price »Pay back “loan” »Give up part of higher prices

22. Contract Examples  Iowa Attorney General »http://www.state.ia.us/government/ag/ag_contracts/  Current research on web » Hogs: http://www.econ.iastate.edu/faculty/lawrence/HOGS.htm »Production and Marketing Characteristics of U.S. Pork Producers, 2000, »Understanding Hog Marketing Contracts - September 18, 1999

23. Producer’s Motivation for Entering Marketing Contract with Packer  Access to capital and better financing  Reduced price risk  Assure a buyer  Reduced marketing costs  Improved prices or premiums

24. Reasons for production integration  Greater control »Product quality / specifications »Scheduling »Industrialization  Risk management  Access to resources

25. Overview of the 2007 USDA GIPSA / RTI Livestock and Meat Marketing Study

26. Extensive Project   Interviews, Surveys of producers and packers, Analysis of procurement and sales transactions data, Analysis of P&L data, and Modeling and simulation of system economic welfare. .  Beef, Pork, Lamb, and Downstream.

27. General Study Conclusions  AMA use for 10/02-3/05 »38% for cattle, 89% for hogs, and 44% for lambs. »Packer-owned <5% for cattle & lamb but 20-30% for hogs.  Little or no increase in AMA use is expected for cattle and hogs »Cash market is important outlet for small producers and packers and reported cash prices are used by AMAs.

28. General Study Conclusions  AMA use is associated with lower cash market prices »larger association for hogs than cattle.  Packers and producers benefit from AMA use »lower costs, risk control, and quality management.  Restrictions on AMA use will have a negative economic impact on producers, packers, and consumers.

29. Beef producers and packers interviewed believed that some types of AMAs   Helped them manage their operations more efficiently, reduced risk, and improved beef quality. »Feedlots identified cost savings of $1 to $17 per head »Packers identified cost savings of $0.40 per head in reduced procurement cost. »Both agreed that if packers could not own cattle, higher returns would be needed to attract other investors and that beef quality would suffer in an all-commodity market place.

30. Reasons for AMAs  Producers surveyed »The ability to buy/sell higher quality cattle, »Improve supply management, »Obtain better prices  Packers surveyed »Improve week-to-week supply management, »Secure higher quality cattle, »Allow for product branding in retail stores

31. Reasons for Cash Only  Producers surveyed »Independence and flexibility, »Quick response to changing market conditions, »Ability to buy at lower prices and sell at higher prices  Packers surveyed »Independence and flexibility, »Quick response to changing market conditions, »Securing higher quality cattle

32. Analysis of procurement transactions data  From the 29 largest plants and included 58 million animals and 590,000 transactions. »61.7% cash »28.8% marketing agreement »4.5% forward contracts »5.0% packer-owned, other, or missing  Regional differences in AMA use.  Individual negotiation most common method to discover purchase price for fed cattle

33. What did the analysis of procurement transactions data show?  Cash, marketing agreement, and packer-owned prices similar.  Auction higher and forward contract lower than cash prices  When AMA use increases cash prices decrease: »10% increase in AMA use (as % of plant capacity) is associated with a $0.40/cwt of carcass weight. »10% increase in AMA use is associated with a 0.11% decrease in cash price.  Impacts are economically small but statistically significant.

34. What did the packer P&L data show?   Substantial economies of size (declining average total costs of slaughter and processing per head) » »Large plants have lower ATCs than small when both are operating close to capacity. » »For all plants ATCs decline over the whole range of volumes. » »The representative plant operating at 95% of max observed capacity is 6% more efficient than when operating in the middle of the observed range of volumes and 14% more efficient than when operating at the low end of observed volumes.

35. What did the packer P&L data show?   Plant costs are lower for those that procure through AMAs.   Costs are directly lower -- all else constant.   Costs are lower because of increased volumes.   Costs are lower because of less variable volumes.   Cost savings are approx $6.50 per animal.

36. AMAs impact price, but producers and consumers lose if AMAs are restricted  Cost savings and quality improvements outweigh the effect of potential oligopsony market power that AMAs may provide packers. »Even if the complete elimination of AMAs would eliminate market power that might currently exist, the net effect would be reductions in prices, quantities, and producer and consumer surplus in almost all sectors of the industry because of additional processing costs and reductions in beef quality. »Collectively, this suggests that reducing the use of AMAs would result in economic losses for beef consumers and the beef industry.

37. Effect of both contract and packer-owned hog supplies on spot market prices  These effects are negative and indicate that an increase in either contract or packer-owned hog sales decreases the spot price for hogs.  Specially, the estimated elasticities of industry derived demand indicate »a 1% increase in contract hog quantities causes the spot market price to decrease by 0.88%, and »a 1% increase in packer-owned hog quantities causes the spot market price to decrease by 0.28% »a 1% increase in cash hogs causes a 0.27% decrease in cash price

38. Measured a statistically significant presence of market power in live hog procurement, but the results are inconclusive.  Two approaches were used with somewhat different results. Both found market power. »One found that the benefits of AMA out weighed the market power harm. »The second couldn’t conclude that AMAs were the source of the market power.

39. Estimated total and average cost functions indicate that economies of scale diminish as the pork packing firm size increases  Estimated that scale economies are exhausted well within the sample output range such that the biggest plants already exhibit negative returns to scale.  Certain combinations of AMAs may reduce costs and/or increase economies of scale.  Relative to using spot market procurements alone, all other combinations of marketing arrangements improve the efficient scale of production.

40. AMAs impact price, but producers and consumers lose if AMAs are restricted.  Three different simulations: »25% reduction in contract & packer-owned hogs »increase the spot/cash market share to 25% »complete ban of packer-owned hogs.  Producers lose because of the offsetting effects of hogs diverted from AMAs to the spot market  Consumers lose as wholesale and retail pork prices rise  Packers would gain in the short run but neither gain nor lose in the long run.

41. Cost Efficiencies are Significant  Although a reduction in AMAs leads to an improvement for hog producers through a reduction in the degree of market power, the loss in cost efficiencies offsets the gains from reduced market power.  In all instances, the price spread between farm and wholesale prices would be expected to increase because of the net increase in the costs of processing. Moreover, wholesale, and hence retail, prices would increase, causing pork to become more expensive for consumers.