In fiscal year 2003, GIPSA received $4.5 million in appropriations for a broad study of marketing practices in the entire livestock and red meat industries from farmers to retailers, food service firms, and exporters. In June 2004, at the culmination of a competitive bidding process, GIPSA awarded a $4.3 million contract to the RTI International (RTI) to conduct the study.

RTI delivered an interim report in July 2005 describing alternative marketing arrangements and their terms, and reasons that industry participants give for using alternative arrangements.

In February 2007, GIPSA released the final report with the results of the analysis of extent of use, price relationships, and costs and benefits of alternative marketing arrangements.

Hog and Pork Industries
Executive Summary

As part of the congressionally mandated Livestock and Meat Marketing Study, this volume of the final report presents the results of analyses of the effects of alternative marketing arrangements (AMAs) in the hog and pork industries. This final report focuses on determining the extent of use of AMAs, analyzing price differences and price effects associated with AMAs, measuring the costs and benefits associated with using AMAs, and assessing the broad range of implications of AMAs. The analyses in this volume were conducted using the results of industry interviews; the industry surveys; and the analysis of individual packers’ transactions data, individual packers’ profit and loss (P&L) data, Mandatory Price Reporting (MPR) data, Agricultural Resource Management Survey (ARMS) data, and other publicly available data.

In this report, AMAs refer to all possible alternatives to the cash or spot market. AMAs include arrangements such as forward contracts, marketing agreements, procurement or marketing contracts, production contracts, packer owned, custom feeding, and custom slaughter. Cash or spot market transactions refer to transactions that occur immediately, or “on the spot.” These include auction barn sales; video or electronic auction sales; sales through order buyers, dealers, and brokers; and direct trades.

The central focus of this report is the market segment between hog producers/farmers and pork packers. In the simulation analyses, the effects of hypothetical restrictions on the use of AMAs were evaluated for the entire vertically integrated chain, from producers to packers to consumers. The other analyses focus, in particular, on hog producers and pork packers. The analyses rely primarily on the data reported in the hog producers’ survey, the pork packers’ survey, the packer purchasing side of the individual transactions data, and the individual packers’ P&L data. To supplement the analyses conducted using the survey and transactions data and to address some of the specific study questions, secondary and publicly available data were used also.

Primary conclusions for this final report, as they relate to the hog and pork industries, are as follows:

• AMAs are an integral part of hog producers’ selling practices and pork packers’ procurement practices. There are significant regional differences in the observed patterns of use of AMAs: a stronger reliance on cash/spot markets and marketing contracts is apparent in the Midwest and a stronger reliance on production contracts and packer ownership of hogs is apparent in the East. The pattern of future use of AMAs is not expected to change dramatically; hence, we do not expect that hog industry industrialization will emulate the industrialization of the poultry sector.
  
  
• Based on individual transactions data, there are substantial differences in daily hog prices paid by packers on a carcass weight basis. On average, the price dispersion is about 40% of the average value of the transaction prices each day. One part of such strong price dispersion can be explained by factors such as region, quality, or plant size. However, even after controlling for these factors, the remaining differences must be due to organizational issues related to supply chain management in the pork processing sector.
  
  
• Results indicate that, on average, plants that use a combination of marketing arrangements pay lower prices for their hogs relative to plants that use the cash/spot market only. In addition, comparing the magnitudes of the portfolio effects to the magnitudes of the individual marketing arrangement effects shows that individual marketing arrangements have minimal additional impact on the average price after accounting for the portfolio effect. That is, the portfolio system categorical variables capture almost the entire effect on lowering the average price.
  
  
• Of particular interest for this study is the effect of both contract and packer-owned hog supplies on spot market prices; as anticipated, these effects are negative and indicate that an increase in either contract or packer-owned hog sales decreases the spot price for hogs. Specifically, 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 higher quantity of either contract or packer-owned hogs available for sale lowers the prices of contract or packer-owned hogs and induces packers to purchase more of the now relatively less expensive hogs and purchase fewer hogs sold on the spot market.
  
  
• Based on tests of market power for the pork industry, we found a statistically significant presence of market power in live hog procurement. However, the results regarding the significance of AMA use for procurement of live hogs in explaining the sources of that market power are inconclusive. Whereas the model based on farm– wholesale price spread data shows that a higher proportion of AMA use leads to increased market power, the model estimated with company-level individual transactions data indicates that AMA use may not be a source of market power in pork packing.
  
  
• Estimated total and average cost functions indicate that economies of scale diminish as the pork packing firm size increases. The estimates indicate that the scale economies are exhausted well within the sample output range such that the biggest plants already exhibit negative returns to scale. That is, they operate on the upward-sloping portions of their average cost curves. The observed patterns of procurement portfolio choices by packers also indicate that certain combinations of marketing arrangements may reduce costs and/or increase economies of scale. In particular, relative to using spot market procurements alone, all other combinations of marketing arrangements improve the efficient scale of production.
  
  
• Based on the observation that packers use marketing arrangements in clusters (portfolios), we hypothesized that marketing arrangements may be complementary to each other in the sense that implementing one procurement practice may increase the marginal return of the other practice; however, the analyses of the complementarity of marketing arrangements produced inconclusive results. Simpler tests based on the correlation/association approach indicate that marketing contracts are in fact complementary to production contracts and/or packer owned arrangements. Also, the portfolio coefficients in the performance equations based on either the earnings before insurance and taxes (EBIT) or the gross margin show that all marketing arrangement portfolios improve plant performance relative to simple spot market purchases. However, the coefficient associated with the portfolio of three marketing arrangements is smaller than the coefficient associated with portfolios of two marketing arrangements, thus violating the complementarity requirement. More conclusive formal tests were not feasible given data limitations.
  
  
• To analyze quality differences in live market hogs across alternative procurement methods (AMAs), we tested whether various quality attributes used by the industry are significantly different across AMAs and found that different AMAs are associated with different levels of quality of hogs. Even though the rankings are not unique, we found that marketing contracts (especially other purchase arrangements and other market formula purchases) are consistently associated with higher quality hogs than negotiated (spot market) purchases.
  
  
• An examination of the relationship between the proportion of AMAs used to procure live hogs and the quality of resulting pork products indicates that a higher proportion of AMA use is associated with higher quality pork products. We measured pork product quality using Hicks’ composite commodity index and hypothesized that a higher percentage share of the AMAs (essentially marketing contracts and packer-owned hogs) should produce higher quality pork products. The correlation coefficient showed that these two series are positively correlated, thus confirming our hypothesis.
  
  
• An analysis of risk associated with different marketing arrangements shows that different types of marketing arrangements exhibit different price volatilities as measured by the variance of prices. Therefore, hog producers selling hogs using different types of marketing arrangements experience different levels of risk. From the hog producers’ point of view, the ordering of marketing arrangements in decreasing order of risk is as follows:
  (1) spot/cash market sales;
  (2) marketing contracts in which the pricing formula is based on spot market prices;
  (3) marketing arrangements in which the pricing formula is based on some futures or options price;
  (4) other purchase arrangements containing ledgers, windows, and other pricing mechanisms, which may serve as a cushion against price volatility; and
  (5) production contracts.
  
  
• In analyzing the importance of hog producers’ risk aversion for contract choice, we found that hog producers who use production contracts are more risk averse than producers who use cash/marketing arrangements. The difference in risk exposure between contract producers and independent farmers is substantial because production contracts eliminate all but 6% of total income volatility. Therefore, the utility losses associated with forcing producers to market their hogs through channels different from their risk-aversion-preferred marketing arrangement choice are substantial.
  
  
• In analyzing the economic effects of hypothetical restrictions on the use of AMAs in the hog and pork industries, we found that hog producers would lose because of the offsetting effects of hogs diverted from AMAs to the spot market, consumers would lose as wholesale and retail pork prices rise, and packers would gain in the short run but neither gain nor lose in the long run. The results applied to three different simulations:
  (1) 25% reduction in both contract- and packer-owned hogs,
  (2) increase the spot/cash market share to 25%, and
  (3) complete ban of packer-owned hogs.
  The reason that producers and consumers lose in all three simulation scenarios is because of efficiency losses from reducing the proportion of hogs sold through contracts and/or packer owned channels. 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.

Decisions regarding methodologies, assumptions, and data sources used for the study had to be made in a short period of time. The analyses presented in this volume are based on the best available data, using methodologies developed to address the study requirements under the time constraints of the study. However, we faced many challenges in resolving inconsistencies within each source and across sources of data under the tight schedule dictated by the study. For example, the plant-level comparison of procurement methods for market hogs between the individual transactions data and survey data reveals substantial differences in some cases. Also, the differences between carcass weight prices and liveweight prices indicate an unreasonably high implicit average yield ratio, which we were unable to resolve. Throughout the report, secondary data, as available, were used to supplement primary data to conduct the analyses.

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February 2007