VERTICAL LINKAGES IN AGRI-FOOD SUPPLY CHAINS IN CANADA AND THE UNITED STATES by Jill E. Hobbs Department of Agricultural Economics University of Saskatchewan and Linda M. Young Trade Research Center Montana State University for Research and Analysis Directorate Strategic Policy Branch Agriculture and Agri-Food Canada June 2001 VERTICAL LINKAGES IN AGRI-FOOD SUPPLY CHAINS IN CANADA AND THE UNITED STATES June 2001 Research and Analysis Directorate Strategic Policy Branch Agriculture and Agri-Food Canada © Her Majesty the Queen in Right of Canada, 2001 Any policy views, whether explicitly stated, inferred or interpreted from the contents of this publication, should not be represented as reflecting the views of Agriculture and Agri-Food Canada. To obtain additional copies, contact: Information Production and Promotion Unit Research and Analysis Directorate (RAD) Strategic Policy Branch Agriculture and Agri-Food Canada Building 74, C.E.F. Ottawa, Ontario K1A 0C6 Tel: (613) 759-1865 Fax: (613) 759-7090 E-mail: ippdist@em.agr.ca Electronic versions of RAD publications are available on the Internet at www.agr.ca/policy/epad. Publication 2083/E ISBN 0-662-30781-X Catalogue A22-226/2001E Project 01-031-r Contract 01B04-9-C009 Departmental Representative: Jeff Corman (613) 759-1741 Aussi disponible en français sous le titre : « Les liens verticaux dans les chaînes d?approvisionnement agroalimentaire au Canada et aux États-Unis » Table of contents Executive summary .......................................................................... vii Introduction ...................................................................................... 1 Section 1: Introduction ......................................................................................... 3 Section 2: The nature of vertical linkages .......................................................... 5 Literature Review ............................................................................. 7 Section 3: Early work on vertical coordination .................................................. 9 3.1 Interest in Vertical Coordination ..........................................................9 3.2 Vertical Coordination in the 1950s and 1960s.....................................9 3.3 Forces for Change .................................................................................11 3.4 Summary ................................................................................................12 Section 4: Recent developments in vertical coordination .............................. 15 Section 5: Factors leading to increased vertical coordination....................... 19 5.1 Changing Consumer Preferences .......................................................19 5.2 Biotechnology ........................................................................................21 5.3 Information Management....................................................................22 5.4 Environmental Issues ...........................................................................23 5.5 Credit and Risk......................................................................................23 5.6 Trade .......................................................................................................23 5.7 Summary ................................................................................................24 Section 6: Theoretical approaches to vertical coordination........................... 25 6.1 Transaction Cost Economics ...............................................................25 6.2 Agency Theory ......................................................................................27 6.3 Competency/Capabilities Approach.................................................28 6.4 Strategic Management Theory ............................................................30 6.5 Convention Theory ...............................................................................33 6.6 Synthesis of the Theoretical Literature ..............................................33 Vertical linkages in agri-food supply chains in Canada and the United States iii Table of contents A Conceptual Framework for Closer Vertical Linkages ............. 37 Section 7: Conceptual framework ..................................................................... 39 7.1 Mapping the Relationships..................................................................39 7.2 Transaction Characteristics, Costs and Vertical Coordination ......40 7.3 Relationships Between Product Characteristics and Transaction Characteristics .......................................................................................42 7.4 Regulatory, Technological and Socio-Economic Drivers................43 Section 8: Application of the framework: the case of US corn and soybeans ................................................. 47 8.1 New Grain Products and Closer Supply Chain Relationships ......47 8.2 Changes in Product and Transaction Characteristics......................50 8.3 Summary ................................................................................................50 Pricing, Policy and Market Failure Implications.......................... 51 Section 9: Price formation and associated issues .......................................... 53 9.1 The Evolution of Agricultural Markets .............................................53 9.2 Bulk Commodity Markets ...................................................................54 9.3 Contract Production Pricing and Associated Issues........................54 9.4 Franchises...............................................................................................58 9.5 Monopolistic Competition...................................................................59 Section 10: Impact on existing agricultural policy arrangements.................... 61 10.1 US Farm Policy ......................................................................................61 10.2 Canadian Income Support Policy.......................................................62 10.3 Marketing Institutions..........................................................................62 Section 11: What is the appropriate role for government?............................... 65 11.1 Public Versus Private R&D..................................................................65 11.2 Dealing With Information Asymmetry .............................................66 11.3 Dealing with Monopoly/Monopsony Power...................................68 11.4 Regulatory Incentives...........................................................................69 Section 12: Looking into the future..................................................................... 71 Section 13: Conclusions and suggestions for future research........................ 75 Section 14: References......................................................................................... 77 iv Vertical linkages in agri-food supply chains in Canada and the United States Table of contents List of Figures Figure 1: Extent of contracting in the 1950s (U.S.) ............................................10 Figure 2: Synthesis of theoretical approaches to vertical coordination.........34 Figure 3: Factors affecting vertical coordination: a framework......................39 List of Tables Table 1: Extent of contracting in selected commodities, United States, 1997................................................................................15 Table 2: The relationship between product characteristics, drivers and transaction characteristics ..............................................41 Table 3: Selected grain products in the United States and Canada..............48 Vertical linkages in agri-food supply chains in Canada and the United States v Executive summary The agri-food sectors of both Canada and production risks were instrumental in the United States are experiencing a trend driving the US broiler sector toward closer toward closer vertical coordination. New contracting and vertical integration. More relationships with downstream product recently, the US hog sector has witnessed handlers and processors raise many ques- an increase in the use of contracting. Simi- tions for producers, including the level lar trends are expected in the Canadian and nature of risk they face, control over hog-pork sector following the removal of management practices and access to single desk selling agencies in several markets. Public policy implications provinces in 1997. Identity preserved sup- include the nature of price discovery and ply chains for value-enhanced crops pro- whether market failure indicates a revised duced on contract are emerging in both role for governments in a vertically-linked countries and co-exist with bulk commod- agricultural sector. ity grain marketing systems. Changing consumer preferences, biotechnology, This report describes the nature of vertical information technology, environmental linkages in agriculture, ranging from spot pressures, credit and risk issues and the markets to vertical integration. It reviews reduction of global trade barriers are some the applied and theoretical literature relat- of the driving forces behind changing ver- ing to vertical coordination. It presents a tical coordination. conceptual framework linking changes in the transaction environment and product A number of theoretical approaches characteristics to changes in vertical coor- enhance our understanding of the motiva- dination. Finally, the report examines the tions behind, and the consequences of, implications of closer vertical linkages for closer vertical linkages. These include industry stakeholders and for policy transaction cost economics (TCE), agency makers. theory, the core competencies approach, strategic management theory and conven- Vertical coordination encompasses a con- tion theory. These approaches share many tinuum of possibilities from open spot overlapping concepts, yet individually market transactions, where price is the also contribute additional pieces to the only mechanism of coordination, to full vertical coordination puzzle. The predic- vertical integration, where managerial tive ability of TCE and agency theory pro- orders direct the flow of goods between vides a set of behavioural and stages. Contracts, strategic alliances and informational assumptions which are cen- joint ventures are other means of vertical tral to the analysis presented here. coordination. Contracting has become increasingly important in Canadian and, This report develops a conceptual frame- in particular, US agriculture. work for examining the forces behind closer vertical relations. The framework Interest in vertical coordination can be has four components: environmental traced back to the 1950s, when changing drivers, product characteristics, trans- technology and the nature of price and action characteristics and vertical Vertical linkages in agri-food supply chains in Canada and the United States vii Executive summary coordination mechanisms. The trans- On the other hand, potential market effi- action characteristics affect vertical coordi- ciencies from closer vertical coordination nation outcomes through their influence may improve the relative competitiveness on transaction costs. In addition, product of an industry and result in an outward characteristics and environmental drivers shift of the demand curve through the (e.g.,technological, regulatory, socio- ability to tailor product quality to the economic drivers) also affect transaction needs of specific market segments. Trans- characteristics. Product characteristics parency of contract terms and a mecha- include perishability, product differen- nism to resolve disputes between tiation, quality variability, and the addi- contractual parties are important and may tion of new (credence) characteristics. represent a different role for industry asso- Transaction characteristics include quality, ciations or governments. The role may quantity and price uncertainty for buyer include facilitation of collective bargaining and/or seller, frequency, asset specificity processes. Franchise relationships and the and complexity. The framework is branding of agricultural products may intended as a starting point for analysis, to present a middle ground for producers. which additional product characteristics and environmental drivers may be added. If closer vertical linkages reduce the cycli- cal fluctuations in some agricultural An application of the framework to the US markets and defuse the traditional adver- corn and soybean sectors reveals the sarial relationships between producers importance of technological change. Both and processors, there may be a reduced biotechnology and advanced breeding need for traditional commodity-based techniques have produced differentiated, farm support programs. The future role of value-enhanced grains, with a potential regulated marketing institutions in the increase in the costs of measuring quality Canadian agri-food sector depends partly and greater uncertainty for buyers and on the extent to which they act as sellers over some aspects of the trans- transaction-cost economizing methods of action. The transaction costs of occasional vertical coordination. supply chain relationships increase, result- ing in growth in contracting and identity What is the appropriate role for govern- preserved supply chains. ments in an agriculture industry charac- terized by closer vertical linkages? The In the future, agricultural markets and answer depends on whether the changing marketing channels are likely to increase supply chain relationships generate new in diversity, with a number of different (or, indeed, nullify old) situations of vertical coordination arrangements co- market failure. Biotechnology has enabled existing to service different market needs. differentiation of bulk commodities, The move toward contract production and enabling the private sector to reap the away from spot market transactions raises rewards of investment in R&D. These the question of how prices are discovered rewards are reflected in a reduced public and whether a thin market problem exists. role in R&D, although government policy This issue is not new. Another important is important in creating a regulatory envi- question is the extent to which an ronment conducive to investment in R&D. ?average? price is relevant for decision- making given the differentiated nature of The traditional price reporting role of production under contract. Questions of governments becomes less feasible, and relative market power and producers? arguably less important, in a closely coor- access to closed supply chains are also dinated system. However, quality infor- important. mation becomes more important. Highly viii Vertical linkages in agri-food supply chains in Canada and the United States Executive summary differentiated agricultural products with emerging as we seek to answer existing credence characteristics suggest a role for ones. By design, this report has taken a governments in reducing information broad approach to vertical coordination asymmetry through the provision of across the agri-food sector. While there quality information or accreditation of has been a reasonable amount of research quality assurance schemes. Alternatively, focussing on vertical coordination in US this may be a role for independent private agriculture, industry-specific studies of sector third parties. The potential abuse of vertical coordination in Canada are few monopoly and monopsonistic power on and far between. In the livestock sector, the part of agricultural input suppliers and the Canadian beef and pork sectors would buyers of agricultural output raises the old benefit from an in-depth study of vertical spectre of producers being caught in the coordination. In the grains and oilseeds middle with relatively weak bargaining sectors, an analysis of the canola and spe- power. While this remains an important cialty crops sectors would provide a valu- policy consideration, the potential trans- able comparison with the Canadian wheat action benefits from membership of a industry. The role of regulated marketing differentiated, value-added supply chain institutions in facilitating or impeding ver- should not be ignored. Further, competi- tical relationships deserves further atten- tions (anti-trust) regulation should con- tion. The framework presented in this sider the economic benefits from vertical report provides a starting point for coordination. analysis. Looking into the future, advances in elec- The lack of basic data describing the tronic communication may ?buck the nature of vertical relations, including the trend? toward closer vertical coordination extent of contracting, in the Canadian agri- among producers, processors and retailers food sector seriously impedes the ability by presenting opportunities for producers of policy makers, industry stakeholders of specialty goods to deliver directly to the and researchers to monitor and to evaluate end-user. Electronic communication may developments in the sector. The collection benefit agricultural producers by increas- and analysis of primary data on the nature ing their access to information. This access of vertical linkages in the Canadian agri- offers a first-mover advantage to those food sector should be a priority for the producers able to manage this information federal government. and to find innovative ways to use it. As with any business opportunity, entre- These recommendations are far from preneurial producers with the requisite definitive. They are intended to suggest business management skills and acumen that in upcoming years, producers, down- will succeed in this endeavour. stream processors and retailers, acade- mics, and policy makers will need The changing nature of vertical linkages in continually to reshape their thinking about the Canadian and US agri-food sector the organization of agricultural supply present both opportunities and challenges chains and associated policy issues. for industry stakeholders, policy makers and analysts. This topic is dynamic and new research questions are continually Vertical linkages in agri-food supply chains in Canada and the United States ix Introduction Vertical linkages in agri-food supply chains in Canada and the United States Section 1 Introduction The agri-food sectors of Canada and the more closely specified vertical linkages United States are moving toward closer between identifiable partners in the vertical coordination. This movement is supply chain. This move is a private sector occurring in varying degrees and forms in adaptation to a market environment that different industries and involves a diver- has changed due to a host of technological, sity of supply chain partners. Some indus- regulatory and financial developments, in tries, notably the United States poultry addition to changes in consumer prefer- industry, developed close vertical coordi- ences (quality, food safety, etc.). nation in the 1950s. In other industries, close vertical coordination is a more recent Interest in this topic is motivated by the phenomenon. scope and pace of change of the linkages between members of the supply chain for It is worth revisiting the definition of ?ver- agricultural goods. For example, new tical coordination? provided by Mighell genetically modified crops are having a and Jones (1963) who explain that the profound impact on the supply chains for term: corn, soybeans and canola. Until recently, these crops were marketed almost solely ??includes all the ways of harmo- through efficient bulk commodity nizing the vertical stages of produc- markets. Now the bulk commodity tion and marketing. The market-price markets coexist alongside closely coordi- system, vertical integration, con- nated supply chains for identity preserved tracting, and cooperation singly or in products. The increase in close vertical combination are some of the alterna- coordination arrangements has been rapid tive means of coordination.? (p. 1) and is manifested in a wide variety of Within this succinct definition is the forms. notion that vertical coordination encom- passes a continuum of possibilities, from Implications of these new closer vertical open market spot transactions at the one linkages for agricultural producers end, through to full vertical integration at include the nature and level of risk they the other and including strategic alliances, face, profitability, scope of control over decisions, and management practices. joint ventures, contracting, etc. In a sense, there is always There are implications as well for public some form of vertical coor- dination?be it directed by price signals policy. In the Canadian grains sector, alone in a spot market or by a combination closer vertical coordination is occurring in of pre-determined factors in a contractual special crops, and to some extent, in situation. Where the interest lies for agri- canola. The Canadian Wheat Board (and cultural economists, policy makers and associated institutions) is a vertical coordi- agri-food industries is in the implications nation mechanism implemented through of the move toward public policy. Currently, there is much closer vertical coordi- nation?i.e., as a sector moves away from debate over whether the Canadian Wheat commodity spot markets and toward Board will evolve in response to the pres- sures for closer vertical coordination in the Vertical linkages in agri-food supply chains in Canada and the United States 3 Introduction wheat supply chain or whether an alterna- Finally, increased vertical coordination tive, private sector system will emerge as a raises the question of whether government more effective coordination mechanism. A action is required to facilitate closer verti- similar debate surrounds the coordinating cal relations in agricultural supply chains. role of marketing boards in the Canadian The underlying question is whether evi- agricultural sector. dence exists of market failure (such as imperfect information) that would justify For some time US public policy has been government intervention. concerned with the maintenance of a viable mechanism for price discovery in This report begins with a description of commodities dominated by contractual the nature of vertical linkages (from spot arrangements, along with the adequate markets to vertical integration). Section 3 provision of price information. At present, reviews the literature on vertical coordina- the rapid increase in close vertical coordi- tion in agriculture. It begins with a review nation for corn and soybeans, and the of early work on vertical coordination in potential increase in wheat, adds a new order to assess changes in its extent, the dimension to questions about the effec- policy issues of concern, and the analytical tiveness of US commodity programs. US approaches used. A summary of the fac- farm policy lacks clear direction. The poli- tors behind vertical coordination and a cies advanced by the 1995 Federal Agricul- review of recent developments in agri- tural Improvement and Reform (FAIR) food sectors in Sections 4 and 5 set the Act have been confused by ad-hoc assis- stage for a discussion of theoretical tance to the agricultural sector from the approaches in Section 6. Sections 7 and 8 U.S. Congress. Other longstanding con- present a framework for understanding cerns for public policy are the potential the factors affecting vertical coordination abuse of market power by members of the and apply the model to a case study of the supply chain and the bargaining position US corn and soybean sectors. Finally, of family farmers vis-à-vis processors and Sections 9, 10 and 11 examine the implica- negotiators. tions of closer vertical coordination for industry stakeholders and policy makers The ability of supply chains to adapt in terms of price formation and the appro- quickly to new market requirements and priate role of government policy in cor- to meet stringent quality standards is of recting marketing failure and facilitating concern as governments attempt to find the development of efficient supply solutions to trade conflicts that arise due chains. to regulations maintained by importers that differ from the country of origin. 4 Vertical linkages in agri-food supply chains in Canada and the United States Section 2 The nature of vertical linkages Vertical coordination includes a conti- Following Mighell and Jones (1963), con- nuum of possibilities?from spot market tracts can be classified into three broad transactions to full vertical integration. groups. Market-specification contracts The middle ground encompasses various represent an agreement by a buyer to pro- hybrid forms including contracts, strategic vide a market for a seller's output. The alliances and quasi-integration (joint ven- buyer may assume some risk and the right tures). In spot markets, goods are to make decisions over the timing of mar- exchanged between multiple buyers and keting. The farmer retains control over sellers in the current time period, and production. Production-management con- price is often the sole determinant of the tracts entail more buyer control, allowing sale, e.g., auction markets. Vertical coordi- the buyer to specify and/or to monitor nation occurs entirely in response to price production practices, input usage, etc. signals. Spot markets are efficient for the Resource-providing contracts represent distribution of homogenous commodities. the greatest level of control for buyers who However, as agricultural products become provide a market outlet, supervise pro- more differentiated and buyers prefer duction practices and supply key inputs. more heterogeneous products, there is a In doing so, the buyer usually assumes a need for improved information flow along greater proportion of the risk and may the supply chain. Thus, methods of verti- retain ownership of the product, with the cal coordination which allows closer farmer, in effect, being paid a management buyer-seller relationships are emerging, fee. This type of contract is close to full such as contracts, strategic alliances and vertical integration. In 1997, 11 percent of quasi-vertical integration. US farms engaged in contracting, with production contracts (2.2 percent of all Under a contract, a farm transfers control farms) being less prevalent than over certain aspects of production and/or marketing-specification contracts (9.2 per- marketing in return for greater surety over cent of all farms)2 (Banker and Perry 1999). access to markets or inputs and lower risk. In 1997, 31percent of the value of US agri- Typically, quasi-vertical integration (a cultural production (almost US$60 billion) joint venture) is a long-term contractual was grown or sold under contract (Banker obligation in which both the buyer and and Perry 1999). While US farms of all seller have invested resources in the rela- types use contracting, larger family farms tionship. It differs from full vertical inte- (sales of at least US$250,000) and non fam- gration because the relationship ceases at ily farms (non family corporations or the end of an agreed period of time and cooperatives and farms run by hired man- the firms remain independent entities. An agers) account for 75 percent of the value of products grown and sold under con- 2. Data were obtained from the Economic Research Service, U.S. Department of Agriculture through tract.1 its Agricultural Resource Management Study (U.S. Department of Agriculture 1997). These data do not distinguish between production- management and resource-producing contracts, 1. Comparable data for Canada are not available. terming them both ?production contracts.? Vertical linkages in agri-food supply chains in Canada and the United States 5 The nature of vertical linkages example would be a joint venture in which duce specific genetics into the supply participants share the costs, risks, profits chain. In this case, the strategic alliance and losses of a venture. Franchises and involves all four parties, spanning the sup- licenses are other examples but are not ply chain from producer to retailer common in the agriculture sector. Section (Sporleder 1992). 9 discusses the circumstances under which franchising might become more prevalent Full vertical integration occurs when one in agri-food markets. firm owns two or more stages of the production-processing-distributionprocess. A strategic alliance is characterized by In the Canadian agri-food sector, food parties sharing an objective, resulting risks retailers have integrated backward into and mutual control over decision making the wholesaling function, ?life-science? (Amanor-Boadu and Martin 1992). Typi- companies have integrated backward into cally, it is more flexible than a contract and genetics and basic R&D companies. In the requires that the parties recognize their United States, poultry processors have mutual goals and work together to achieve integrated backward into production them. Trust is implicit in a successful stra- (although sometimes the relationship is tegic alliance. An example might be a stra- contractual rather than outright owner- tegic alliance between a group of ship). Of course, forward vertical integra- producers who follow specified produc- tion is also possible. Sunterra farms in tion practices and a pork processor who Alberta, originally a family hog farming receives hogs of a specified quality. The enterprise, e.g., integrated forward into processor may also have a strategic alli- hog slaughter and processing and into ance with a food retailer to introduce a food retailing, opening specialty delica- high-quality packaged pork product tessen and catering outlets in Calgary and developed jointly and another strategic Edmonton. alliance with a hog breeding firm to intro- 6 Vertical linkages in agri-food supply chains in Canada and the United States Literature Review There is an extensive literature relating?both directly and indirectly ?to vertical coordination in agriculture. Section 3 of this report reviews the earlier applied work directly dealing with vertical coordination in agriculture, beginning in the 1950s and extending to today. Recent literature describing ongoing developments is then summarized, including literature reviewing factors leading to increased vertical coordination (Sections 4 and 5). Then an overview of the key theoretical approaches is presented in Section 6. Vertical linkages in agri-food supply chains in Canada and the United States Section 3 Early work on vertical coordination 3.1 Interest in Vertical 3.2 Vertical Coordination in the Coordination 1950s and 1960s In the late 1950s when vertical coordina- In the 1950s, US industries with a large tion started to receive the attention of agri- percentage of integrated and contractual cultural economists and the U.S. arrangements included fluid milk, sugar Department of Agriculture, some indus- crops, processed vegetables, citrus, and tries were already characterized by close some seed crops (see Figure 1). A high vertical coordination. Factors behind degree of coordination existed between increasing vertical coordination included the producers and processors of specialty the level of risk faced by agricultural pro- products due to their limited market and ducers, changes in technology, and an uncompetitive market structure. Peri- increased needs by farm operations for shable commodities, such as fruits and capital and managerial skills. In this vegetables for processing, had closely section, early literature is reviewed to managed supply chains since the begin- identify the types of increased vertical ning of those industries. Efficient use of coordination examined in the literature, plant capacity and stringent quality the forces for change in the 1950s and early requirements for processing are given as 1960s, and the analytical approaches used. reasons for these close vertical relations. After a surge of interest, relatively few The supply chains of major storable com- articles appeared in 1970s and 1980s. In modities, such as corn, wheat, cotton, rice the 1990s and currently, new analytical and peanuts, did not develop closer verti- approaches coincide with analyses from cal relations at that time because these the agricultural economics, economics, commodities were durable and amenable business and management perspectives. to storage. In addition, standardized grading and pricing appeared to be a satis- factory method of communicating quality attributes. Vertical linkages in agri-food supply chains in Canada and the United States 9 Early work on vertical coordination Figure 1: Extent of contracting in the 1950s (U.S.) Percentage of output under integrated and contractual arrangements Crops Animal & Animal Products Vegetable seeds Fluid milk Hybrid seed corn Broilers Sugar crops Turkeys Citrus fruits Eggs Other fruits Cattle on feed Process vegetables Hogs Fresh vegetables 0 25 50 75 100 Potatoes Dry beans & peas Percentages are approximate estimates. Cotton Tobacco 0 20 40 60 80 100 Economic Research Service Neg. ERS 985-62(4) Economic Research Service Source: Mighell and Jones, 1963. The agricultural economics literature of occurred with the passage of the 1929 the 1950s and 1960s often used the terms Marketing Act, which strengthened the vertical integration and vertical coordina- ability of cooperatives to stabilize prices. tion interchangeably. However, there was Marketing orders and agreements were a general consensus that vertical coordina- related attempt to increase producer tion includes ?any type of formal or infor- involvement in, and returns from, market- mal arrangement that has the effect of ing their crop. In Canada, provincial legis- more closely relating successive steps in lation providing for group marketing the production and/or processing of food initiatives and the establishment of pro- and fiber? (Davis 1957, p. 301). In many vincial marketing institutions for agricul- cases the term did not refer to the coordi- tural commodities was introduced in a nation of different business enterprises but number of provinces initially in the 1930s was used to refer to an extension of the but was declared unconstitutional by the producer?s role into marketing the com- Supreme Court. Federal enabling legisla- modity produced. tion, which provided the framework for provinces to set up provincial marketing An early development which increased boards, was finally introduced in 1949. vertical coordination was the establish- Activities of the U.S. Commodity Credit ment and growth of cooperatives as pro- Corporation associated with farm pro- ducers extended their role in marketing grams were considered a type of vertical (Davis 1957). In the United States, this integration due to their impact on market 10 Vertical linkages in agri-food supply chains in Canada and the United States Early work on vertical coordination prices (Davis 1957). Contractual arrange- Resulting production techniques are likely ments between producers, feed dealers to reduce production risk, and improve and processors, such as in the United access to credit, as both the bank and the States broiler industry, are also examined producer are more willing to invest in the in the early literature. farm operation. Jones and Mighell note that feed and fertilizer firms, hatcheries, canneries and other processors furnish 3.3 Forces for Change capital to producers, while usually retain- ing ownership. They debate the extent to New technology and the need for asso- which contract farming results from ciated human capital, price and produc- imperfections in the capital market. tion risks faced by producers, and economies of scale are examined as factors In a later work, Mighell and Jones (1963) provide an exhaustive treatment of verti- contributing to increased vertical coordi- nation. Butz (1958) recognizes that new cal coordination in a U.S. Department ofAgriculture Bulletin. Using a static partial technology and an associated need for more sophisticated managerial skills con- equilibrium framework, they analyze how the optimum level of integration is influ- tributed to increased vertical coordination. He notes that new technology was accom- enced by the cost curves associated with panied with a commensurate need for different technologies. They conclude that the firm with the largest scale of opera- increased operating capital. Butz argues tions will realize economies from integra- that difficulties in transferring a farm operation to a single operator would moti- tion, and hence, is likely to become the vate new forms of farm organization. integrator. Collins (1959) discusses the inadequacy of In the same paper, Mighell and Jones hypothesize that the increase in contract the price mechanism in conveying infor- mation about a broad range of characte- production in the broiler industry was a response to the high degree of risk and ristics. It is costly to report many quality uncertainty faced by producers. Sources of characteristics of a single good with asso- risk are wide fluctuations in weekly price ciated prices. In contrast, direct contract- quotes and high levels of disease and mor- ing avoids miscommunication by tality in birds. The integrator, drawing on specifying to the producer the characteris- production from a large number of pro- tics desired by the buyer. ducers, would expect small losses with Kolb (1959) discusses research on the some certainty but did not face the level of broiler industry, relating characteristics of risk of independent producers. Develop- family farms to their degree of integration. ments in feeding technology also moti- A survey of highly integrated broiler pro- vated feed dealers to have greater control ducers in Ohio and more independent over production. They propose a typology broiler producers in Maine found less dif- of contracts that continues to be used: ference in objective farm characteristics market-specification,production-management than in the value operators placed on inde- and resource-providing contracts. pendence and security. Araji (1976) discusses previous studies of Jones and Mighell (1961) observe that an cow-calf operations integrated with meat increase in close vertical coordination, e.g., packers. Integrated operations reduced with the use of contracts, is associated costs due to lower expenditures on trans- with an infusion of new technology and portation and selling commissions, as well managerial skills into the farm operation. Vertical linkages in agri-food supply chains in Canada and the United States 11 Early work on vertical coordination as reduced shrinkage and death loss. He works well in the cheese industry due to did not find improvements in internal effi- the existence of the National Cheese ciency due to integration. Exchange, where all industry participants are present, and distortions are quickly A study by the Organisation for Economic communicated and corrected. Cooperation and Development (OECD) (1978) evaluates changes in the supply Kilmer (1986) evaluates the increase in for- chain for beef in member countries. ward and backward integration in agricul- Improvements in the cold chain distribu- ture. He predicts that vertical integration tion system involving refrigeration tech- will continue to increase gradually in niques affected supply chain relationships crops, particularly for vegetables, citrus since shipping boxed beef is more efficient and other fruits, and tree nuts. Motiva- than shipping carcasses. The study notes tions for increased vertical integration the decline of wholesale meat markets as include perishability, capital intensity, and producers sell to plants that perform discontent among farmers over prices. slaughtering, processing and packing. In Kilmer predicts that the extent of vertical the United States and Canada, packers act integration in corn, soybeans and wheat in as a middleman between producers and the United States is unlikely to change as retailers. The study recommends that the current exchange mechanism works public policy move from a production ori- well. He argues that the livestock industry entation toward a recognition of the has a great deal of potential for vertical importance of the whole chain. Increased integration due to increasing concentra- efficiency and transparency of the chain tion in slaughter plants and feed-lot indus- and a balance of power between chain tries and the need for a continuous flow members are cited as key public policy through slaughter plants. He lists seven concerns. factors as determinants of vertical integra- tion: concentration, capital intensity, flow Hayenga and Schrader (1980) discuss for- economies, number of inputs and outputs mula pricing which occurs frequently per firm, economies of scope, firm size and between closely coordinated firms. For- future demand. mula pricing contracts use a formula and a specific price quotation to determine prices for individual shipments. Formula pricing decreases the percentage of the 3.4 Summary supply chain that determines open market Early applied work in vertical coordina- prices, potentially creating a thin market tion discussed some issues still of concern problem. Benefits of formula pricing today. Several authors discussed the include assured market outlets (particu- trade-offs between the reduced level of larly for unique products), continuous risk faced by producers and the decrease grower-seller relationships and a reduced in the level of control they have over all risk of forward arrangements being aspects of the farm operation. Authors unfavourably compared to prices at the also noted that many farms were too small time of delivery. The absence of a well- and under capitalized to be competitive. accepted and accurate price is stated by Closer vertical coordination was often industry members as one concern regard- accompanied by significant changes in ing formula pricing schemes. Hayenga farm operations, such as an infusion of and Schrader discuss how the success of new technology, capital and managerial formula pricing, paradoxically, may skills. Little attention was given to the destroy the market that provides the base problem of thin markets and inadequate price. They note that formula pricing price discovery in the literature surveyed 12 Vertical linkages in agri-food supply chains in Canada and the United States Early work on vertical coordination until Hayenga and Schrader raised these The motivations for, and implications of, issues in their 1980 article. The impact of close vertical coordination were addressed vertical coordination or integration on largely within neoclassical economic market advantage (market power) was theory. In contrast to later analysis, the discussed. However, most vertically inte- role of information and of consumer grated agricultural businesses were quite demand are notably absent. Analysis was small compared to the total market, and largely qualitative and included some par- economists largely dismissed concerns of tial equilibrium graphical analysis. While market power at the retail level. Some some interesting hypotheses were authors, including Butz and Mighell, advanced, most of this work was in a made a prediction that has been born out, period that predates the extensive use of that great political pressure would be regression analysis to test hypotheses. brought to bear to stymy the evolution of This work also predates the use of trans- the independent family operator to a actions cost economics and other new contract-based wage labourer despite the institutional economic approaches, and inevitability of the trend toward contract there was little discussion of a variety of farming. forms of vertical coordination and why one would be chosen over another. None- Other issues, such as the use of close ver- theless, these early papers raised key ques- tical coordination as a means to control the tions, including how coordination affects supply of agricultural commodities, have the efficiency of the operation, what enter- faded (Dawson 1959). The interaction of prise is the driving force in closer coordi- vertical supply chain relationships and US nation and how the scale of operation is farm programs was not an important determined. theme as the commodities where close coordination was prevalent did not tend to be included in farm programs. Vertical linkages in agri-food supply chains in Canada and the United States 13 Section 4 Recent developments in vertical coordination Although there was a flurry of interest in management and resource-providing con- vertical coordination during the 1950s and tracts and it appears that this estimate for 1960s, interest faded. Vertical coordination ?production contracts? includes both. Pro- became a renewed subject of investigation duction contracts currently are more com- by agricultural economists in the 1990s mon for some types of livestock. Almost and currently, as a trend toward closer all contracting in the poultry sector is (i.e., more formal) vertical coordination through production contracts and emerges. This section explores the nature accounts for 68 percent of the value of pro- of these changes and Section5 discusses duction. For hogs, production contracts their origin. are dominant and account for 33 percent of the value of production. A smaller per- One of the challenges for researchers is the centage of the value of cattle production is scarcity of data available on the extent of under contract and there is a balance different types of vertical coordination. between production and marketing con- Table 1 presents data on the extent of con- tracts. tracting across commodities in the United States.3 Unfortunately, the data do not 3. To the authors? knowledge, comparable data for differentiate between production- Canada are not available. Table 1:Extent of contracting in selected commodities, United States, 1997 Value of production under contract In production In marketing Farms with Total Total contracts contracts contracts (million $US) (percent) (percent) (percent) (percent) Wheat 448 5.5 0.1 5.4 7.1 Barley 162 19.3 a 19.3 7.3 Soybeans 1,616 10.6 a 10.2 14.0 Corn 1,674 8.9 0.2b 8.7 12.1 Potatoes 694 41.5 a 36.7 25.7 Poultry 8,937 70.0 68.3 a 66.7 Hogs 3,271 36.1 32.9 a 11.6 Cattle 6,876 28.4 17.5 10.9 2.1 a: Data insufficient for disclosure. b: The relative standard error of the estimate exceeds 25 percent, but no more than 50 percent. Note: Totals are not US totals as they exclude low resource, residential and retirement farms. See Banker and Perry (1999) for a detailed classification. Source: U.S. Department of Agriculture, Economic Research Service, 1997 Agricultural Resource Management Study. Vertical linkages in agri-food supply chains in Canada and the United States 15 Recent developments in vertical coordination Relative to livestock, a small percentage of Although analogies have been drawn grain is grown or sold under contract in between developments in the US hog the United States. Malting barley is the industry and the earlier move toward con- exception, with maltsters accounting for tracting and vertical integration in the US the relatively high percentage of barley poultry industry, several commentators under marketing contracts. However, for observe that developments in the hog soybeans (10.6 percent), corn (8.9 percent) industry are different. In the broiler indus- and wheat (5.5 percent), a small percen- try the integrator was often another party tage of the value of production is in the supply chain, such as a feed accounted for by contracts. The situation is supplier integrating forward or a proces- changing quickly for soybeans and corn, sor integrating backward into production. however, due to recent developments in However, until recently this was not gene- the supply chain for these commodities, as rally the case with hogs. Contracting in the discussed in Section 8. US hog industry was most prevalent hori- zontally among large producers using In the United States, there were changes in contract production to increase their pro- the poultry and hog industries as trans- duction levels (Rhodes 1995). Typically, actions shifted from spot markets to pro- hog producers finishing feeder pigs pro- duction and marketing contracts between vide the capital and labour inputs, while farmers and first stage buyers. The share the contractors provide the young pigs, (volume) of broilers produced under con- feed, medical services and managerial tract in the United States stood at about 90 advice. In a few cases, larger producers percent in the 1990s, with contracting also integrated forward into packing and back- important for turkeys, eggs, sugar beets ward into feed supply. Drabenstott (1998) and fruits and vegetables?e.g., chipping points to Premium Standard Farms and potatoes, apples, tomatoes, pickles Smithfield Foods as examples of vertically (Sheldon 1996; Tsoulouhas and Vukina integrated pork supply chains from gene- 1999). tics through to final packaging. The US hog industry has received a lot of Rhodes (1995) conducted a survey of the attention recently due to its rapid move 57 largest US producers in 1993 and found toward contract production during the that about one third of their hog market- 1990s. Rhodes (1995) traces the beginning ings were from vertically integrated pro- of ?industrialization? in the US hog indus- ducers. A greater proportion of their hog try back to the 1970s when larger indoor marketings (58 percent), however, were production units began to emerge. This from horizontally contracted production, change in production technology paved i.e., not with packers or feed companies. the way for closer vertical linkages along Estimates of the extent of hog production the supply chain. By 1997 the largest hog transacted through production or market- farms marketing over 50,000 hogs a year ing contracts with packers differ. Rhodes accounted for 37 percent of US production states that, in 1993, less than five percent but only one percent of hog farms. These of national production was from opera- figures contrast to the situation in 1988 tions involved in vertical integration, con- when the largest producers accounted for tract production or joint ventures with only seven percent of production. Clearly, packers or commercial feed companies. the change has been relatively rapid (Dra- Whereas, Martinez (1998) reports that benstott 1998). 11?13 percent of hog sales to packers were coordinated by contracts and through integrated operations in 1993, rising to an estimated 29?34 percent by 1998. This esti- 16 Vertical linkages in agri-food supply chains in Canada and the United States Recent developments in vertical coordination mate is based on packer expectations in a their exclusive rights to market hogs pro- 1994 survey.4 In fact, it appears that con- duced in their provinces. This change in tracting has increased at a much faster rate the mandate of the marketing boards than estimated previously by the packers. opened the way for closer packer- Martinez (1999a) estimates that in January producer contractual relationships. 1999, 56 percent of US hog marketings were coordinated through contracts and Neither the Canadian nor the US beef about two percent through vertical inte- industries have so far experienced a move gration. Martinez (1998) confirms that the toward closely coordinated contractual large producers tend to be the (horizontal) systems or alliances on a large scale. Pierce integrator and that, for the most part, hog and Kalaitzandonakes (1998), however, production operations and packers remain report the emergence of hybrid forms of separate entities. vertical coordination in the US beef indus- try. These can best be described as ?value Marketing contracts or agreements chain? relationships between specific part- increasingly characterize the packer-large ners in the supply chain. In some cases producer transaction, with price usually they involve a producer cooperative form- based on the prevailing spot price ing an alliance with packing and process- adjusted for quality. The US hog industry ing firms for the supply of identity underwent a major structural change in preserved, branded beef. A system of pre- 1999 with the purchase of the three largest miums and discounts for pre-determined US hog producers by Smithfield Foods. quality attributes and the provision of The company will control an estimated detailed individual carcass feedback to 10?15 percent of US hog production (Agri producers are typical features of these sys- marketing 1999). In general, spot market tems. This information gives the system an transactions rapidly have become less important informational (and ideally, important, replaced by formal long-term quality) advantage over traditional beef marketing and production contracts or marketing systems. A mixture of vertical strategic alliances. coordination arrangements feature in the Farmland Supreme Beef Alliance The close contractual linkages observed in described by Kalaitzandonakes and the US hog industry are not as prevalent in Pierce. These range from vertical integra- Canada, partly as a result of the institu- tion, whereby Farmland Industries (the tional structure previously in place. Man- largest regional cooperative in the United datory provincial marketing boards acted States) has a major ownership share of the as single desk selling agencies for hogs but packing firm, to looser downstream rela- did not exercise supply controls. Prices tionships with the suppliers of finished were established on the basis of formulas cattle, including informal contracts and negotiated between producer marketing preferred trading agreements. These types agencies and processors. This institutional of vertical linkages remain atypical in the arrangement inhibited closer vertical rela- Canadian and US beef industries. tions between producers and packers. In 1997, the hog marketing boards in Alberta, The grain marketing system in both coun- Manitoba and Saskatchewan relinquished tries remains predominantly a commodity-based system; however, other 4. The apparent discrepancy in numbers could be supply chain structures are emerging for explained if Rhodes excludes marketing con- tracts from his estimates. Lawrence et al. (1997), some crops. Given the uncertainty of from a survey of major packers representing 86.5 selling specialty crops (e.g., mustard, percent of US slaughter, found that in 1993 just 2.3 percent of the packers? hogs were obtained lentils, flax, etc.) into a spot market, con- through production contracts or vertical integra- tracts are often used to coordinate the mar- tion. Vertical linkages in agri-food supply chains in Canada and the United States 17 Recent developments in vertical coordination keting of these crops in Canada zontal contracting and more recently (Weleschuk and Kerr 1995). Identity pre- toward the use of vertical strategic alli- served supply chains are also emerging. ances, marketing or production contracts Kennett et al. (1998) describe the relation- and vertical integration. The Canadian ship between Warburtons (a UK bakery hog industry has been slower to move in company), Manitoba Pool Elevators (now this direction. Examples are emerging of Agricore) and a selected group of Cana- vertical alliances between packers and dian growers to supply Warburtons with producers (and sometimes also retailers) wheat exhibiting specific baking characte- in the beef industries of both the United ristics. States and Canada and of identity pre- served systems for selected grains. Agricultural life-science companies are creating networks incorporating firms at Data on the extent of contracting in the various stages of the supply chain, from United States for various commodities, by R&D to food firms, and involving a range the type of contract, illustrates the uneven of coordinating mechanisms including use of contracting between sectors vertical integration, strategic alliances and (Table1). Data by the type of operation in joint ventures (Thompson and Bonderud the United States are provided in Banker 1999). The apparent consumer backlash and Perry (1999). To our knowledge, against genetically modified organisms equivalent data are not available for the (GMO) in Europe may speed the develop- Canadian agri-food sector. However, even ment of identity preserved supply chains, where summary data are available for the ironically, to preserve the identity of non- United States, they cannot capture the rich GMO crops. This separation of GMO and variety of vertical coordination arrange- non-GMO crops cannot be done through ments used or the nature of their evolu- commodity-based spot market trans- tion. actions (Hobbs and Plunkett 1999). The need for more information about the ori- Data on products transacted through stra- gin and production characteristics of grain tegic alliances, through quasi and fully products requires closer vertical linkages vertically integrated firms are not gene- between producer, processor and distri- rally available. In some cases, the data are butor. not available in a form which allows us to distinguish between complex production To summarize, there has been a steady contracts and other forms of close vertical growth in vertical linkages in many agri- coordination. In other cases, the informa- food industries in the United States and tion is proprietary which presents a chal- Canada. These developments are by no lenge for analysis and for regulatory means symmetrical across all sectors or oversight of vertically-related markets, as between the two countries. The US hog discussed in Section 11. industry has moved rapidly toward hori- 18 Vertical linkages in agri-food supply chains in Canada and the United States Section 5 Factors leading to increased vertical coordination In this section, we explore the factors an increase in the number of food behind increased vertical coordination products. Consumers now have a wealth and summarize the literature dealing with of information available on the relation- these factors. The market environment is ship between food and health, and evolving rapidly due to changes in con- demand a wide range of products that are sumer demands, government regulation fresh, low fat, low salt or with some other and advances in technology. To succeed, desirable health characteristic. All of these firms adjust the level and mechanisms of factors increase the demand for a diverse vertical coordination with their upstream selection of food products, which is illus- or downstream supply chain partners. trated by the data presented by Connor and Shiek (1997) and Henderson (1998) on new product introductions. 5.1 Changing Consumer In recent years, food safety concerns, Preferences including both incidents of food-borne ill- Consumer demand for food quality and ness and assessment of the safety of spe- diversity has been a pivotal factor in cific food production and processingmethods, have become increasingly increasing vertical coordination in the important to consumers. As incomes food industry. Kinsey (1997) notes that: increase, consumers are willing to pay ?Postmodern consumers make a life more for food safety standards to mini- project out of creating and displaying mize risk. At the same time, modern con- their individual sense of style sumption habits, ready-to-cook and through... the foods they eat... Their convenience foods have made consumers endless pursuit of new experiences more dependent on public authorities for and distinguishing tastes creates a food safety than in traditional societies market climate where product differ- (Bureau et al. 1999). Incidents of bovine entiation and fragmentation spongiform encephalopathy (BSE), E. coli, flourish.? (p. 35) Salmonella, and Listeria in both Europe and Kinsey (1997) and Connor and Shiek North America have heightened consumer concern over the safety of the food supply. (1997) identify the underlying demo- graphic changes that contribute to changes These consumer concerns motivated the adoption of new food safety regulations in consumer preferences, including the by governments. For example, in the increase in women working outside the household, longer hours for both men and United Kingdom, companies are legally women in the workplace and smaller required to exercise due diligence in assur- households. These factors caused an ing the safety of the products that they sell (Hobbs and Kerr 1992). increase in the number of convenience foods. Growth in the number and impor- Public concern over numerous outbreaks tance of ethnic groups desiring food of food-borne illness has prompted volun- unique to their culture also contributed to tary actions on the part of many Vertical linkages in agri-food supply chains in Canada and the United States 19 Factors leading to increased vertical coordination industries. Quick identification and isola- not provide us with a definition of a tion of the member of the supply chain ?metasystem,? the word meta means a responsible for the outbreak is recognized more organized or specialized form, there- as critical by both industry and govern- fore a more specialized form of a quality ment. For example, the beef industry in management system. The authors do how- Canada is working toward traceability of ever, provide a definition of quality individual animals through the supply management as: chain (Hobbs and Kerr 1998). Many indus- tries developed food safety standards and ?all activities of the overall manage- undertook the administration of those ment function that determine the quality policy, objectives and respon- standards, requiring close industry coordi- nation. An example is the British Meat sibilities, and implement them by Manufacturers Association, whose com- means such as quality planning,quality control, quality assurance prehensive hygiene and manufacturing and quality improvement within the standards are more stringent than public quality system.? (p.556) standards (Bureau et al. 1999). The maintenance of quality metasystems Food safety concerns extend beyond food- requires close relations between the mem- borne illness. The use of irradiation in bers of a supply chain. Caswell et al. pro- food processing, the use of bovine growth pose three categories of quality systems: hormones in milk production, and the pro- government mandated, voluntary and duction of genetically modified foods con- quasi-voluntary. The authors note that cern consumers and have motivated government mandated systems may lead public debate. firms to recognize the advantages of qual- ity control and motivate them to adopt Some consumers have ethical concerns additional voluntary systems. Different about how domestic and imported food is types of systems are used to achieve diffe- produced. Specific concerns include the rent goals. Goals frequently motivating impact of production processes on the the adoption of quality metasystems environment, the use of child labour, and include producing a product with a high animal welfare. Concerns over animal welfare are most prevalent in Europe. and consistent level of quality, environ-mental management, worker empower- These concerns have resulted in regula- ment and customer feedback. tions requiring the use of natural condi- tions for birds and other animals, banning Labelling is one mechanism used to con- of battery cages, abolition of tethering for vey information to consumers about the sows and reduction or elimination of visible (search) and invisible (experience crates for veal (Gordon 1998). These issues and credence) quality attributes of a good. have implications for supply chain rela- Caswell (1998) discusses how labelling of tionships as retailers seek to provide con- safety and process attributes affects sumers with animal welfare assurances markets for food. She notes that con- when selling meat products. To provide sumers consider information on process information about on-farm production characteristics in their decisions. Pro- practices, producers, processors and ducers, processors and retailers may retailers must communicate through voluntarily chose labelling as a method of closer vertical relations (Hobbs 1996a). conveying this information to consumers, or labelling may be required by The increase in demand for quality led to government. As with animal welfare the introduction of quality metasystems assurances, labelling of process attributes for food production and processing requires closer supply chain relationships. (Caswell et al. 1998). While the authors do 20 Vertical linkages