Market Power, Misconceptions, And

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American Journal of Agricultural Economics Advance Access published November 24, 2012

MARKET POWER,MISCONCEPTIONS, AND MODERN AGRICULTURAL MARKETS

RICHARD J. SEXTON

Although microeconomics textbook writers many other textbook writers: “Thousands of Downloaded from continue to point to agricultural markets as farmers produce wheat, which thousands of examples of competitive markets, in real- buyers purchase to produce ﬂour and other ity probably none are, especially in light of products. As a result, no single farmer and no dramatically increased concentration in food single buyer can signiﬁcantly affect the price manufacturing (Rogers 2001) and grocery of wheat,” (p. 8). Yet, the U.S. Department of

retailing (McCorriston 2002; Reardon et al. Justice (1999) sued to prevent the merger of http://ajae.oxfordjournals.org/ 2003), emphasis on many dimensions of prod- Cargill and Continental Grain Company,alleg- uct quality and differentiation (Saitone and ing that, “Unless the acquisition is enjoined, Sexton 2010), and the rapid increase in vertical many American farmers likely will receive coordination through integration and contracts lower prices for their grain and oilseed crops, (MacDonald and Korb 2011; Goodhue 2011). including corn, soybeans, and wheat.”1 Sales For the basic precept of a competitive mar- from the production of the “thousands” of ket to hold, namely that all buyers and sellers farmers in Canada, the second-largest wheat are price-takers, three conditions must be met: exporting country, were until August 1, 2012, under the control of a single state trader, and at Libraries-Montana State University, Bozeman on March 20, 2013 • Buyers and sellers must be small relative wheat is a highly differentiated product based to the total size of the market, meaning upon protein content and other factors (Wil- there must be many of each; son 1989; Lavoie 2005). Indeed, Lavoie (2005) • The products of all sellers must be homo- showed econometrically that the Canadian geneous in the eyes of buyers; Wheat Board was able to influence the price • Information in the market place must be of Canadian wheat, which directly contradicts perfect, so that all buyers and sellers are the price-taking claim. aware of the prices being charged and the When researchers have pursued imperfect characteristics of the products being sold. competition issues in agricultural markets, the traditional focus has been food manufacturers’ I don’t know of any modern agricultural mar- and on occasion retailers’ market power over ket that meets all three of these conditions. consumers (Connor et al. 1985; Marion 1986). Most don’t meet any of them. For example, The market-power pendulum has, however, consider the classic case of the wheat market swung increasingly to focus upon processors’ offered by Pindyck and Rubinfeld (2009) and and occasionally retailers’ roles as buyers from farmers,as reflected in the competition policies proposed, and to some extent implemented, in the 2002 and 2008 farm bills, and now under Presidential Address. consideration with the impending 2012 farm Richard J. Sexton ([email protected]), Professor and Chair, Department of Agricultural and Resource Economics, University bill. of California,Davis and member,University of California Giannini As a profession we have only begun to under- Foundation ofAgricultural Economics.The author is grateful to Ian Sheldon and seminar attendees at Ohio State University for helpful stand the implications of increasing prod- comments on this paper and to colleagues and graduate students uct differentiation and vertical coordination at UC Davis who contributed to the research which provides the backdrop to the present paper. Presented at the 2012 AAEA annual meeting, Seattle, WA. 1 The merger ultimately was allowed to proceed, but only after Invited addresses are not subjected to the journal’s standard the firms agreed to divest themselves of 10 grain elevators in seven refereeing process. states (MacDonald 1999).

Amer. J. Agr. Econ. 1–11; doi: 10.1093/ajae/aas102 © The Author (2012). Published by Oxford University Press on behalf of the Agricultural and Applied Economics Association. All rights reserved. For permissions, please e-mail: [email protected] 2 Amer. J. Agr. Econ. among firms for market performance and concentration is rising over time (Kaufman distribution of benefits among participants. 2000; Rogers 2001). For example, the average A key point of this paper is that we must 4-firm concentration ratio (CR4) in 15 key not focus on concentration alone when think- food-manufacturing industries (comprising ing about departures from perfect competition 41% of total food-processing sales) in 2002 in modern agricultural markets, nor in eval- was 56% compared to 45% in 1982 (U.S. uating their performance. Rather, the trends Government Accountability Office [GAO] towards greater concentration and vertical 2009). Particular concern has been expressed coordination, along with increased emphasis regarding rather dramatic increases in con- on product quality and differentiation, must centration in livestock processing. The leading be considered and evaluated jointly. Although four firms slaughtered 64% of all U.S. hogs Downloaded from such an expanded focus can greatly compli- in 2007, compared with 32% in 1985, while cate efforts at formal modeling, conclusions CR4 for steer and heifer processing rose generated from such analyses are likely to dif- from 41% in 1982 to 84% by 2007 (Johnson fer significantly from those based upon tradi- and Becker 2009).2 Relevant procurement tional market power analyses that have tended markets for farm products, depending upon to ignore product differentiation and vertical the commodity,may be localized in geographic http://ajae.oxfordjournals.org/ coordination. scope due to high costs of transportation, In what follows, the recent evolution of meaning that national concentration ratios agricultural markets in the dimensions of con- may vastly understate the level of buyer centration, product differentiation and qual- concentration in relevant geographic markets ity, and vertical coordination and control for raw agricultural products. is discussed. If these developments render Leading grocery retailers have emerged as the perfect competition model inappropriate, dominant players in the food chain worldwide. what are the consequences of its application? In the United States national CR4 in food I provide some answers based upon work I retailing, only 16.8% in 1992, increased almost at Libraries-Montana State University, Bozeman on March 20, 2013 have conducted with colleagues and graduate continuously, to 35.5% in 2005. However, students over the past several years. How- because consumers are distributed geograph- ever, the core analytical framework for that ically and incur significant transaction costs in research, a flexible, homogeneous-product traveling to and from stores, relevant retail oligopoly/oligopsony model, may itself be too markets are localized in geographic scope. restrictive to capture essential features of mod- Average grocery retailing CR4 in 2006 for 229 ern agricultural markets. I thus offer some key metropolitan statistical areas based on analysis stylized facts that characterize many of today’s of Nielsen Market Scope data was 79.4%. agricultural markets and arguably will characterize even more in the near future. I argue Product Quality and Differentiation that these stylized facts are fundamental to how these markets operate, but they are too often The dimensions of food quality that are valued ignored in economic analyses. Finally, I sketch by consumers have expanded rapidly. In addi- ways in which these features might be incorpo- tion to traditional characteristics such as taste, rated into our analysis, and indicate the likely appearance, convenience, brand appeal, and consequences of doing so. healthfulness, characteristics of the production process (e.g. usage of chemicals, sustainability, location, or confinement conditions of animals), marketing arrangements (in particular, Key Trends in the Structure of U.S. their “fairness”), and implications of produc- Agricultural Markets tion and consumption of the product for the environment also matter increasingly to some I emphasize market conditions in the United consumers. States for the sake of brevity, but the same Empirical studies have demonstrated con- evolutionary forces are impacting markets sumers’ willingness to pay for differenti- worldwide in both developed and developing ated product attributes such as organic, pro- economies. duced with sustainable practices, produced in Concentration

The U.S. food industry is highly concentrated 2 CR4 in cattle processing is now higher due to the JBS acquisi- at both the retail and processing stages, and tion of the Smithfield cattle operations in 2009. Richard J. Sexton Market Power, Misconceptions, and Modern Agricultural Markets 3 particular geographic locations, certified safe, downstream trading partner restraining the and marketed under fair-trade practices. behavior of its upstream suppliers in terms An additional critical dimension of product of varieties produced, inputs used, production quality is its consistency. If firms are differen- schedules, handling practices, etc. By control- tiating themselves based on quality attributes ling the use and application of key inputs, of their products, they must ensure a consis- downstream firms address moral hazard issues tent supply of products capable of attaining the that could otherwise diminish product quality specified quality standards (Goodhue 2011). and increase food safety concerns. Contracts Quality differences, product heterogene- can also specify and reward quality standards ity, and meaningful brands are incompatible and thereby address adverse selection prob- with the perfect competition axiom of homo- lems that might be caused by the failure of spot Downloaded from geneous products. If firms succeed in truly markets to adequately recognize and reward differentiating their products, they face indi- quality. vidualized, downward-sloping demand curves Despite having a clear efficiency rationale,4 and are not price-takers. close vertical coordination between farming Further, differentiation among firms and and downstream marketing stages has long products in these modern dimensions of prod- been controversial because of its potential http://ajae.oxfordjournals.org/ uct quality leads inevitably to violation of implications for the economic freedom of farm- the competition axiom of perfect information, ers, the exercise of buyer market power, and because a variety of important differentiating the survival of small-scale traditional farms attributes of food products, such as presence/ (Breimyer 1965; Barkema and Drabenstott absence of genetically modified organisms,eco- 1995; McEowen, Carstensen, and Harl 2002). logical characteristics of the production pro- Policy focus has increasingly been directed cess, treatment of animals, etc., are not readily towards regulations and legislation to pro- discernable by consumers through ex ante scribe certain coordination practices. searching or even ex post after consumption. The livestock sector has been most widely at Libraries-Montana State University, Bozeman on March 20, 2013 In other words,these product features are“cre- studied and scrutinized with respect to these dence attributes” (Roe and Sheldon 2007). trends, where vertical coordination mecha- Credence quality claims by individual firms, in nisms are often called “captive supplies.” The the absence of a verification or enforcement broiler industry represents the most vertically mechanism, are normally not credible. integrated sector in U.S. agriculture. Nearly all broiler production is marketed through Vertical Coordination and Control vertically coordinated chains, in most cases Increasing vertical coordination and control through resource-providing production con- and use of production and marketing contracts,wherein the grower does not own the live tracts throughout stages of the food chain have animal,and his/her ability to act independently been stimulated by concerns about food qual- is severely proscribed (Goodwin 2005).5 ity and safety and the need to insure or certify The share of cattle marketed under verti- the attributes of food products. The degree of cal coordination mechanisms doubled between vertical coordination ranges from essentially 1980 and 1998 from about 10% to more than none in open-market transactions to complete 20%, and the pace of vertical coordination control in the case of vertical integration. Con- has accelerated rapidly since then. By 2009- tracts represent intermediate forms of vertical 10 negotiated cash procurement accounted for control and have a long history in agriculture. only 34.1% of cattle transactions (Ward 2010), Their use is increasing rapidly in the United and the percentage had fallen to under 20% States and elsewhere,as is the degree of control during various weeks in the summer of 2012. exercised through them.3 Contracts governed Vertical coordination in the pork industry at least 39% of the value of U.S. agricultural has proceeded even more rapidly. As recently production in 2008, up from 28% in 1991 and 11% in 1969 (MacDonald and Korb 2011). Control in food-industry contracts is almost 4 Key and McBride (2003), for example, found dramatic effi- always exercised in the direction of the ciency gains to contract production, on the order of 20% output gains holding inputs constant–gains they attributed to knowledge transfer from integrators to growers. 5 Arguably these contracts are labor-service contracts with the 3 In the developing world contract farming,where a downstream additional feature that a significant capital investment (in the form processor/marketer provides inputs and technical advice to pro- of growing houses) is required of the grower. Ex ante these growers ducers, has been a key approach to incorporating smallholders have substantial alternatives for their labor input, but the capital into high-quality export supply chains (e.g. Key and Runsten 1999; investment creates an ex post lock-in, which exposes the grower to Takane 2004). possible post-contractual opportunism. 4 Amer. J. Agr. Econ. as the early 1990s, nearly 90% of hogs were example, the U.S. GAO (2009), in respond- purchased in the spot market, but by 2010, the ing to Congressional concerns about trends in percentage of spot market hogs had fallen to concentration and prices in the food sector, the 5–7% range, with about one-fourth of hogs concluded: procured through packer vertical integration, and 68% acquired through production con- The empirical economic literature has tracts,following the path of broilers (Lawrence not established that concentration in 2010; O’Donoghue et al. 2011). the processing segment of the beef, pork, or dairy sectors or the retail Does Agriculture Have a Market-Power sector overall has adversely affected

Problem? commodity or food prices. Most of Downloaded from the studies that we reviewed either found no evidence of market power As the preceding discussion indicates, the or found efﬁciency effects that were processing and retailing sectors in many larger than the market power effects food industries ﬁt a prototype differentiated- of concentration.

product oligopoly/oligopsony structure based http://ajae.oxfordjournals.org/ upon the presence of a few large firms operating in the relevant geographic markets, Yet, only modest departures from perfect perhaps a fringe of smaller competitors, and competition should not provide solace to agri- substantial barriers to entry in the form of sunk cultural market researchers intent on applying assets, including brand capital and specialized the competitive model. In what follows, I sum- plant and equipment with little value in an marize work conducted with several colleagues outside use. and former graduate students that shows even Moreover, the same leading firms interact modest departures from competitive pricing of the type commonly found in empirical repeatedly, both as buyers and sellers over at Libraries-Montana State University, Bozeman on March 20, 2013 time and across regions in these markets, cre- studies–relatively weak oligopoly or oligop- ating opportunities to learn to cooperate, at sony power–are sufficient to lead analysis least tacitly. Basic industrial organization anal- based upon the competitive model to severely ysis would suggest that these aforementioned biased conclusions in many cases. Thus, the conditions are rife for the exercise of market empirical research on market power does power. not resurrect the competitive model. How- Additional potentially worrisome considera- ever, I then proceed to question whether the tions from a market-power perspective are that homogeneous-products market-power model product differentiation and vertical control that underpins these conclusions is itself too increasingly create lock-in situations between limited to capture the essential features of farmers and their buyers. Farmers make spe- modern agricultural markets. cialized investments in capital and crops to suit the needs of particular buyers, making it Implications of Market Power for difficult to attract alternative buyers should Agricultural Market Analysis the need arise. Reports by farmers of limited competition among buyers to secure their A basic approach from the work we have con- patronage are widespread. ducted regarding the implications of market These facts have provided the impetus for power in agriculture has been to parameter- considerable policy concern at the state and ize the extent of market power along the unit national levels regarding competition in agri- interval. A market power parameter equal cultural markets, especially for farm prod- to 0 denotes perfect competition, a market uct procurement. Yet considerable research power parameter equal to 1.0 denotes pure effort to investigate market power in specific monopoly or monopsony, and intermediate industries, most notably the red-meat indus- values indicate various degrees of oligopoly tries, has found at most only small depar- and oligopsony power.7 This model is very tures from competitive pricing on either the selling or buying sides of the market.6 For

provide summaries for a broader cross-section of industries and product categories. 6 Azzam andAnderson (1996) andWard (2002) summarize much 7 The conceptual basis for this approach (or, as some would of this research for livestock and meat products, and Sheldon and argue, lack of such a basis) is discussed in various papers cited in Sperling (2003), Kaiser and Suzuki (2006),andU.S. GAO (2009) this section. Richard J. Sexton Market Power, Misconceptions, and Modern Agricultural Markets 5

flexible in handling oligopoly and/or oligop- the pure efficiency consequences. This sony power at various (and multiple) stages point is important because much of of a vertical market chain. A simple version our market analysis is policy-oriented, is presented in Excel format in Saitone and with specific policies designed to help Sexton (2009),where users can input key model farmers and frequently also consumers. parameters reflective of markets of importance Graphically, the profits earned by the to them, and view fundamental results. marketing sector represent a rectangle However, this model’s flexibility in handling with height equal to the retail price minus market power at different stages of the mar- farm price and marketing-sector costs, ket chain comes at the expense of simplifica- and width equal to the market output. tions achieved elsewhere, notably by retaining Any market power that causes output Downloaded from the perfect-competition assumptions that the in the market to decrease even slightly products sold at the farm and to consumers relative to the competitive level raises are homogeneous, and that information is per- the price to consumers and reduces price fect. Thus, it will be worth questioning whether to farmers, thereby expanding the height even this generalized model is appropriate for of the entire rectangle and generating analysis in modern agricultural markets now concomitant reductions in consumer and http://ajae.oxfordjournals.org/ characterized by extensive product differen- producer surplus. tiation and vertical control implemented to • Market intermediaries, with even rather address asymmetric-information problems. modest amounts of market power, can The following are key conclusions generated capture large shares of the benefits from work based upon this homogenous- from policies intended to benefit farm- products model of oligopoly/oligopsony ers. This point follows directly from power: the preceding one and has been made through analysis of several specific policies, including public sector invest- at Libraries-Montana State University, Bozeman on March 20, 2013 • Efficiency (deadweight) losses from mod- ments in farm research (Alston, Sexton, est departures from competition in the and Zhang 1997), trade liberalization food-marketing sector are minor (Alston, (Sexton et al. 2007),8 and agricultural Sexton, and Zhang 1997; Sexton 2000). price supports (Russo, Goodhue, and This is the same fundamental point made Sexton 2011). Saitone, Sexton, and Sexton by Harberger (1954). For a small depar- (2008) extended this framework to con- ture from competition, the deadweight sider market power both upstream and loss (Harberger) triangle is small, in the downstream from the farm level in an limit infinitesimally small. However, it evaluation of the U.S. subsidy provided increases at an increasing rate as a func- for corn ethanol. tion of the degree(s) of market power • The large distributional consequences due exercised. So if market power is severe, to market power of intermediaries distort or is exercised at multiple stages along farmers’ incentives to invest. For exam- the market chain (Sexton et al. 2007), ple, intermediaries with market power deadweight losses become large and con- can capture a large share of the ben- sequential, approaching upwards of 25% efits from the supply shift induced by of the total market surplus that would be farm sector research or adoption of new available under perfect competition. technology (Huang and Sexton 1996; • Oligopsony power matters for market effi- Alston,Sexton,and Zhang 1997),or a large ciency only to the extent that the farm share of the benefits from a retail demand input matters as a factor in producing the shift induced by commodity promotion final product. The farm share as a frac- (Zhang and Sexton 2002), thus attenuat- tion of the food retail dollar is now less ing farmers’ incentives to invest in such than 20% on average in the United States, programs. making oligopsony power quite inconse- quential as a source of overall economic

inefficiency (Alston, Sexton, and Zhang 8 This analysis shows, for example, that even moderate levels 1997; Sexton 2000). of market power when exercised at multiple stages of the mar- • The distributional consequences of ket chain allow market intermediaries to capture over half of the benefits from trade liberalization, leaving relatively little for market power exercised by market developing-country farmers who are the intended beneficiaries of intermediaries are much greater than such a strategy. 6 Amer. J. Agr. Econ.

• Accepted “wisdom” regarding agricul- (ii) fixed shelf-space allocations in retail tural policies may not hold for imperfectly stores, and/or; (iii) fixed sales contracts for competitive markets. A key example is its finished product(s). the widely acknowledged superior wel- • The firm will seek to secure, ex ante, the fare consequences of decoupled agricul- requisite fixed supplies of the agricultural tural income support programs relative products with the required quality charac- to the traditional price floor or deficiency teristics for its products. Reliance ex post payment programs. Russo, Goodhue, and upon the open market would leave the Sexton (2011) showed that either pro- firm vulnerable to not finding products gram, by fixing a minimum farm price with the characteristics it seeks or in a situ- outside of the market process, restricts ation where it is unable to secure sufficient Downloaded from downstream buyers’ ability to exert raw product to meet its selling obligations oligopsony power. Thus, coupled sup- and/or operate its facilities at efficient port policies can be pro competitive and capacity. Such a failure would subject the welfare-enhancing relative to the unregu- firm to branding as an unreliable supplier. lated market. • Transaction costs of executing con-

tracts/agreements will be significant in this http://ajae.oxfordjournals.org/ environment and increasing in the degree Does a Prototype Market-Power Model Fit to which product quality, differentiation, Modern Agricultural Markets? and/or safety are issues. • The value of a farmer’s production in any How do we reconcile food industries that are market period will normally be greatest structural oligopolies/oligopsonies with high for the buyer who purchased it in the prior barriers to entry,ample opportunities to obtain period because the farmer’s production is cooperative outcomes, and anecdotal evidence tailored to that buyer’s needs and is not supporting little competition in farm-product readily altered.9 The transaction costs of at Libraries-Montana State University, Bozeman on March 20, 2013 procurement with an extensive empirical liter- executing a new agreement with a differ- ature that finds little market power? ent buyer will be greater than the costs of I think the answer lies in considering how the extending an existing agreement. aforementioned structural changes in agricultural markets impact the prototypical market Some of these stylized facts are probably intermediary. At the risk of overgeneralizing, self-evident based upon the preceding dis- I set forth here several stylized facts regarding cussion, but some elaboration on others is the operations of these firms, whether they are likely helpful. From basic production theory, food manufacturers, produce grower-shippers, we are normally motivated to posit smooth, grocery retailers, or other agricultural-market downward-sloping input demands for buyers intermediaries. I argue that, although these of agricultural products. Yet consider the fol- factors are pivotal in guiding the operational lowing conclusions from recent comprehensive strategies of agricultural-market intermedi- studies of the U.S. livestock industries: aries, they are things we seldom consider explicitly in our analyses. Large processing plants achieved cost economies by ensuring a smooth and • The firm has a substantial investment in undisrupted flow of hogs so they assets that are sunk in its present indus- could operate their plants at near try. Such assets might include physical full capacity.Therefore,their desire to plant and capital with little alternative use, continue purchasing hogs to achieve investments in distinctive products and these cost savings could overwhelm brands, or even a firm’s reputation. any incentives to exercise market • The firm produces differentiated finished power by restricting purchases (U.S. products and seeks differentiated farm GAO 2009, p. 29). products with characteristics that facilitate When both are operating close to production of its differentiated products. capacity, smaller plants are at an • The firm has a very inelastic demand for absolute cost disadvantage compared the agricultural product in any given procurement period due to, depending upon the particular product, firm, or indus- 9 These considerations may include spatial/location factors, as try: (i) processing capacity constraints; well as characteristics of the product itself. Richard J. Sexton Market Power, Misconceptions, and Modern Agricultural Markets 7

to larger plants. When larger plants This characterization of the farm-product operate with smaller volumes, they procurement process is fully consistent with have higher costs than smaller plants farmer complaints regarding an absence of operating close to capacity and, thus, competition among processors to procure their have incentive to increase through- products, but is it consistent with buyers exer- put. For all plants, large and small, cising traditional market power over farmers? average total cost increases sharply as volumes are reduced (Muth et al. 2005, p. ES-6). Modeling Modern Agricultural Markets

The demand (or ability to pay) curve for A linear-pricing oligopolist or oligopsonist Downloaded from live animals for these processors is essentially exercises market power by restricting sales or flat at the level of final product value less purchases so as to raise prices to consumers marginal processing costs until the plant capac- and/or depress price to producers. Such behav- ity is reached, at which point it declines rapidly, ior creates deadweight losses. We know from in essence having a right-angle shape.The same basic theory that these deadweight losses can http://ajae.oxfordjournals.org/ characterization will apply to the farm product be reduced or eliminated if firms have the demand of intermediaries that lack such capac- flexibility to employ nonlinear prices. Con- ity constraints but have fixed sales contracts, tracts provide transacting parties with exactly fixed access to retail shelf space, etc. such flexibility. Thus, concerns about efficiency It is well understood among agricultural mar- losses from market power are dissipated in keting professionals that a supplier’s reliability an environment of contract agriculture. Effi- is of paramount importance. Unreliable sup- ciency losses from adverse selection and moral pliers will not have selling opportunities in the hazard problems are also addressed through future. Thus, a supplier who fails to satisfy its contracts, creating the clear efficiency moti- at Libraries-Montana State University, Bozeman on March 20, 2013 customers’ demands in one period not only vation for contracts that many authors have foregoes profits in that period but also likely discussed. in future periods as well. How do contracts between farmers and mar- A dynamically optimal procurement strat- ket intermediaries affect the distribution of egy for such intermediaries is to secure ex ante, market surplus between them, and thus deter- through contracts or vertical integration, the mine farm income? This is the key concern requisite supplies of the farm product needed of many, and the reason that efforts to pro- to meet its sales commitments, but such firms scribe contracting practices have come to the have little or no incentive to procure prod- forefront in policy discussions. uct beyond those needs. These firms, too, have I address this question within a simple frame- right-angle input demands that become very work consistent with the aforementioned styl- inelastic at the quantity of farm product asso- ized facts. A buyer, i, has fixed demand to ciated with their fixed sales commitments. purchase Q¯ quantity of an agricultural prod- In an environment where transaction costs i uct.11 The variable V denotes the maximum are important, buyers will seek to limit these ij value of grower j’s production, Q , to buyer i costs by executing relatively few contracts, j (net of i’s costs).This value emerges if i and j are meaning they will seek to engage buyers who able to execute a contract for the production can reliably supply large quantities of the of Q . Contract provisions are assumed to be needed product, or they will seek to provide j flexible enough that Q is chosen to maximize these supplies internally through vertical inte- j the total surplus available in the transaction. gration. Further, transaction costs of engaging Let CS(Q ) denote grower j’s variable costs with repeat suppliers will likely be consider- j j L ably less than transaction costs of locating and of fulfilling the contract, and Cj (Qj) denote contracting with new suppliers. Accordingly, the total costs. Finally, Tij denotes the trans- an optimal procurement strategy for buyers action costs of i and j reaching an agreement, will be to attempt to secure the long-term patronage of a relatively small, stable group of high-volume suppliers.10 dominated on a transactions-cost basis by a strategy of procuring on an ongoing basis from a stable group of suppliers. 11 This demand would be limited by a reservation price, above 10 An alternative procurement model involving seeking raw which it would not be optimal for the buyer to operate. I ignore product on the “open market” at the best price would certainly be this consideration. 8 Amer. J. Agr. Econ. which depend upon whether a prior contract of securing the contract.12 This result is not relationship exists between i and j. due to any collusion among buyers, but, rather, The economic surplus to the transaction is purely to their ability to foresee the equilib- = − S − Sij Vij Cj (Qj) Tij.If rium to the contracting game among buyers and sellers. Any tacit collusion or “mutual for- ∀ = (1) Sij > Skj k i bearance” among buyers only reinforces this outcome.13 and the additional condition is met that j is an Although setting α = 0 meets a short-run par- optimal supplier to i in the sense that a suf- ticipation constraint, it is insufficient to retain ficient number of alternative suppliers do not the farmer’s patronage in the market in the exist, m, such that

long run. Yet it is likely optimal in a dynamic Downloaded from framework for the buyer to incentivize the ≥ ¯ (2) Smj > Sij and Qmi Qi seller to remain in the market in the long run. m Exit of its incumbent sellers would require the buyer to seek other sellers, either those then it is efficient for i and j to execute a serving other buyers or new entrants. Solicit- contract. ing incumbent suppliers to other firms would http://ajae.oxfordjournals.org/ What will the terms of this contract be? The raise transaction costs relative to contracting common approach to studying this contract with a stable group of suppliers, and engender would be to invoke a principal-agent frame- head-to-head competition with other buyers work with the buyer as principal and farmer and possible retaliation. Attracting de novo as agent, effectively giving the power to dic- entrants by incentivizing them to sink entry tate terms of trade to the buyer, subject to costs would require offering long-term con- meeting participation and incentive compati- tracts with payments sufficient to recover the bility constraints for the farmer-seller. I focus entrants’ capital costs. on the participation constraint that is crucial Thus, it will be optimal for buyers to offer at Libraries-Montana State University, Bozeman on March 20, 2013 to answering the question of distribution of sellers contracts that meet a long-run partic- economic surplus between the buyer and seller. ipation constraint, namely by offering α > 0 A necessary condition to satisfy the grower’s sufficient to insure that participation constraint is that the contract payment, Pij, at least covers the variable costs, (4) P ≥ Cl(Q ). S ij j j Cj (Qj) of producing Qj. We can thus express the contract payment to j by i as follows: A contract that satisfies (4) gives the farmer at least a long-run normal rate of return on (3) P = CS(Q ) + αS ij j j ij investment, that is, the long-run equilibrium return for a competitive firm. The difference is that is, j receives payment for his variable costs, that receipt of this rate of return in this con- plus a share 0 ≤ α ≤ 1 of the surplus generated α = text is not due to long-run adjustments in a from their transaction. Setting 0 is not suf- competitive market but, rather, to an optimal ficient to meet j’s participation constraint if j is dynamic procurement strategy for a buyer who able to obtain a competing offer that earns a α = may hold considerable oligopsony power, but surplus above his variable costs. Indeed, 1 also has a substantial investment of sunk costs in the equilibrium in a competitive market due and a long-term commitment to the industry.14 to competition among buyers to procure the However, not all farmers need receive con- product. tract offers in this model.A seller who does not The model sketched here lacks sufficient structure to predict formally whether such an offer is forthcoming in equilibrium. However, 12 The model’s prediction that sellers do not switch to different if we attribute positive transaction costs to the buyers is easily reversed by introducing the possibility of market- act of seeking buyers and offering contracts, and seller-specific shocks to the model that are sufficient to disrupt the matching between buyers and sellers. and if conditions (1) and (2) hold, it would not 13 Fear of retaliation for “poaching” another firm’s suppliers be rational for any other buyers operating in provides a rational basis for mutual forbearance. the market to offer a contract to j because (i) it 14 These capital investments represent a credible commitment or “hostage” in exchanges between farmers and buyers such that each would be costly to do so, and (ii) the equilib- party to the transaction has a significant sunk asset involved–the rium outcome is for buyer i to bid sufficiently marketable farm product in the farmer’s case and, for example, the processing facility in the case of a food processor. The mutuality to secure this contract. Other bidders would of this arrangement protects both sides in the transaction from expend transaction costs with no rational hope opportunistic behavior (Williamson 1983). Richard J. Sexton Market Power, Misconceptions, and Modern Agricultural Markets 9 satisfy condition (2) for at least some buyer buyers is a public good from the collective per- L spective of the buyers, and the preservation of will be excluded. To the extent that Cj (Qj) this capacity is subject to free riding. Buyers embodies economies of size,and Tij is relatively independent of size such that the average trans- will exercise whatever short-run market power action cost is declining in output, producers they have in this environment because they excluded from this market will be those con- internalize at most only the portion of the long- strained for whatever reason to produce at a run negative consequence of a drain of capital smaller scale. from the industry equivalent to their share of The equilibrium in this market with contract the market, or they internalize none if they dis- procurement is not easy to reconcile with the count the future enough. In contrast, firms in the stylized contract market fully internalize spot-market equilibrium of a market-power Downloaded from model such as discussed earlier in this paper. the benefit of maintaining the production of In general, buyers have no incentive to dis- their suppliers in the long run. tort sellers’ outputs in this model, and sellers’ The irony then is that most critics of mod- earn at least a normal or competitive return ern agricultural markets may have it just on their investment,although they may capture wrong;they criticize and try to restrain contract relatively little of the economic surplus gener- exchange and exalt spot markets. Examples http://ajae.oxfordjournals.org/ ated by their production. Sellers also seldom, include attempts in prior farm bills and cur- if ever, receive a competing offer for their pro- rent legislation to mandate that a minimum duction, an outcome fully consistent with the fraction (generally 25%) of a buyer’s livestock frequent producer complaint of lack of com- purchases must be made in the spot market, petition among buyers to procure his produc- the recent regulatory restrictions on livestock tion. Is there buyer market power in this type contracting proposed by the U.S. Depart- of procurement setting? If there is, it cannot ment of Agriculture, Grain Inspection, Packers be quantified using the traditional approaches & Stockyards Administration (GIPSA), pro- such as the flexible oligopoly/oligopsony model posed legislation to ban packer ownership at Libraries-Montana State University, Bozeman on March 20, 2013 discussed earlier in the paper. of live animals, and proposed legislation to severely limit contract provisions. The GIPSA What Happens When the Model Doesn’t regulations would have required standardiza- Apply? tion and uniformity of animal procurement practices, prohibited “paying of a premium or This model does not predict that an oligop- applying a discount... without the reason(s) sony/monopsony market will pay farmers as and substantiating the revenue and cost jus- much as or more than a competitive market in tification associated with the premium or dis- all settings. The equilibrium emerges because count,” and required that processors “maintain buying firms produce differentiated products, written records that provide justification for require vertical coordination through contracts differential pricing or any deviation from stan- with significant transactions costs,and are com- dard price or contract terms offered to poultry mitted to a future in the industry due to their growers, swine production contract growers, or own sunk investments. In settings where the livestock producers,” (75 Fed. Reg. 119 2010, future matters less and vertical coordination p. 35351). The Livestock Marketing Fairness is not an issue, all of the well-known concerns Act before Congress now contains many of the about exercise of buyer power would apply. same provisions. Thus, for example, an itinerant trader purchasing a staple commodity from smallholder farmers in a developing country will likely exer- Conclusions cise any short run buyer power he has, whereas a beef packer, wine maker, and fruit processor Agricultural markets throughout the world in the United States likely will not. have undergone a rather dramatic transforma- The exercise of buyer market power can tion. It is marked by consolidation and mar- drive returns to farmers’ investments below the ket domination by large processing, trading, competitive rate and cause farming resources and retailing firms,disappearance of traditional to exit the industry to the long-run detriment auction or spot markets for exchange of farm of buyers of farm products. However, in a products, and their replacement by various spot-market environment where there is no forms of contracts and vertical control, and a matching of buyers and sellers, the availability growing emphasis on product differentiation of productive capacity on the farm to supply and increasingly broad dimensions of product 10 Amer. J. Agr. Econ. quality. This paper has summarized some of Imperfectly Competitive Market:Applica- these changes and discussed their implications tion to Mechanical Harvesting of Process- for public policy and how we study agricultural ing Tomatoes in Taiwan. 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