How Markets Coordinate Decisions

By Wayne D. Purcefl

M Coordination of economic activities year create time . The Mm from producer to consumer is im- wants the product on a yearround basis. •^ portant. If what is produced is not If the consumer is willing to pay for consistent with what is being demanded them, the system will provide the by , valuable resources are time-related services. not used in the best way. Producers, consumers and middlemen could benefit If the market system offers the con- from changes which brought improved sumer a product form inconsistent with coordination. A market system is like a consumer , the "assembly line" is complex assembly line. The farmer starts not working very well. The optimal level the process by producing the basic raw of coordination between and material. is not being achieved. Changes need to be made. How the As the raw material moves up through changes are prompted depends on the the system, it is processed to meet de- way the system is organized. For most mands of the final consumer. Form util- , the production-marketing ity, where utility equals satisfaction, is system is characterized by separate being created by changing the product to ownership of each stage of economic ac- make it acceptable to the consumer. The tivity. Negotiated become impor- amount of processing varies among com- tant. signals come from buyer-seller modities, but consumers are increasingly negotiations along each interface where willing to pay for the services required to two stages of economic activity merge. It create form utility. Ready to cook broil- is these price signals that bring coordina- ers are acceptable to consumers — a live tion. chicken is not. Consumers can start the process by buy- Market systems also create place and ing more aggressively a particular prod- time utility. The processed food or fiber uct or quality within a product line. As product is moved to a place where it is consumers compete for the available sup- readily accessible to the consumer. The ply, price gets "bid up." Retailers bid modem supermarket, with its wide array higher prices to wholesalers in an at- of products, emerged because the con- tempt to get more of the product which sumer looks for convenient access to is moving well. Wholesalers bid higher to products and services. Storage of the the processors from whom they buy — nonperishable product and canning, fireez- and the process is continued until the ing and other methods of making perish- price signal, a price premium in this in- able products available throughout the stance, reaches the producer. Theoreti-

Wayne D. Purcell is Professor of Agricultural , Virginia Tech, Blacksburg.

151 cally, the producer reacts to this price "work station" in that assembly line. signal by reallocating resources and pro- Thus they do not see interstage coordi- ducing more of the preferred product or nation as something they should worry the preferred quality. Coordination be- about, and make no attempt to work with tween what is demanded by consumers others in the system. and what is provided is restored. Price discounts reverse the process and en- Cutability and courage producers to offer less of a par- If a system of price signals is to be ticular product or quality. effective, the available grades or de- scriptive terminology used in negotiating Obstacles — The process is obviously prices must be adequate. All significant more complex than a simple assembly and discernible differences in value must line which has an overseer to observe be identified and categorized by grades the level of interstage coordination being and the grades must be widely used by achieved. Price signals follow a long and all buyers and sellers. A price signal complicated path and there are obstacles cannot be attached to a product attribute along the way. Among those obstacles which is not identified. which have been identified in the re- search literature are: Goal conflicts at the As an example, consider the situation in interface where buyer and seller must in- the beef complex prior to the initiation teract; absence of any perception of a of yield grades. Quality grades (Prime, total system; inadequate gi'ades and re- Choice, Good, etc.) were being used as lated descriptive terminology; and lack of a measure of palatability. But within the competition on a price basis. Choice grade, beef carcasses of compa- rable weight could vary significantly in Buyer and seüer have a most legitimate value because of different ratios of lean conflict of interest. Sellers want high and valuable cuts to total carcass prices, buyers want low prices. But the weight. Price signals could not be ex- goal conflicts encountered sometimes go pected to motivate changes toward high beyond the legitimate arena. For exam- cutability cattle (high ratio of lean to tot- ple, producers will often try to maximize al carcass weight) by producers when output — yield per acre, weight per head cutability was not being brought into the at weaning time, etc. This may or may process. A set of grades which not meet the needs of the processor w^ho allows all important value-related prod- is looking to the producing sector for a uct attributes to be brought into the timely flow of raw material of a certain pricing process is a necessary condition and consistent quality. If processors to high levels of coordination between could control what is being done at the what is being produced and what is in producing level, they would often do it demand at the consumer level. differently.

Participants in the production-marketing system often do not perceive of them- selves as part of an overall system. They Today's supermarket has a wide array of do not see the "assembly line" at work products thai are avaiiabie on a year-round and do not see what they are doing as a basis.

152 753 Absence of competition on a price basis most food and fiber systems often gets can block transmission of price signals. in the way. For example, a wholesaler might recog- nize the higher bid from a retail chain for Along the vertical continuum from pro- a particular and simply ducer to consumer, tremendous differ- absorb it in the form of a wider operat- ences in the economic structures prevail. ing margin instead of passing it to his The modem retail chain is part of an in- supplier. A high level of competition, dustry sector organized as what which encourages the "passing on" of economists might call an . the price premium, is important. There are a few large firms. These firms tend to compete by spending huge sums The cutability issue in cattle provides an of money on advertising. A particular interesting illustration. Since 1975, all firm reacts to the competitor's price beef carcasses which are quality graded specials by also running price specials to must also be yield graded (or vice ver- "offset" impar; of the other firm's adver- sa). Yield grade 1 is attached to carcass- tising program. You can be sure the es with the highest ratio of lean cuts to manager of a supermarket in a particular total carcass weight, and yield grade 5 market keeps a close eye on newspaper identifies low cutability carcasses. Yield ads of the competition. grade 3 is the average or "par" carcass. The market is currently attaching a price Sticky Prices Fail to Do Job discount, often substantial, to yield Except for this type of retaliatory price grades 4 and 5. But there is little or no competition in the newspapers, retail visible evidence of a premium being paid prices tend to be "sticky" and slow to for yield grades 1 and 2 — and there change. Changing prices is costly to the are usually as many I's and 2's in a pen supermarket and irritating to the final of cattle as there are 4's and 5's. There consumer, so retailers hold the line on is room for an hypothesis that the level prices and let them go up over time in a of competition is not adequate to "force" stairstep fashion. Such an approach does the paying of premiums for I's and 2's. not do much to help the probability that price signals will turn out to be effective The is actually a com- messages in a communication system. munication system. If high levels of ver- tical coordination are to be achieved, the "Middlemen" tend to operate in a similar system must "communicate" effectively organizational structure. There are a to producers. The few, large firms in any particular market must be an effective overseer of the area. There is price competition, but systemwide assembly line. Economic in- these large firms (flour mills, cotton centive in the form of price signals must merchants, grain exporters, vegetable replace the verbal communication the processors, meat packers, etc.) have at overseer of an assembly line uses to make sure inter-stage coordination is achieved. Achieving effective levels of WhBat haulBd to a ¡ocal e/euaíor, such as this communication is no small assignment. one in $t John, Wash., brings the posted bid price for that day with premiums or discounts Even if all other obstacles are over- for protein /eve/, moisture, foreign matter, come, the organizational structure of etc.

154 least a degree of — the run as the firm wields an element of capacity to influence price or other market power. Needed resource reallo- terms of . The goal is often the cation is blocked or slowed. realization of a certain gross margin per head, per ton, etc. Price Takers — Skipping down to the producer level, the operating structure When a limited supply of raw material changes completely. The norm here is forces the processor's procurement cost many small producers, approaching con- up, this might simply mean taking a ditions economists call pure competition. smaller margin than desired for a few The individual is a price taker, not a price weeks. But when raw material is in maker. Price is determined at the aggre- abundant supply, the large processor gate level by interaction of demand and tends to "get even." Operating margins supply and the producer sells, on any are allowed to increase, at least for a particular day, at the prevailing price. A limited time, as the price of the raw ma- truckload of wheat hauled to the local terial is forced lower. Any price signals elevator brings the posted bid price for which enter this operating arena from that day with premiums or discounts for higher up in the system may be totally protein level, moisture level, foreign concealed or even reversed in the short matter content, etc.

J55 Price for raw material at the producer effective this approach will be in prompt- level is a derived price, reflecting ing alinement between what is produced essentially value at the consumer level and what is demanded depends on ability less the sum of the operating margins of of the processor to interpret what is all middlemen. And since the middlemen needed at the consumer level, get this have at least some element of market reflected in a contract, and offer an in- power, the price to the producer does centive which will motivate producers to not and will not vary directly with change. changes in value at the consumer level. Add to this the complicating influence of Buying and selling by description can en- extreme price variability at the producer hance the effectiveness of price signals. level and it is easy to see why some The emerging electronic marketing sys- researchers have questioned the effec- tems, where buyers bid or buy over tiveness of the price mechanism as a computerized or other electronic sys- communication system. If there is con- tems, must consistently use a complete cern about the effectiveness of that com- and detailed set of grades or other de- munication effort, then there must be scriptors. Insofar as price differences are concern about the level of vertical coor- clearly related to differences in identified dination being achieved. product attributes, the producer is better able to "sort out" and see the message Contracts Supplement Signals inherent in the prices because of the in- Relying on the communication processes creased visibility and importance of of the price mechanism is not the only grades. way to get vertical coordination. The alternatives range from approaches which supplement the price mechanism to ver- tical integration, a way of organizing which replaces price signals with man- agement directive. Contracts can be used to supplement price signals. Say a pro- cessor is having difficulty getting a con- sistent flow of high quality raw material. Contracts with producers which specify quality standards, indicate time of deliv- ery, and offer appropriate economic re- wards for compliance can help. Such approaches are widely used throughout agriculture, but are especially prevalent in the ôxiits and vegetables sector. How

Almost all broiler production is in the hands ol integrated firrrts. Chicl(ens are hatched, led, processed, packaged, and made ready for retail by one iirm. Tfiese broilers are feeding on a special formulated and mixed feed in IHississippi.

Í56 Vertical integration is at the other end of Types of Efficiency — In discussing im- the continuum from the open exchange plications of various ways of achieving systems. A type of vertical coordination, vertical coordination, it is useful to recog- it involves the bringing of two or more nize that analysts of marketing systems stages of economic activity under the talk about two types of efficiency. Tech- ownership and control of a single busi- nical efficiency deals with the cost of ness entity or management. Management doing a job. The ratio of useful output to directive replaces price signals as a inputs gives a mental picture. Other con- means of coordination. Management in siderations equal, a higher level of tech- the processing arm of the business sim- nical efficiency would be desirable. There ply passes the specifications for raw ma- is evidence in the research literature that terials back to the producing arm of the the vertically integrated system can business. Within technological and cost achieve higher levels of technical efficien- limitations, quality and timing of product cy than an open market exchange sys- flow are controlled and there are no visi- tem. This is consistent with the oppor- ble, negotiated prices. Vertical integra- tunity to specify raw material attributes tion is not unusual in fruits, vegetables, and control the flow of those raw and grains. And almost all broiler produc- materials. tion is in the hands of integrated firms. The chickens are hatched, fed, proc- The second type or form of efficiency is essed, packaged, and made ready for re- pricing efficiency. High levels of pricing tail display by one firm. efficiency suggest that what is being pro- duced is consistent with what is demand-

157 ed by consumers. Pricing efficiency, sidering the position of a processing firm. therefore, is a measure of the system's If the system does not generate a con- communication effectiveness. In a verti- sistent flow of raw materials of accept- cally integrated system, the ability to able quality, the firm has a difficult time "match" what is produced with the de- meeting orders from its customers. A mands of consumers is constrained only variable flow of raw materials is sure to by management's ability to decipher increase the per unit costs of processing. those consumer , by the avail- Labor, for example, is either overworked able technolog>^ and by the cost-benefit or underworked depending on the flow of ratio of making changes to maintain aline- raw materials into the plant. In the short ment with consumer demands. But this run, therefore, failure to coordinate can does not mean society would necessarily mean poor alinement between what is benefit from moves to vertical integra- produced and what is demanded by con- tion. sumers and increased costs of the final product at the consumer level. The net benefits of vertical integration are perhaps impossible to measure. Since Over a longer planning horizon, failure to price negotiations are effectively elimin- coordinate has significant cost implica- ated, what are the implications to society tions. Continuing to use the processing of the disappearance of previously firm as an example, the type of plant observable prices? And if integrating which is planned and constructed will means larger size and the possibility of vary with anticipated problems in raw increased market power, what are the material flows. If a hightly variable flow is implications to society? Leaving these anticipated, the plant must be flexible in issues for another forum, this chapter temis of daily or weekly quantity it can will focus attention on the current and handle. A flexible plant will be less effi- pending interplay between open ex- cient in a technical sense than a plant change systems and vertically integrated which can be designed for a particular systems. For purposes of discussion, it operating volume and a stable flow of is useful to hypothesize that failure of the raw materials into the plant. Over time, price mechanism, in an open exchange the reduced efficiency and higher costs system, to achieve high levels of vertical get passed on to the consumer in the coordination will prompt moves to verti- form of higher product prices. cally integrated systems. Let's look at some reasons why this might occur. In a short and long run context, there are economic incentives for higher levels Short and Long Run Impact of vertical coordination. If the exchange In the short run (within a year), failure of system and the price mechanism do not the marketing system to achieve high generate acceptable levels of coordina- levels of interstage or vertical coordina- tion, pressures for vertical integration tion are costly to society in general and emerge. Everyone, from producer to to the individual firm. Consumers are de- consumer, has a stake in what type of nied access to preferred products and/or system we will see and the level of coor- qualities at the levels and with the dination realized. More widespread consistency they would prefer. Impact on understanding of how markets coordinate the individual firm is best seen by con- decisions would help.

158