No. 104 - Opportunities and Benefits from Pork Industry Reorganization (Summary)

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OVERVIEW

Changes in consumer demand for pork products over the past 20 years have led to rapid changes in the way hogs are produced and marketed. Vertical integration--in which successive stages of production and distribution are placed under the control of a single company--and virtual integration--when processors choose to use qualified suppliers who ensure the availability of at least a portion of their needs with known quality--are two of the most pervasive and controversial changes. This analysis finds increased integration in the pork industry benefits hog producers, consumers, and processors. Production and marketing contracts are helping many small and mid-sized producers better manage risk while gaining access to the capital and markets they need to remain competitive. Well-intentioned policymakers should leave well enough alone.

1. Changes in consumer preferences are forcing the pork industry to reorganize.

Five trends are having large impacts on the demand for pork products:

• Consumers no longer accept that certain foods will be more available in some seasons than in others.

• Consumers want food that takes less time and effort to prepare.

• Consumers prefer branded food products over unbranded products.

• Consumers are increasingly aware of and concerned over food health and safety issues.

• Consumers eat a rising portion of their meals away from home.

2. Hog farmers are becoming increasingly specialized, enabling them to develop core competencies that make them more efficient than yesterday’s farmers and ranchers.

Farmers and ranchers are sometimes viewed as remnants of the pre-specialization era, a time when families and small independent firms produced goods and services for their own use or for small local markets. But mechanization has changed the face of farming in the U.S., reducing manpower needs and increasing economies of scale. With mechanization and consolidation has come greater specialization. Large hog production operations now may be owned and operated by individuals with advanced skills and training in business management who employ workers who specialize in certain tasks, such as breeding, feeding, facilities maintenance, and transporting hogs. Smaller hog production operations may specialize in supplying small pigs to other producers, or feeding hogs born on another farm. Others, either big or small, may choose not to own the hogs, but to raise hogs owned by others.

3. The pork industry has become more vertically and “virtually” integrated in order to respond to consumer demands and capture the benefits of producer specialization.

Vertical integration refers to the extent to which successive stages of production and distribution are placed under the control of a single company. Vertical integration allows a firm to capture profit opportunities up and down the supply chain as well as minimize or control risks associated with supply interruption or unreliable quality from suppliers. Because it typically operates on a larger scale, the vertically integrated company can negotiate higher prices from retailers, benefit from direct-to-consumer advertising campaigns for its brands, and get capital at lower cost through equity markets.

Offsetting these advantages are some disadvantages, including less information from competitors and producers outside the firm; loss of ability to make and execute decisions quickly; and in some cases (e.g., antitrust), subjection to rules and regulations that do not apply to smaller companies.

Virtual integration occurs when processors choose to use qualified suppliers who ensure the availability of at least a portion of their needs with known quality. Some of these networks are large and driven by price and volume considerations. Others are smaller, more tightly aligned supply networks that limit participation to producers who have agreed to meet specific guidelines for production to meet consumer demands for niche products, such as “organic” or antibiotic-free pork. Hog operations owned by processors account for almost 25 percent of the total number of hogs produced. Some 28 percent of all hogs are produced by a vertically integrated entity, either a supplier or a packer.

4. Integration benefits pork consumers and creates new opportunities for pork producers to profit and manage their risk.

Vertical and virtual integration exist side-by-side in the pork industry today. Vertically integrated companies often contract for some of their supply and enter into marketing agreements with other firms. Both types of integration have been shown to produce significant efficiency gains resulting in higher quality products and lower prices for consumers.

The biggest benefit of virtual integration is that it allows meat processors to focus on their core competency, which is meeting the needs of their customers: retail food stores, restaurants, and the food service industry. Raising livestock requires different skills, which producers have acquired in increasing amounts over the years. Tapping the expertise of specialized producers requires that processors surrender some control over the production process and rely on others to supply live animals.

Producers who choose to raise hogs owned by others substantially reduce the cost of capital and eliminate market price risks. As long as they can maintain production volume and efficiently produce hogs for the contracted amount, they can make money.

5. Some advocacy groups and elected officials claim recent changes in the industry’s organization threaten consumers or producers. This analysis found little basis for such fears.

There is little doubt production contracts have made hog farming more efficient by allowing producers to focus on what they do best and giving them access to the capital they need to buy new, state-of-the-art facilities. A 2003 study by the USDA Economic Research Service found, “The rapid and widespread growth of contract hog production has substantially raised productivity in the industry. On average, contracting raises total productivity by 20-23 percent and by as much as 50 percent for some inputs.”

The USDA study also found, “The trend toward fewer, larger, and more productive hog operations will likely continue into the foreseeable future. Many of the highest cost hog operations are small, independent operations, operated by older producers who plan to soon exit the hog industry. The lowest cost operations are mostly large, produce under contract, and are operated by younger producers with newer facilities.”

Some contract producers express concern over the market power of producers, the transfer of risk and liability to producers, and whether the contract relationship is being used by contractors to avoid tax, wage, and tort liabilities they legally ought to bear due to the large investments and exclusive nature of the contracts they have producers sign. Some contracts used by some marketers and processors are probably written in ways that do raise these issues, but such practices do not appear to be widespread.

Nevertheless, producers themselves are generally satisfied with being part of an integrated industry. A 2004 study of the structure of the pork industry by Glenn Grimes et al. reported that contract growers rated their contracts an average of 4.9 on a scale of 1 to 6, with 6 being very satisfied. Contractors (the owners of the hogs) rated the contracts at 4.6, even though many have suffered significant losses over the past five years. Producers who are not contractors or contract growers rated contracts at 3.7.

Most production contracts are for four to five years. When contract producers were asked what they would do when their current contract expires, 80 percent said they would attempt to renew their contract with the current company. Only 9 percent said they would attempt to go with a different company, and 4 percent said they would go independent.

6. Regulations that prohibit or curtail the use of production and marketing contracts would be detrimental to all market participants.

Concerns about consolidation in the pork industry, unequal bargaining power, poorly written contracts, and inadequate dispute settlement procedures have led members of state legislatures and the U.S. Congress to propose legislation to more heavily regulate the industry. These laws would limit packer ownership of livestock (to limit or prevent vertical integration) and regulate the content of production and marketing contracts used in virtual integration.

Efforts to restrict vertical integration by banning packer ownership of livestock are unnecessary and likely to be counterproductive. Vertical integration is a reasonable business response to consumer demands for reliable quality, branded products, adequate year-round supplies of products, and other trends identified in this analysis.

There is no evidence that packer ownership of livestock is inhibiting competition or leading to higher prices for consumers. A recent study by eight agricultural economists found, “none of the impacts [associated with contracting] have approached what the Department of Justice and Federal Trade Commission use as a regulatory standard to assess non-competitive behavior.”

Poor drafting and less-than-adequate understanding of contracts can lead to risk transfers that are not apparent until a quality or quantity issue arises. In response to this possibility, at least six major agricultural states, including the major hog production states of Illinois, Iowa, and Minnesota, have passed laws that establish minimum requirements for agricultural contracts.

It is tempting to endorse industry-specific legislation in the name of advancing clarity and fairness, but common law and statutes already on the books prohibit fraud and misrepresentation. Moreover, legislation that is industry-specific--designed to produce greater “clarity and fairness” in hog production contracts, for example--often restricts entry or benefits insiders, who economists call “rent seekers.” The valid interests of small producers should not be used to disguise legislation that actually seeks to prohibit or curtail the use of contracts.

Based on “Opportunities and Benefits from Pork Industry Reorganization” by Ross Korves, Heartland Policy Study #104 (Chicago, IL: The Heartland Institute, October 2004). Printed copies of the 20–page study are available for $10 each; the full text is also available on The Heartland Institute’s Web site in Adobe Acrobat PDF format.. Permission is granted to reprint or quote from this Executive Summary, provided appropriate credit is given.

© 2004 The Heartland Institute. Nothing in this Heartland Executive Summary should be construed as reflecting the views of The Heartland Institute, nor as an attempt to aid or hinder the passage of legislation.

Questions? Contact The Heartland Institute, 19 South LaSalle Street #903, Chicago, IL 60603; phone 312/377-4000; fax 312/377-5000; email think@heartland.org; Web http://www.heartland.org.