Industrialization and Contracting in U.S. Agriculture

Journal of Agricultural and Applied Economics, Aug 2005 by Ahearn, Mary Clare, Korb, Penni, Banker, David

This paper examines the industrialization process of U.S. agriculture by examining the trends in the number of farms, the concentration of production during the last decade, and the dynamics of farm survivability, entry, and exit underlying aggregate statistics. We next examine vertical coordination as part of the industrialization process and highlight contracting in the poultry industry. The analysis provides evidence that production is continuing to be concentrated on a smaller number of farms at a relatively rapid rate, in spite of the stability in the number of farms. Although contracting clearly dominates the broiler industry, it is less prevalent in egg and turkey production, where other forms of vertical coordination are likely established.

Key Words: broilers, contracting, eggs, industrialization, poultry, structural change, turkeys, vertical integration

JEL Classification: D23, D40, L11, L14, L22, L23, Q12

The industrialization of U.S. agriculture has been documented for some time (e.g., Drabenstott). The industrialization has been, at least in part, motivated by more specific demands of consumers requiring a tighter supply chain to adequately respond. Major features of this tighter supply chain include greater concentration of production on a decreasing number of farms, more vertical coordination in the system, and significant concentration downstream from the farm. While the total number of farms has been remarkably stable for decades, this has been true because of the sustainability of very small farms. The endurance and growth of small farms result from the investment opportunities and the amenities they provide to their owners and communities, and are distinct from the industrialization process.

The increasing concentration of production in an industry is a longstanding public policy interest because it is not obvious whether this concentration is the desirable result of cost efficiencies in production or the undesirable result of market power on the part of various players in the supply chain (Williamson). Traditionally, concentration in production is a concern when a very few firms, e.g., four, control a significant share of the market. For this reason, most empirical applications on market power in U.S. agriculture are focused on meatpacking and, for example, the role of captive supplies (Azzam; Azzam and Anderson) because the processing sector of the supply chain is significantly more concentrated than is the farm production sector.

A related public policy issue is raised with respect to one approach to more vertical coordination in the supply chain, namely, contracting between farmers and downstream processors. For example, Perry, Banker, and Green reported that, for broilers which are largely produced under production contracts, the top 10 processing firms controlled two thirds of broiler processing in 1997. Empirical applications, where contractors operate in a concentrated processing industry while farmers operate in a sector with many other producers, include the analysis of the effects of individual clauses in contracts. (For example, Xia and Sexton analyze top-of-the-market pricing in cattle to evaluate whether the clause is due to efforts by contractors to exploit market power or to capture efficiencies.) The farm production component of the supply chain is not a highly concentrated industry in a traditional industrial organization sense; in fact, it is still used as a textbook example of a perfectly competitive industry. However, because of the institutional context of farm policy, there is a longstanding interest in family farms and an interest in tracking how farm production is concentrated among farm firms. Hence, concentration is a relative term and can take on different meanings, depending on which sector of the supply chain is of interest.

Questions relevant to the issue of the industrialization process in agriculture are: Why do farmers choose to contract? Why is certain commodity production concentrated in select states? And, why do processors locate in select states? Although these questions are generally addressed independently, they are likely interrelated. For example, if markets are incomplete locally, contracting may be the only option available to a farmer in that locale. Applied economic literature has largely explained the observed farmer adoption of contracting ex post. The principal-agent model is the most common economic framework employed to consider why individual farmers contract. This framework can address the two most commonly cited reasons for parties entering into contracts, namely risk management and minimization of production and/or transaction costs. Empirical research is mixed on which is most important.1 McBride and Key analyzed the choice of hog farms to contract or not contract and found important increases in productivity resulted from contracting in the hog sector, compared to independent production. Some of the literature is focused on how specific terms of contracts affect their performance. In studies of the poultry industry, Knoeber and Knoeber and Thurman found that the terms of broiler contracts could be explained largely by the incentives to produce more efficiently. Growers are often rewarded based on relative performance, i.e., relative to other growers. In an aggregate analysis of how contracting has affected productivity of the U.S. farm sector since 1978, Ahearn, Yee, and Huffman found that the use of production contracting had a small but positive influence on the productivity of the sector.