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Summary of Report

Vertical Coordination by Food Firms Rising,
Along with Contract Production

AIB-720, June 1996

Contact: Steve Martinez, 202-694-5378, martinez@ERS.USDA.gov

If recent trends in the U.S. food industry continue, food production may be increasingly dominated by firms exercising control over several stages of food production, according to From Farmers to Consumers: Vertical Coordination in the Food Industry, a new report from USDA's Economic Research Service.

Vertical coordination refers to the way products are acquired or traded in a market. This report examines the various forms of vertical coordination, and looks at its future, including its implications for market control and environmental protection.

There are three basic types of vertical coordination that a firm can exercise:

  • Open production. A firm purchases a commodity from a producer at a market price determined at the time of purchase.
  • Contract production. A firm commits to purchase a commodity from a producer at a price formula established in advance of the purchase.
  • Vertical integration. A single firm controls the flow of a commodity across two or more stages of food production.

The food industry has traditionally operated in an open production system. However, more discriminating consumers, plus new technological developments that allow farm product differentiation, are contributing to a decrease in open production and an increase in contract production and vertical integration.

Also fueling this trend are changing demographics and the increasing value of homemakers' time, both of which have contributed to consumer preferences for a wide variety of safe, nutritious, and convenient food products.

Providing food products with specific characteristics preferred by more discriminating consumers will likely involve increasingly more detailed raw commodity products, such as a frying chicken of a specific weight and size, or a corn kernel with a specific protein content. This effort to carefully tailor raw commodities with processing in mind is already underway in some food industries, accompanied by changes in vertical coordination.

Any trend toward contract production and vertical integration, as opposed to open production, implies that firms at one stage of production exert more control over the quality of output at other stages.

For example, pasta processors who prefer a specific type of wheat for a specific type of pasta gain control over planting decisions or seed selection that were previously made by farmers who sold their wheat on the spot market. Farmers are compensated for relinquishing control through bonuses for quality and through reduced uncertainty.

Recent changes in vertical coordination have been accompanied by an increase in concentration in the food sector. These developments have raised two primary policy concerns: market power in the processing sector and environmental protection.

Changes in vertical coordination and increased concentration in the food sector can allow a small number of firms to affect prices or other terms of trade. Because of the changing nature of vertical coordination, new methods and data may be needed to accurately monitor food industry concentration. On the environmental front, the growth of massive livestock operations has increased the potential for environmental degradation and the need for technological and policy solutions.


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