Cattle prices go down as consumer beef demand declines due to decreasing beef quality, and risk increases. That's what happens when you try to legislate the market.
Specifically, that's what would happen if Alternative Marketing Agreements—basically anything that isn't a cash trade in the spot market—were restricted, according to the recently concluded $4.5 million dollar GIPSA
Livestock and Meat Marketing Study. It was conducted by RTI International for USDA at the behest of the industry, including the National Cattlemen's Beef Association (NCBA).
“During debate of the 2002 Farm Bill, concerns from producers about packer concentration led NCBA members to ask Congress to study the livestock and meat marketing complex,” explains John Queen, NCBA president. “In 2003, Congress authorized $4.5 million to conduct an independent study of the livestock and meat marketing complex and provide a report that would be the definitive answer on this issue.”
In sum, the cattle portion of the study concludes that if Alternative Marketing Agreements (AMAs)—including packer-owned fed cattle, formula pricing and forward contracting—were reduced or eliminated feeder cattle producers, feedlots and packers would all make less money, while the consumer would pay more for a product of less quality.
“The cost savings and quality improvements associated with the use of AMAs outweigh the effect of potential oligopsony market power,” says the report. “In model simulations even if the complete elimination of AMAs would eliminate market power that might currently exist, the net effect would be reductions in prices, quantities and producer and consumer surplus in almost all sectors of the industry because of additional processing costs and reductions in beef quality. Collectively, this suggests that reducing the use of AMAs would result in economic losses for beef consumers and for the beef industry.”
Try this on for size, researchers—some of the top agricultural economists in the nation—simulated both a 25 percent reduction in AMAs and the complete elimination of them.
When AMAs were reduced by 25 percent, what is termed producer surplus—basically what would be compared to what could have been—decreases by an estimated $1.9 billion and consumer surplus decreases by an estimated $0.4 billion in the short run. Consumer surplus decreases because consumers would have to pay more, yet no one in the production chain would be making any more. By year 10, producer surplus declines by an estimated $0.7 billion and consumer surplus declines by an estimated $0.2 billion.
In the scenario where AMAs are eliminated, producer surplus decreases by an estimated $10.5 billion and consumer surplus decreases by an estimated $2.0 billion in the short run. By year 10, producer surplus declines by an estimated $4.0 billion and consumer surplus declines by an estimated $0.8 billion.
According to these simulations, salt in the wound comes with the fact that any market power such restrictions would take away from packers would be overwhelmed by other economic losses.
“The positive effect of reduced potential oligopsony market power that might result from restricting AMAs is unable to offset the negative effects of increased processing costs and reduced quality associated with restricting AMAs. In describing these results, it is important to note that the economic incentives associated with using individual types of AMAs by individual industry participants may differ from the results for the industry as a whole,” say the researchers. Oligopsony is basically the condition that exists when there are a relatively small number of participants who control a relatively large proportion of market share.
The study includes prices for fed cattle during the October 2002 through March 2005 period. The survey data are from 293 beef cattle producer and feeder responses and 64 beef packing plant responses across a range of sizes. The purchase data represent all purchases of fed cattle by 29 of the largest beef packing plants during the time period and include 58,066,440 head sold in 591,410 transactions. This is also the first industry study to include actual Profit and Loss data from the packing industry.
Furthermore, approximately 60 percent of the transactions were either cash or direct trade. The AMA cattle represented about 40 percent of the transactions—marketing agreements (29.5 percent); forward contracts (4.2 percent); packer-owned (less than 5 percent). Thus the focus of the study on how AMAs affect the market.
Marketing Agreements Decrease Cost—Increase Quality
“The direct cost savings from AMAs is approximately 0.9 percent of Average Total Costs, or approximately $1.22 per head,” says the study. “Packers also experience additional cost savings from reduced variability in cattle supplies ($1.70 per head) and increased slaughter volumes ($3.56 per head) at packing plants. The total cost savings associated with AMAs is approximately $6.50 per animal. For an industry with an average loss of $2.40 per head during the 30-month sample, this is a substantial benefit.”
According to the study, feedlots identified cost savings of $1 to $17 per head from improved capacity utilization, more standardized feeding programs, and reduced financial commitments required to keep the feedlot at capacity. Both feeders and packers agreed that if packers could not own cattle, higher returns would be needed to attract other investors and that beef quality would suffer in an all-commodity market place.
In fact, states the report: “Beef producers said that cattle quality would suffer in an all-cash market environment because it is more difficult to control quality when using the cash market rather than using long-term or forward contract arrangements. Although many believe it is possible to purchase quality cattle in the cash market, they also believe that the quality of cattle procured in the cash market is more variable… Some producers stated that they need formula sales under a marketing agreement to obtain premiums for producing cattle for customized buying programs. Packers said the ability to obtain quality cattle under AMAs was a much stronger incentive than issues related to procurement costs. Because beef product buyers are demanding higher quality products, packers use AMAs to ensure that cattle purchased meet the quality standards needed to meet buyer requirements for beef products…”
In other words, decrease quality and consistency, and you decrease beef demand.
“Consumer demand for meat is affected by the use of AMAs if those arrangements allow for the production of higher quality products and/or sale of beef products at lower prices. Based on the analysis of the transactions data, we found that fed cattle purchased through marketing agreements had a higher percentage of Choice and Prime Quality Grade cattle without a higher percentage of Yield Grade 4 and 5 cattle,” say the researchers. “Restrictions on the use of AMAs would decrease the quality of beef products. Beef products are substitutes for other types of meat and poultry, and thus a decrease in the quality of beef due to reductions in the use of AMAs would decrease the competitiveness of beef relative to its substitutes.”
It's About Risk
Spin this around, AMA's provide both producers and the industry a sturdy, reliable risk-management tool, in more ways than many usually consider.
Looking at packer ownership, specifically, the study concludes: “One implication of restricting AMAs that was noted by several respondents was the impact on risk-bearing ability and capacity utilization. Full or partial packer ownership of a pen of cattle reduces the equity the feeder (or other cattle owners) must provide to feed cattle. Packer ownership also allows the feeders to secure better terms from lenders. Feeders may be able to own more of the cattle that are currently owned by packers, but they would face a capital constraint preventing them from owning all the cattle. The individual feedlots would have underutilized capacity or would have to find new investors to replace the capital packers once provided. To attract capital that is not in cattle feeding would require a higher rate of return than cattle feeding currently offers; otherwise, that capital would already have been invested in cattle feeding. Given that the supply and demand of beef is relatively fixed in the short run, fed cattle prices are not expected to change substantially. Thus, higher rates of return would have to come from downward pressure on feeder cattle price. Likewise, if feeders have more debt and/or more risk, the higher cost of borrowing will result in lower bids for feeder cattle.”
The study results comprise a massive volume (you can find it at www.gipsa.usda.gov). But it's one every producer should give a gander. Aside from accomplishing its purpose of quantifying the impact of arbitrarily deciding cattle businesses can't do business with one another how they choose, the study serves as a short course for what drives industry economics beyond the cow-calf pasture.
“Buyers of livestock and meat may choose to use specific marketing arrangements because they reduce the cost of procurement, improve the quality of animals and products purchased, aid in risk management, and generate efficiencies in procurement and marketing. Likewise, sellers of livestock and meat may choose to use specific marketing arrangements because they facilitate market access, reduce the cost of selling, increase the price received, and reduce risk,” says the report.
The benefits outweigh the costs.