vertical integration and contracting in the u.s. poultry ...the broiler industry is often considered...

Vertical Integration and Contracting in the U.S. Poultry Sector

Tomislav Vukina

This paper provides an economic explanation of the existing market organization of the poultry industry. The verticalintegration and the emergence of contracts with independent farmers is explained by risk sharing, technologicalprogress and innovation dissemination, consumer demand for product reputation and uniform quality, and access tocapital. In addition, the sources of growers' discontent with existing contracts are analyzed and the potential need forgovernment regulation is discussed.

The poultry industry in general and particularlythe broiler industry is often considered a role modelfor the industrialization of agriculture. The poultryindustry is a vertically integrated production, pro-cessing, and distribution system where the physi-cal production of birds is handled almost entirelyby contract growers. This industry has dominatedthe competitive scene in the meat complex overthe last 30 years, expanding its market share dra-matically as it improved efficiency, maintainedlower prices than its competitors, and improved itsproduct offerings and variety. The poultryindustry's vertical integration and reliance on pro-duction contracts with independent farmers un-doubtedly facilitated the industry's efficiency andresponsiveness to consumers, making it a more for-midable competitor in the global meat market.

Judged by their prevalence, poultry contractshave proven to be very popular among Americanfarmers. They have benefited farmers by provid-ing diversified opportunities to earn income andby alleviating cash flow problems that typicallyplague small farms. However, contracts also havetheir critics, largely within the growers' own ranks.Growers complain that the gains from contract ar-rangements accrue largely to integrators whilegrowers receive small or even negative returns.Federal legislation to provide uniform contractregulations for all growers engaged in agriculturalproduction contracts has recently been contem-

Tomislav Vukinais is associate professor, Department ofAgricultural and Resource Economics, North Carolina StateUniversity.

An abbreviated version of this paper appeared in theproject report: Hayenga, M, T. Schroder, J. Lawrence, D.Hayes, T. Vukina, C. Ward and W. Purcell. "Meat PackerVertical Integration and Contract Linkages in the Beef andPork Industries: An Economic Perspective." American MeatInstitute, Arlington, Virginia, 2000. The author thanks threeanonymous referees on their constructive comments andsuggestions.

plated. Several states made attempts to regulatevarious aspects of poultry contracting within theirown jurisdictions.

This paper provides an economic explanationof the existing market organization in the poultryindustry. The focus is on production contracts withindependent farmers as the critical link in the ver-tically integrated chain of procurement of inputs,production, processing, marketing, and distributionthat characterizes the modern poultry sector in theUnited States. In addition, the sources of growers'discontent with existing contracts are analyzed andthe potential need for government regulation is dis-cussed.

Organization of the Poultry Industry

After World War II the U.S. poultry industryevolved into one of the most integrated agriculturalindustries. The broiler industry is entirely verticallyintegrated from breeding flocks and hatcheries tofeed mills, transportation divisions, and process-ing plants. The finishing stage of production is or-ganized almost entirely through contracts with in-dependent growers. The processors became thecoordinators of the industry mainly because a largeproportion of the value is added in processing andsignificant economies of scale in processing led toa significant industry concentration. A 1996 sur-vey of broiler companies (Thornton 1997) lists 48companies that control virtually the entire U.S.broiler output, with the top 15 companies control-ling 77 percent of the total industry production. Thelargest broiler company was Tyson who controlledclose to 22 percent of the entire market with esti-mated annual sales of about 4 billion dollars.

The pattern of vertical integration is less uni-form in the turkey industry than in the broiler in-dustry. A turkey company is less likely to own itsown hatchery but is more likely to have company-

Journal of Food Distribution Research

owned production farms (Martin et al. 1993). Thereis also more variation among production contractsin terms of division of risks and profits from grow-ing turkeys than in the broiler industry. The pro-cessing plant is the center for control of placement.A processor may contract directly with farmers orcontract with a feed supplier who in turn contractswith farmers. In the turkey industry, there are stillsome independent producers with formal market-ing contracts with processors. Such marketing con-tracts do not always provide any price or marginguarantees to producers. Based on the 1996 surveyof leading turkey companies (Hefferan 1997) thecomparison of the estimated annual sales betweenturkey and broiler industries reveals that the lead-ing turkey companies are smaller than their coun-terparts in the broiler industry. Butterball, the larg-est turkey company, controlled only about 13 per-cent of the market, and with its annual sales of $600million would place be the eighth largest broilercompany. From 1979 to 1996 the turkey industry's15-firm Herfindahl index dropped from 0.0681 to0.0663 and remained lower than in the broiler, pork,and beef industries, indicating that the turkey in-dustry concentration did not change significantlyin the last couple of decades (Gulliver 1997)1.

Modern poultry production contracts are agree-ments between an integrator company and farmers(growers) that bind farmers to tend a company'sanimals until they reach market weight in exchangefor monetary compensation 2. Poultry contracts havetwo main components: the division of responsibil-ity for providing inputs and the method used todetermine grower compensation. Growers provideland and housing facilities, utilities (electricity andwater), and labor. Operating expenses such as re-pairs and maintenance, clean-up cost, and manureand mortality disposal are also the responsibility

i Generally, if the Herfindahl index is below 0.18 theindustry is considered to operate under perfect competition.

2 The specific information on poultry contracts design isrepresentative of the contracts offered to growers in NorthCarolina. The information gathered is considered to berepresentative of the entire industry. North Carolina ranksfirst in turkey production and fourth in broiler productionnationally. We focus our discussion on the so-called finishingcontracts where a certain age group of animals - e.g. one dayold chicks - is brought to the farm and then grown to marketweight. Other types of production contracts include breederand hatching-egg contracts in the broiler industry and broodingcontracts in the turkey industry.

of the grower. Integrators provide animals to begrown to processing weight, feed, medication, andthe services of field personnel and makes decisionabout the frequency of flock rotations on any givenfarm. The costs for items such as fuel or litter canbe the responsibility of either party or they can beshared. Most integrators require houses to be builtand equipped according to strict specifications. Newhouses are typically well-insulated units with highlyautomated feeders, drinkers, and heating and cool-ing devices.

An interesting feature of the existing contrac-tual arrangements is the simultaneous presence ofdistinct remuneration schemes in these two simi-larly organized industries. The broiler industry al-most completely adopted a two-part piece-ratetournament whereas some turkey companies usetournaments and others use some form of a fixedperformance standard. In a two-part piece-rate tour-nament scheme the grower receives a bonus if hisperformance is better than the group average and apenalty if his performance is below the group av-erage. In a fixed-performance-standard scheme theperformance of a grower is compared to a prede-termined technological standard. Tsoulouhas andVukina (1999) refer to the limited liability of theintegrator, which can hinder the use of tournaments,to explain the use of different payment mechanismsby different poultry industries. The theoretical re-sults were supported by empirical evidence on theoutput price volatility and the firm size. Given theprevalence of smaller companies in the turkey in-dustry, larger price volatility generates a signifi-cant bankruptcy risk for some companies render-ing the use of tournaments infeasible. By contrast,with large companies dominating the broiler indus-try, smaller price volatility facilitates the use oftournaments.

Design of Poultry Contracts

The evolution of the design of poultry contractshas been followed chronologically by Martin(1994). The industry started with open account con-tracts where growers were given loans by banks,production credit associations, or feed mills in re-turn for interest payments. To reduce risks of lossesto growers some integrators started offering openaccount-no loss contracts which carried a clauseensuring that any deficit incurred by the grower after

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Vertical Integration and Contracting in the U.S. Poultry Sector 31

broilers had been marketed was absorbed by thecontractor. This arrangement resulted from com-petition among integrators for growers and thethreat by growers to discontinue broiler production.The next stage was guaranteed-price contracts,which contained an additional clause guaranteeingthe grower a certain price per bird delivered. Guar-anteed price contracts were popular in the broilerindustry in the 1950s and 1960s, but their use inthe turkey industry was limited. The holiday con-sumption pattern and the long grow-out period forturkeys made output price unpredictable at the be-ginning of the cycle.

The next generation of contracts wereflat-feecontracts under which growers were compensatedfor their husbandry and inputs by payment perpound, per bird, or per week. The integrator retainedownership of birds; provided feed, medicine andchicks; and coordinated production and marketingdecisions. Due to low incentive compatibility, flat-fee contracts encouraged growers to shirk. To miti-gate agency problems, both broiler and turkey com-panies started including feed-conversion bonusesin their flat-fee contracts and introduced profit shar-ing. Share contracts stipulated proportions accord-ing to which profits were shared between the inte-grator and the grower with the responsibilities ofthe two parties remaining as in the flat-fee contract.A basic feed-conversion contract compensatedgrowers according to a specified schedule of feedconversion (pounds of feed per pound of liveweight). Such contracts were often used with a flat-fee payment, which made those contracts very simi-lar to the contracts we observe today.

Broiler Contracts

As mentioned earlier, virtually all modernbroiler contracts are settled using a two-part cardi-nal-tournament scheme consisting of a fixed basepayment per pound of live meat produced and thevariable bonus payment based on the grower's rela-tive performance (sometimes called the prime-costrating). The bonus payment is determined as a per-centage (bonus factor) of the difference betweengroup-average settlement costs and producer's in-dividual settlement costs. The calculation of thegroup-average performance includes growerswhose flocks were harvested at approximately thesame time (typically within the same week). Settle-

ment costs are obtained by adding chick, feed,medication, and other customary flock costs dividedby total pounds of live poultry produced. Thegrower receives a bonus for below-average settle-ment costs (above-average performance), and apenalty for above-average settlement costs. Thebonus factor ranges from 50 to 100 percent. Thetotal revenue to the grower is the sum of the baseand bonus payments multiplied by the live poundsof poultry moved from the grower's farm.

In addition to a performance-based paymentmost broiler contracts also have two auxiliary pay-ment mechanisms: the minimum guaranteed pay-ment and the disaster payment. If the producer'srevenue based on the performance payment issmaller than some minimum guaranteed revenue,the minimum-payment formula will be applied. Inthe event of a disaster such as fire, flood, or hailinvolving a loss of part or all of a flock the growerwill be compensated based on the disaster-paymentformula. With the majority of integrators, neitherthe minimum guaranteed payment schedule nor thedisaster payment applies in cases of gross negli-gence. Minimum-guaranteed-payment and disas-ter-payment schemes differ substantially among in-tegrators. Both are designed to secure sufficientpayments to prevent a grower from defaulting onthe chicken-house mortgage.

A recent development in broiler contracts hasbeen the introduction of the market-price clause.This payment mechanism was added to the perfor-mance payment scheme (i.e., base plus bonus) withthe idea to tie growers' payments to the fluctua-tions of the market. The market-price clause is de-fined as a percentage (e.g., 2 percent) of the differ-ence between the market price for broilers and theintegrator's average variable cost of producingthem. The market price is typically defined as a 3-week average of the composite whole bird pricedelivered to one of the major markets (e.g., NewYork City). The average variable cost is the sum ofthe average settlement costs, some other expensessuch as vaccination and sanitation (sometimescalled nonchargeable expenses), and processingcosts.

Turkey Contracts

During the last two decades turkey productionwas organized mainly through contract production

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with a standard technological production unit con-sisting of one brooder house and two finishinghouses covered by one contract. In recent years,mainly as a result of the outbreak of the diseasePoult Enteritis Mortality Syndrome (PEMS)-popularly known as spiking mortality-and otherbio-security reasons, the production technology isgradually changing towards separate (off-site)brooding and finishing operations. The rationale forthe change is to avoid the presence of multiple gen-erations of turkeys on the same farm at any giventime. With the new management practice the farmerspecializes in either brooding or finishing of tur-keys, and the two stages of the production processare covered by separate contracts. The old produc-tion technology (joint brooding and finishing) isstill very much in existence. Turkey contracts usesome combination of a flat fee and a feed-conver-sion bonus paid per pound of live meat producedto determine growers' compensation. At least threedifferent remuneration schemes are observed.

The first type is a fixed-performance-standard(benchmark) scheme where growers are paid a floorpayment (e.g., 3.75 cents/lb.) augmented by thefeed-conversion bonus, if achieved. The feed-con-version bonus is calculated by comparing agrower's feed conversion to a predetermined bench-mark (e.g., 3.00, i.e., three pounds of feed per onepound of meat). If an individual grower's feed con-version is lower than the benchmark, each pointdifference will be converted into money and addedto the floor payment. The critical difference be-tween a tournament and a fixed standard is in thecomputation of the benchmark against which theperformance of an individual grower is compared.Whereas in the first case the benchmark is deter-mined by the contest among growers, in the sec-ond case it represents a predetermined technologi-cal constant. Most of the contracts are designed tohave an upper and a lower bound on the paymentper pound, expressed as a minimum- or a maxi-mum-allowable feed conversion. In this case thefloor payment simultaneously serves as a minimumguaranteed payment, i.e., there is no punishmentfor the feed conversion higher than the pre-estab-lished benchmark.

The second category can be labeled a perfor-mance-brackets-payment scheme. The essence ofthe scheme is the existence of predetermined feed-conversion ranges (brackets) for different weight

groups of harvested birds. Each feed-conversionbracket is associated with a different payment perpound of approved meat delivered. Lower feed-conversion brackets yield higher payment perpound.

The third type of payment used in the jointbrooding and finishing operations is virtually iden-tical to the broiler tournament with some minormodifications related to the treatment of the con-sumption of LP gas. Gas is used extensively forheating in the brooding stage and is a significantcomponent of the growers operating expenses, soit is typically shared between the integrator andgrowers.

Efficiency Gains from Contract Production

The transaction cost framework provides a use-ful perspective for examining the choice among spotmarkets, contracts, and vertical integration. Theimportance of relation-specific assets provided bygrower (chicken houses) and integrator (feed milland processing plant) makes spot markets uneco-nomical for organizing broiler production. Thechoice between contracts and vertical integrationdepends largely on the anticipated need to adapt toa changing or uncertain future. Anticipation of avolatile and uncertain future, which characterizesbroiler production, should lead to vertically inte-grated production, yet contracting with individualfarmers is nearly universal. As pointed out byKnoeber (1989), the resolution to this puzzle hastwo parts. First, compensation by tournamentseliminates the bias toward vertical integration byreducing the cost of contracting. Tournaments pro-vide an effective adaptation to technological changewithout contract renegotiations and enables theshifting of common production risk to the integra-tor without requiring complex contingent contracts.Second, the requirement that growers provide capi-tal in the form of chicken houses creates a bondthat assures growers' performance, makes the con-tracting relation long-term, and induces self-selec-tion of high-ability growers.

The emergence of vertical integration via con-tracts with independent farmers in the poultry in-dustry can be explained by the formation of eco-nomic circumstances that required adequate mecha-nisms to facilitate risk sharing or provision of in-surance, technological progress and innovation dis-

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semination, response to consumer demand for prod-uct reputation and uniform quality, and access tocapital. The same four categories can be used tosummarize the most important benefits that thewidespread adoption of production contracts gen-erated during the past 40 years.

Risk Sharing

The first important reason for contracting is theprovision of insurance by risk-neutral (or less-risk-averse) integrators to risk-averse growers. How-ever, insurance provision can be hindered by theintegrator's inability to fully monitor growers' ac-tions and by growers' opportunistic behavior. Inpoultry production contracts, however, the provi-sion of relationship-specific capital by growers vir-tually eliminates the opportunism problem. Theintegrator's inability to observe the growers' ef-forts remains a problem, however. Therefore theintegrator can never provide full insurance to thegrowers, so payment schemes cannot be indepen-dent of realized outcomes. With payment schemesthat depend on observed outcomes, contracts pro-vide sufficient incentives for growers to exert adesired level of unobservable effort. Yet in the pres-ence of production uncertainties common to allgrowers, the integrator may be able to offer someinsurance if growers' results convey informationabout common uncertainties. Examples of commonproduction uncertainties include the effects ofweather, untried feed mixes, and newly introducedgenetic stock. In the presence of such uncertaintiesrelative performance evaluation via tournamentsprovides a mechanism to partially insure the grow-ers by filtering away common production uncer-tainty.

The magnitude of risk shifting from growersto integrators has been investigated by Knoeber andThurman (1995). They decomposed the total riskin the broiler industry into price, common produc-tion, and idiosyncratic production risks and foundthat price risk accounted for 84 percent of total risk,common and idiosyncratic production risks eachaccounted for three percent, and the remainder wasattributed to the joint contributions of the three com-ponents. The form of contracting used in broilerindustry shifts nearly all risk to the integrator ex-cept for the 3 percent of the idiosyncratic risk. Thelikely explanation for the weak relation between

price risk and broiler supply found elsewhere inthe literature (Aradhyula and Holt 1989) is not thesmall price risk but the fact that all risk is shifted tolarge, sometimes publicly owned, integrator com-panies who have relatively small risk-bearing costs.

Technological Change

The expedient adoption and implementation oftechnological innovations is another importantcause of the emergence of contracts as well as oneof the major benefits created by contracting in thepoultry industry. The rapid technological changegenerated tremendous productivity gains whichresulted in a significant reduction in the cost of pro-duction, which to a large extent ended up beingpassed to consumers via reduction in the consumerprices of poultry meat.

To isolate the impact of contracting on produc-tivity one can compare the broiler industry to otherlivestock industries where contracting did not oc-cur, such as the pork and beef industries. Contractproduction of broilers began just after Word WarII and quickly came to dominate the entire indus-try. From 1950 to 1980 the broiler industry was theonly industry using production contracts. Contractproduction in the pork industry did not start untilthe late 1970s, and the elaborate production con-tracts used for poultry and hogs are still virtuallyabsent from the beef industry. Over the 25-yearperiod of experimenting with contracts, the feed-conversion ratio in the broiler industry droppednearly 30 percent from 2.85 in 1955 to 2.08 in 1980.The number of days to grow a broiler to marketweight fell from 73 to 52 while the average marketweight actually increased from 3.1 to 4 pounds(Lasley 1983). This increased productivity cameabout through disease control, development of ge-netically superior breeding stock and innovationsin animal nutrition.

Other evidence of the exceptional pace of tech-nological change in broiler production is found bycomparing the changes in real broiler meat priceswith those of beef and veal and pork prices duringthe same period. The results are presented in Table1. The numbers suggest a rapid technologicalchange in broiler production and little or no changein beef and pork production. The decline in broilerprices is continuous except during the 1970-1975period, which was largely due to the dramatic in-

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Table 1: The Dynamics of Real Meat Prices: 1955-1980.

Percentage Change in Price

Time Period Broilers Beef and Veal Pork

1955-60 -29 +17 -71960-65 -11 -4 +101965-70 -13 +3 -11970-75 +8 +3 +231975-80 -23 +4 -311955-1980 -54 +18 -14

Source: Lasley (1983), reproduced from Knoeber (1989) p. 273

crease in grain prices in 1973. The 54-percent dropin the real price of broilers during the 25-year pe-riod was much larger than the drop in pork prices,and real beef prices actually increased. The pricereduction is even more important if one keeps inmind that the per capita consumption of broiler meatincreased from 13.8 pounds in 1955 to 46.7 poundsin 1980 (Lasley et al. 1988).

The expansion of broiler production and thedecline in real broiler prices continued into the1990s. Additional evidence of the magnitude of thebroiler industry's production and marketing effi-ciency gains can be illustrated by the results ob-tained by Martinez (1999). He simulated the retailprice of whole broilers by holding technology andinput-output relationships constant and varyingbroiler production and marketing costs accordingto changes in input prices. The simulated retail pricewas then compared to the actual price to measurethe productivity gains passed to consumers. Theresults showed that if higher input prices had beenpassed to consumers, average retail broiler pricesfor the 1992-1996 period would have been $1.58per pound instead of the actual average of $0.91per pound.

Response to Changes in Consumer Preferences

An important characteristic of the poultry in-dustry that differentiates it from other livestock in-dustries is the ability to rapidly respond to changesin consumer preferences. Per-capita broiler con-sumption nearly doubled from 1976 to 1997, com-pared to a 5-percent increase in pork consumptionand a 30-percent reduction in beef consumption.In 1986 per-capita consumption of broiler meatexceeded the consumption of pork and in 1993 it

surpassed the consumption of beef. Increasing per-capita consumption and more-or-less constantprices suggest the possibility of a demand shiftcaused by changing consumer preferences.

The poultry industry measures significant im-provements in product form differentiation. Dur-ing 1980s the combined sales of cut-up and furtherprocessed chicken exceeded sales of whole birds.By 1995, 63 percent of broiler volume was sold asparts and 11 percent as further-processed products.The poultry industry is the leading prepackagedconsumer-ready meat-products industry. Accord-ing to its 1996 listings one major supermarket chainoffered consumers 70 prepackaged consumer-readypoultry products, 58 pork products, and less than10 each of veal, lamb, and beef products (Martinez1999).

Contracting and vertical integration have alsogiven the poultry industry greater control over boththe volume and quality of its products, which turnedout to be especially important in meeting the needsof large food-away-from-home establishments andsupermarket chains. In the 1980s approximately25,000 fast-food outlets added chicken items to theirmenus (Lasley et al. 1988). Poultry producers areincreasingly pursuing the creation of brand namesthat consumers associate with uniformly high-qual-ity product. According to Bugos (1992) brandnames accounted for half of all supermarket salesof chickens, and shoppers were willing to pay 14-percent more for brand-name broilers than for su-permarket brands.

Access to Capital

Yet another benefit of contracting comes fromsharing the cost of capital expansion between inte-

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grators and growers. One of the reasons for the rapidexpansion of the broiler industry was a relativelyeasy and inexpensive access to capital through Fed-erally insured loans the construction of housingfacilities. Grower provision of capital investmentsprovides an efficient way for the integrators to fi-nance expansion, with a positive employment feed-back on growers. Productive growers typically en-joy a long-term relationship with an integrator.Grower provision of capital is the fee for enteringa long-term relationship with an integrator and animportant device for screening out low-abilitygrowers. Relationship-specific investments have theadded benefit of enhancing an integrator's abilityto provide insurance to risk-averse growers by re-ducing grower opportunism.

Growers Discontent and Potential Need forRegulation

Whereas most of the poultry growers seem tobe satisfied with their contracts, some complainabout various aspects of contracting. Most of thecomplaints are about the tournament schemes.Growers are opposed to the system where onegrower's payment depends on the performance ofothers. They seem to be more favorable to the fixedperformance standards used by many turkey com-panies. The crux of the growers' complaints abouttournaments is the issue of the group-compositionrisk. Under a tournament system, consecutive flocksgrown by the same grower and with similar pro-duction costs could receive substantially differentpayments because of the results of other growersin the settlement group. The essence of the con-tract settlement through tournaments is the elimi-nation of the common production risk from the re-sponsibility of the grower. Tournaments require thatthe calculation of the group average performanceincludes growers whose flocks were harvested atapproximately the same time, so that they are allexposed to the same influence of common stochas-tic factors including weather, disease, feed quality,genetic strains, etc. Therefore the group composi-tion changes on a flock-by-flock basis because ofthe unequal rotation lengths of flocks grown ondifferent farms and logistical considerations relatedto the transportation of feed and chicks. Hence agrower's payment can vary from one flock to thenext even if all else is constant. Growers have ex-

pressed exasperation over this form of remunera-tion since they have no way of accurately forecast-ing their revenues.

In addition to complaining about the settlementprocess, growers have also raised complaints aboutthe quality of chicks, the way live birds and feedare weighed, and the length of time between flockplacements. They also complain about contract non-renewal, contract terminations, requirements thatfacilities be modified or upgraded (excessively),their limited choice of integrators or their inabilityto change integrators, and alleged integrator repris-als for joining grower associations and for seekingredress of grievances.

The magnitude of the mistrust can best be il-lustrated by the results of a survey conducted in1993 by Tyson, the largest broiler processor com-pany in the U.S., of its own growers. The surveyrevealed that more than 50 percent of growers donot trust the company scale weights, 44 percent donot trust feed weights, 62 percent are unhappy withthe quality of chicks provided by the company, and40 percent do not fully understand how their pay-ments are determined (Bjerklie 1994). In a 1998study of Delmarva Peninsula poultry growers byIlvento and Watson (1988) contract growers ex-pressed relatively high satisfaction with their poul-try business, their contractors, and their flock su-pervisors. Nearly half felt communication was in-adequate and feared retaliation if they raised con-cerns. Most felt that income was adequate or thatthey were getting a fair return on their investment.Earlier Alabama grower surveys (Kennedy 1994;AP&EA 1998) found substantial differences inoverall grower perceptions of the fairness of thecontractual arrangements, with satisfaction rang-ing between 20 and 73 percent. The 1998 surveyresults were generally more positive toward inte-grators' performance, with 50 to 90 percent gener-ally favorable, but some still complaining aboutvarious aspects of contracts.

Out of concern for such grower discontent, anumber of states have considered legislation to pro-tect growers. In Southern states such legislative pro-posals generally failed as integrators voiced strongopposition. For example, in 1993 the North Caro-lina Legislature introduced a bill that would haverestricted the types of contracts that growers andintegrators could sign. The bill specifically prohib-ited payments to a grower based on his performance

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relative to other growers (Vukina 1997). Legisla-tion with provisions that protected the rights ofgrowers to organize and create associations werealso defeated in Alabama and Louisiana. However,various forms of legislation aimed at regulatingcontracts without explicitly targeting tournamentswere passed in Minnesota, Wisconsin, and Kansasin the early 1990s (Lewin 1998).

On the Federal level, in 1997 a regulatory ini-tiative came from the Grain Inspection, Packers,and Stockyards Administration of the U.S. Depart-ment of Agriculture. In an advanced notice of pro-posed rulemaking, the agency announced that it isconsidering "the need for issuing substantive regu-lations to address concerns in the poultry industrywith respect to contract payment provisions tied tothe performance of other growers" (GIPSA 1997,p. 5935). Furthermore, in 1998 the National Com-mission on Small Farms recommended that theSecretary of Agriculture evaluate the need for Fed-eral legislation to provide uniform contract regula-tions for all growers engaged in agricultural pro-duction contracts. In reference to poultry contractsthe recommendation specifically focused on thefactors used in ranking growers and determiningperformance payments. No concrete regulatoryactions have been taken so far but the pressure fromthe growers' circles to regulate the industry con-tinues.

The literature on the economic impact of inte-grator practices and procedures on poultry grow-ers and consequently the need for government regu-lation of contracts is quite small. In somewhat re-lated papers, Vukina and Foster (1998) assessedhow optimal input decisions by growers changewith the adoption of alternative contract designsand Goodhue (2000) showed how integrators re-duce the information rents paid to growers by con-trolling inputs. The closely related literature on fran-chising has generally been very critical of govern-ment regulation on the grounds that any regulationwill interfere with the ability of economic partiesto negotiate efficient agreements (Beales and Muris1995; Brickley, Dark, and Weisbach 1991).

Addressing the theoretical rationale for gov-ernment regulation of poultry contracts, Lewin(1998) argued that by requiring growers to makelarge specific investments in chicken houses inte-grators can increase grower incentives without in-creasing grower compensation since the risk of los-

ing the investment will increase a grower's fear oflow performance. She concludes that because assetspecificity has such an effect on distribution, integra-tors have an incentive to insist on investments thatare unnecessarily specific. Lewin is in favor of regu-lation to allow the unionization of growers thatwould increase their bargaining status; she also fa-vors the regulation of contract duration.

Analyzing the welfare effects of the regulatoryproposal to ban tournaments and replace them withfixed performance standards, Tsoulouhas andVukina (2001) investigated if such regulation wouldincrease grower welfare and the social surplus (thesum of integrator's and growers' welfare). Theyshowed that the mandatory replacement of tourna-ments with fixed performance standards absent anyother rules can decrease grower income insurance(i.e., increase income volatility) without raisingwelfare. However, income insurance and welfarecan simultaneously be increased provided the slopeof the bonus-payment scheme, the so-called "piecerate," is also regulated. The enforcement of fixedperformance standards absent any rules concern-ing the magnitude of the piece rate will result in anunambiguous reduction in social surplus. Regula-tion accompanied by a rule determining the mag-nitude of the piece rate may or may not reduce so-cial surplus, depending on the technology and pref-erences, because integrator welfare is reduced butgrower welfare is increased.

There are many other important facets of poul-try contracts that were not addressed in the litera-ture. In addition to the issue of regulating the pay-ment schemes, the need for government interven-tion in private contracts may or may not be justi-fied on some other grounds. One of the more inter-esting issues is the effect of regional competitionon the market for growers, and the related problemof a potential "hold-up." It is certainly conceivablethat by making growers incur large specific invest-ments integrators can increase grower incentiveswithout increasing grower compensation, since therisk of losing his investment will increase agrower's fear of low performance. Because assetspecificity has such an effect on distribution, inte-grators have an incentive to insist on investmentsthat are unnecessarily specific. Thus, especially ingeographical regions where the integrator enjoysmarket power, grower complaints about excessiveinvestments may be theoretically justified.

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Conclusions

The poultry industry is a significant competi-tor in the global meat market, rapidly gaining mar-ket share over the last 30 years. The broiler indus-try is entirely vertically coordinated through own-ership or contract. Breeding flocks, hatcheries, feedmills, transportation divisions, and processingplants all have a single owner. The integrator hasproduction contracts with growers to feed the chicksto market weight. The significant economies ofscale in poultry processing and the large propor-tion of the value added in processing are two mainreasons why processors became the industry coor-dinators. Turkey production is mainly organizedthrough contract production with individual farm-ers. Recently, farmers have tended to specialize ineither brooding or finishing of turkeys under dif-ferent contracts. Some independent producers whohave formal marketing contracts with turkey pro-cessors still exist.

There are possible advantages and disadvan-tages to contract production in the poultry indus-try. The extensive use of contracts with indepen-dent farmers in the poultry industry has resulted inlower financial risk for farmers, rapid technologyadoption, quicker response to changing consumerdemand, and improved industry access to capital.The broiler industry has dramatically improved itscompetitive position in the last 30 years, improv-ing efficiency, developing innovative products,keeping consumer prices low, and greatly increas-ing its market share.

While a large number of contract broiler grow-ers surveyed recently expressed satisfaction withtheir contract arrangements, including their incomeand the rate of return on invested capital, manygrowers expressed dissatisfaction with bonus de-termination, communication, and a number of otheroperational issues with their contractor. Despite thefact that there may be some theoretical grounds forthe regulation of broiler contracts, the complexityof welfare-improving regulatory solutions shouldserve as a strong deterrent for more aggressive gov-ernment involvement.

References

Alabama Poultry and Egg Association (AP&EA).1999. "AP&EA Releases Survey of Alabama

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vertical integration and contracting in the u.s. poultry ...the broiler industry is often considered...

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