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Proposal
DRAFT
June 27, 2003
Submitted by Shon Ferguson
March 25, 2003
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Table of Contents
PROBLEM SITUATION .............................................................................................................. 1
NEED FOR STUDY ....................................................................................................................... 2
OBJECTIVES ................................................................................................................................ 2
HYPOTHESIS ................................................................................................................................ 3
BACKGROUND ............................................................................................................................ 3
LITERATURE REVIEW .............................................................................................................. 9
THEORETICAL FRAMEWORK ..............................................................................................12
CONCEPTUAL THEORY ................................................................................................................12
Thwarting Opportunism through Increased Vertical Coordination ......................................13
Negating Information Asymmetry through Increased Vertical Coordination ........................15
Vertical Coordination and the Role of the CWB ....................................................................17
Increasing Producer Returns through Increased Vertical Coordination ..............................18
EMPIRICAL THEORY ....................................................................................................................18
METHODOLOGY ........................................................................................................................24
LAYOUT OF THESIS ..................................................................................................................28
REFERENCES ..............................................................................................................................28
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Problem Situation
The supply chain institutions in the organic wheat supply chain are in their
infancy stages. The organic grain industry in Canada has quickly evolved from a cottage
industry towards an industrialized system that exports internationally. The trend towards
increased consumption of organic food has catalyzed organic production around the
world, which has created a competitive export market. It is in the interest of the entire
organic food industry that its supply chain is as efficient as possible in order for the
Canadian organic industry to flourish in the face of competitive pressures.
Efficiency can be gained through either efficiencies in production or efficiencies
in transactions between stages of a supply chain. Transaction efficiencies are determined
by the institutions under which they are controlled. The relative efficiency of different
transaction institutions has not been investigated in the Canadian organic industry. The
efficiency of transaction institutions has been examined in the poultry and pork industries
(Boger 2001, Martinez et. al. 1998), where researchers have found that the drive towards
transaction cost efficiency and increased quality explains the abundance of increased
vertical coordination in those sectors.
There is evidence that institutions and their associated transaction costs are
important to firms when making marketing choices. Several studies have concluded that
transaction costs have a significant effect on the choice of vertical coordination by
farmers. Hobbs (1996) found that transaction costs significantly influenced the
proportion of cattle sold by farmers through auctions in the U.K. Boger (2001) examined
vertical coordination between Polish hog producers and buyers at a time when high
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quality markets are emerging, and found that transaction characteristics had a significant
effect on the farmers’ choice of marketing channel.
Need for Study
Organic wheat is one of the most important organic crops grown in the prairie
region on Canada. Given the significance of transaction costs in the efficiency of many
agri-food supply chains, there is a desire to know whether alternative forms of vertical
coordination in the organic wheat supply chain would significantly increase its efficiency.
Any such efficiency gains through changes in the supply chain’s institutional structure
would benefit all market participants, including organic wheat producers.
Objectives
The main objective of this thesis is to determine which proposed or existing
supply chain governance structure in the organic wheat industry offers the greatest
transaction cost efficiency.
There are two sub-objectives of the thesis that are related to the main objective.
The first sub-objective is to provide information on the types and magnitudes of
transaction costs in organic grains. The second sub-objective is to identify potential holdup problems for the development of these supply chains and how the regulatory and
institutional environment can be modified to facilitate their emergence.
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Hypothesis
The hypothesis of this thesis is that there exists an alternative supply chain
governance structures in organic wheat transactions between producers and marketing
service providers that significantly enhance transaction cost efficiency compared to the
existing spot market governance structures.
Background
The organic wheat industry in western Canada is small compared to the nonorganic wheat industry, but it is a fast growing segment of the wheat industry. Organic
wheat acreage increased by 126 percent from 1998 to 2001 (AAFC 2002). There were
7899 acres of registered organic wheat in Canada in 2001, making it the second largest
organic crop in terms of area. There were approximately 1200 organic and transitional
producers in Alberta, Saskatchewan, and Manitoba in 2001.
There are several members of the organic wheat supply chain, consisting of
primary producers, grain companies, brokers, export buyers, and processors (AAFC
2002). There are further upstream and downstream components of the supply chain
beyond these five members, such as upstream seed providers, and downstream
distributors and retailers of the processed wheat.
There are several supply chain combinations between the five members. In the
case of domestic or foreign organic wheat sales, the supply chain begins with primary
producers selling to grain companies, brokers, export buyers, and/or foreign distributors,
who sell to end-users (processors), or it can consist of primary producers selling directly
to end-users. Producers can also sell to foreign end-users through a grain broker. To
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generalize, wheat transactions are therefore performed directly from producer to enduser, or through an intermediary. Horizontal transactions can also take place between
intermediaries.
Given these possible supply chains, there are five main options for organic
farmers to market their wheat. The first option is to sell to a Canadian processor, such as
a mill. The second option is to sell through a broker or to an export buyer, which is
common in the export case. The third option is to make a sale directly to an end-user.
The fourth option is to sell to a grain company. The fifth option is to sell to an organic
livestock producer.
The Canadian Wheat Board (CWB) is legislated to market all wheat and barley
that is destined for export or domestic human consumption in the prairie region of
Canada. The presence of the CWB creates a unique situation for organic wheat
producers, since the CWB does not market on behalf of organic wheat farmers, but
permits agents to market organic wheat on their behalf. Within all the first four
aforementioned options, some grain companies and Canadian processors act as agents of
the CWB. In this case, the farmer makes the transaction with the CWB, and negotiates
for an organic premium over and above the CWB price. The CWB pays the farmer the
pooled CWB price for conventional wheat, and the buyer pays the farmer the difference
between the conventional price and the organic price. Some Canadian grain companies
and processors, as well as all foreign companies and brokers/export buyers are not agents
of the CWB. In these cases, wheat must be sold at the pooled wheat price and bought
back at the cash price from the CWB in order to maintain the integrity of price pooling,
then the primary producer can sell his or her wheat directly to the buyer.
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Transaction costs are incurred by the CWB upon producers whether an organic
wheat sale is made through the CWB or not. In the case marketing outside of the CWB,
the “buy back” from the CWB costs producers $5 per tonne, which is a serviceless
transaction cost. In the case of marketing through the CWB, the producer receives a
pooled price from which the CWB’s costs are deducted. The marketing costs deducted
represent the CWB’s costs accrued to the entire wheat pooled account. This means that
organic wheat prices reflect cost deductions from the marketing of non-organic wheat.
When wheat is sold through a CWB agent and a pooled price is received, the producer
must still negotiate for the organic premium with the buyer. This contrasts to a nonorganic sale of wheat through the CWB, where the total price is negotiated collectively.
In the fifth option, producers can sell organic wheat for livestock feed without interacting
at all with the CWB.
Price discovery for organic wheat is very different than price discovery in nonorganic wheat. For non-organic wheat, the CWB, the government, and other private
firms collect extensive surveillance of the supply and demand situation in all parts of the
world. The CWB and the government disseminate and distribute this information for
their use as well as for producers’ use. There are also futures markets for wheat in
Canada and the U.S, providing price discovery information.
There is much less market information available to the organic wheat industry
compared to the non-organic wheat industry, as there does not exist any institution that
gathers and distributes organic wheat price information, nor is there a futures exchange
for organic wheat. This results in significantly lower market information flows in the
organic wheat case, especially for producers. Despite these institutional limitations to
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price discovery, producers, intermediaries, and end-users communicate prices regularly
through person-to-person communication.
Low degrees of vertical coordination characterize the organic wheat supply chain.
The transactional relationships between the producer and their buyer of organic wheat are
mainly market specification contracts, using the terminology of Mighell and Jones
(1963). The “buyer” in this case can be one of the five options discussed earlier, and
include either intermediary grain buyers and grain end-users. In the spot market case,
producers grow their wheat and then communicate their available quantities and qualities
to potential buyers. Producers and buyers must communicate individually with each
other through telephone or internet. A producer may be in a situation where buyers
tender bids to the producers if demand exceeds supply, but the producer may become a
price taker at the mercy of buyers if supply exceeds demand.
Spot market contracts are used almost exclusively by intermediaries and their
buyers in organic wheat transactions. “Buyers” in this case refers to other intermediaries
or end-users. These contracts specify the time, place, quantity, and quality aspects of the
transaction. Some contracts are arranged after harvest, but some are arranged prior to
seeding. The intermediary’s decision on when to contract with buyers depends on their
perception of the risk of not being able to fulfil a contract. It is perceived as less risky to
contract before harvest with organic wheat compared to other crops, as it is a very large
crop with plenty of supply. Intermediaries must contract simultaneously upstream with
producers and downstream with their buyers in order to minimize inventory risk.
In the organic wheat supply chain, Identity Preservation (IP) gives consumers the
necessary quality signal credibility that the wheat contains organic credence attributes
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(Hobbs, Kerr, and Philips 2001). IP in organic wheat does not add credibility to other
important quality characteristics, such as physical appearance, baking quality, and others
attributes that determine wheat quality. Weather is the greatest cause of wheat quality
variability (Wilson and Dahl 1999), and an IP system cannot negate this factor.
Hobbs and Young (2000) explain the trend towards increased vertical
coordination by examining the technological, regulatory, and socio-economic drivers of
the changes. Regulatory drivers include liability and traceability. Technological drivers
include perishability, product differentiation, and biotechnology. Socio-economic drivers
include changes in consumer lifestyles and preferences
Much of the increased coordination in grain markets has come in the form of
increased contracting between producers and grain buyers, although this phenomenon is
partially attributed to biotechnology, a driver to which organic wheat is immune.
Organic wheat has its own set of influential drivers. Traceability drivers have already
driven vertical coordination in organic wheat related to its IP system. Consumer
preference drivers encourage direct selling from farmers to consumers, which can be
aided by the internet. A driver towards increased vertical coordination is also provided
by producers, who want to own downstream marketing and processing services in an
effort to increase their market power and therefore increase their profits through
capturing the marketing margin.
There are three main potential uncertainties regarding transactions between
producers and buyers, defined as quality uncertainty, price uncertainty and payment
uncertainty (Hobbs and Young 2000).
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Quality dispute uncertainty can be a concern to producers and their buyers in the
spot market or production contract scenario if the buyer rejects the load due to quality
problems. In this situation the producer can pay the added cost of taking his/her grain
elsewhere, or can negotiate a lower price with the buyer. The expectation is that
discounts would be larger for quality inadequacies in organic wheat than non-organic
wheat, as most organic wheat human consumption end-users demand only high quality
wheat.
There is a possibility of wheat buyers using a quality clause in a contract in an
opportunistic manner, since producers may have incurred costs specific to the transaction
before quality is assessed by the buyer. When the wheat has been delivered to the
buyer’s location, the next best price available to the producer is another buyer’s price less
the cost to transport the wheat to the new buyer’s location, less the added logistical costs
to the farmer. If the buyer knows this “salvage value” of the wheat, he or she may act
opportunistically by saying that the quality is inadequate and attempt to renegotiate a
price for the wheat.
Payment uncertainty can be defined as the chance that a buyer will not make
payments within the time period specified by the contract, or not at all.
Price uncertainty can be defined as the uncertainty of the seller receiving a “fair”
price for a given quality. Information asymmetries may exist for producers, resulting in
uncertainty over current and future price.
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Literature Review
Literature from several areas is relevant to this thesis. The seminal literature on
transaction cost economics (TCE) is central to the conceptual framework. The genesis of
TCE was provided by Coase (1937) in his seminal paper “The Nature of the Firm,” in
which he stated that there is a cost to using the market mechanisms for making vertical
transactions. Williamson (1979) further developed this concept by postulating that
governance structures in transactions are not fixed, but a decision variable that is chosen
by comparing their relative costs. Willliamson’s theories on the choice of governance
structure in transactions is of particularly useful to this thesis. Literature on the relevance
of transaction cost concepts to contemporary supply chain management are found in
Hobbs (1996), who explains the conceptual relevance of transaction cost economics in
contemporary supply chain issues. Agency theory complements the transaction cost
approach to the conceptual framework, as it provides explanations of inefficiencies
stemming from contracting and vertical integration. Crawford and Guasch (1983)
provides a useful paper relating to this area. Williamson (1971) discusses the perceived
coordination benefits of vertical integration. The concept of the evolution of institutions
is provided by North (1990). The idea of evolving institutions provides the context for
the research problem.
There is no available literature that exactly matches the objectives of this thesis,
but some studies exist that are similar in nature. The study in the literature with an
objective that is most similar to the proposed thesis is by Lentz and Akridge (1997),
which evaluates alternative supply chains for soybean peroxidase. The study employs a
production cost framework to empirically evaluate the status quo and alternative supply
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chains. A study by Martinez, Smith, and Zering (1998) employs a transaction cost
approach to analyzing the effect of increased quality in the U.S. pork industry. They
show the effects of decreased production and transaction costs from sorting and
measuring efficiencies, coupled with a projected increase in demand, on the welfare of
producers and consumers using neoclassical methods of surplus measurement. The
concept of vertical coordination causing a shift in the supply curve was tested by
Kinnucan and Nelson (1993). They found that the substantial decrease in the farm-retail
price spread in the U.S. egg industry is explained by increased vertical control, exhibiting
itself through a downward shift in the supply curve.
As this thesis aims to measure the welfare effects of alternative supply chains,
relevant literature in this area is needed. Freebairn et. al. (1982, 1983) provides examples
of fixed proportions models of measuring economic surplus in vertical markets with
respect to surplus gains from research. These concepts lend themselves well to
measuring surplus gains from governance structure change.
Wohlgenant (1989) found that the assumption of zero elasticity of substitution
between farm and marketing inputs does not hold in many commodities, though wheat
was not tested. Alston and Scobie (1983) found that a zero versus non-zero elasticity of
substitution assumption significantly effects the measurement of economic surplus.
Fisher (1981) provides an argument for a perfectly elastic marketing services supply
curve to exist.
Literature that supports the effect of information asymmetry on prices is found is
necessary to support claims of information asymmetry in the organic wheat market.
Perloff and Rausser (1983) postulate that if a small number of firms have superior market
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demand information, they can use their information to increase their market power.
Information about future demand changes allows such firms to contract in advance to
capture increases in prices. Adam et. al. (1991) study the concept of information
asymmetry and find that a dominant buying firm with superior downstream market
information can significantly lower prices from equilibrium levels compared to the
competitive equilibrium in a one-sided English auction. Stigler (1961) explains the effect
of price information search costs on the frequency dispersion of asking prices in a
market. By turning Stigler’s argument around to discuss bidding prices instead of asking
prices, a conceptual framework for the effect of search costs on price can be developed
for organic wheat.
The use of supply and demand functions as a means to empirically evaluate
alternative governance structures is controversial in the literature. Several studies state
that it may be conceptually incorrect to employ such analyses (Hobbs 1996, Dorward
2001). The main argument against using transaction costs in a supply and demand
framework is that their existence is subtle and that they are not considered on the margin
like production costs. Other studies have embraced the use of shifts in supply and
demand and have proceeded further to welfare measurement in this context (Martinez et.
al. 1998, Kinnucan and Nelson 1993). One can argue that many managers understand the
importance of transaction costs, and that they think about them very much like production
costs, or at least they should if they want to optimize their surplus.
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Theoretical Framework
Conceptual Theory
The theoretical framework of this study centers on a synthesis of Transaction Cost
Economics (TCE) and neoclassical economics. There is a cost to making transactions in
the organic wheat supply chain (Coase 1937), and the choice of governance structures in
the organic wheat supply chain affects the extent of these costs (Williamson 1979).
Governance structures for transactions can be chosen ranging from low coordination spot
markets to vertical integration, the highest form of vertical coordination.
The choice of optimum governance structures corresponds with firms’
maximizing activity, which is an evolving process of learning by doing and by investing
in the types of skills and knowledge that will pay off (North 1990). The organic wheat
industry is in its infancy and is in the initial stages of the learning process.
The key characteristics of transactions are the degree of uncertainty surrounding
the transaction, the degree of asset specificity, and the frequency of the transactions
(Williamson 1979). Increases in uncertainty, asset specificity, and frequency increase
transaction costs. Transaction costs can be categorized as search costs, negotiation costs,
and monitoring costs (Hobbs 1996).
Transaction costs exist in either fixed or variable forms. The distinction between
fixed and variable transaction costs is similar, but not identical to those of production cost
theory. Fixed transaction costs can be defined as costs in a transaction that are fixed for a
given product over a given period of time. Examples of fixed costs include some search
costs, negotiation costs, and monitoring costs. Variable transaction costs can be defined
as costs per transaction, and can also include aspects of search, negotiation, and
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monitoring costs. A change in variable transaction costs will shift the marginal cost
curve. If an aggregation of individual marginal cost curves is taken, the changes in
individual marginal cost act to shift the aggregate supply curve. A change in fixed
transaction costs will have no effect on the individual marginal cost curve or the
aggregate supply curve.
One can evaluate the relative least-cost governance structure for a specific
transaction by calculating and comparing the search, negotiation, and monitoring costs
associated with the status quo and alternative governance structures. Some governance
structures already exist and their actual transaction costs can be readily compared, while
other governance structures have not emerged, necessitating the collection of individual’s
hypothetical perceptions of those transaction costs. The managerial perceptions of
transaction costs are very important, as they direct future actions by managers (Buckley
and Chapman 1997).
Thwarting Opportunism through Increased Vertical Coordination
As mentioned earlier, producers and their buyers face quality, price, and payment
uncertainty. Opportunism on the part of marketing and milling firms associated with
quality disputes may be negated by improved through more coordinated contracting
measures or by vertical integration between producers and their buyers.
More coordinated contracting measures between producers and their buyers, such
as production management contracts, could decrease uncertainty by insuring that the
buyer has complete information about the producer’s quality of wheat before they take
delivery. Production management contracts could also reduce uncertainty of
opportunistic behavior by completely specifying the expected quality, what constitutes a
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discount grade, and methods of resolving quality disagreements. Production management
contracts that are created before the wheat is harvested could also include more stringent
quality monitoring by the buyer in order to negate unexpected quality problems. These
measures would act to decrease uncertainty to both the producer and the buyer, and
therefore decrease each group’s negotiation transaction costs. Coordination costs related
to quality monitoring may also increase for the buyer as a result, but it is expected that
the buyer’s total transaction costs would decrease.
It is proposed that vertical integration could occur in organic wheat by producers
owning a marketing agency, where the producers could have the option of selling through
their marketing firm with the marketing component receiving a commission. Williamson
(1971) states that the advantages of vertical integration can be divided into three
components: incentives, controls, and “inherent strategic advantages.” From an incentive
perspective, vertical integration between producers and marketers would eliminate
opportunism resulting from quality problems between these two stages. The marketer
would act as an agent to the producers and would be required to act in their interests. The
absence of opportunistic behavior on wheat price due to quality disputes would decrease
negotiation costs of the transaction. The more precise control of marketer performance
would not be possible through the market mechanism, making vertical integration a
benefit in this respect.
Other potential benefits of vertical integration include easier conflict resolution,
resulting in lower negotiation costs and economies of market information exchange.
Integration between the production and marketing stages would allow for crop quality
information to flow more freely from the producer to the marketer, thus decreasing
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monitoring costs for the marketer and quality uncertainties causing decreased negotiation
costs for the marketer.
There would be a greater coordination cost of the vertical integrated arrangement
compared to transacting through the market. These costs would include the resources
expended by the producer owners to control the operations of the marketing agency and
monitor the marketing agent’s performance. The problem of moral hazard can result if
the producers that own the marketing agency cannot induce the marketing agent to
maximize the producer’s profits by finding the highest prices (Crawford and Guasch
1983). The greater the uncertainty of moral hazard, the greater the monitoring costs
necessary to negate it. If the agent does or is perceived to act inefficiently, then this will
decrease the production cost efficiency of the marketing stage.
Monitoring costs would also be incurred to ensure that farmers do not partake in
strategic misrepresentation of their wheat. The control of farmer strategic
misrepresentation is a cost in both vertical integration and spot markets arrangements, but
may be more efficient through vertical coordination (Williamson 1971).
Negating Information Asymmetry through Increased Vertical Coordination
Information asymmetry that producers face with respect to wheat prices may be
reduced by producers vertically integrating forward into marketing and or processing
services. A coordinated solution to information asymmetry may also be attained through
the creation of a market price information gathering institution.
The importance of price information search costs on the price of goods is
discussed by Stigler (1961). The lack of price discovery mechanisms other than by
personal communication among individual producers provides evidence that search costs
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are relatively high for organic wheat, compared to conventional wheat. The bidding price
dispersion of a good is a function of the amount of search. The amount of search is a
negative function of the cost of search, and a positive function of the percentage of the
seller’s revenue and the percentage of experienced producers in the market. Stigler states
that the cost of search can be a function of the market’s geographic area, but a synthesis
of the TCE concepts illustrates that the choice of governance structure can also affect the
cost of search. Given diminishing returns to search, an optimizing individual will search
to the point where the marginal return from search equals its marginal cost. Any nonzero cost of search leads to a frequency dispersion of bidding prices from organic wheat
buyers. Moreover, greater variance of supply and demand leads to greater price
dispersion. As the price dispersion increases the marginal return from search,
endogenously leading individuals to take measures that decrease search costs. As
mentioned above, changes in governance structure can lower search costs. Vertical
integration in its purest sense would eliminate search costs, but producers that sell a
portion of their organic wheat outside of a vertically coordinated arrangement could
benefit from the integrated firm’s economies of market information exchange in outside
transactions. Such information would decrease producers’ search costs in concurrent
contract or spot market transactions. A market price information gathering institution
could provide market price information and detailed supply and demand analysis, which
could also decrease farmer’s information search costs.
A vertically integrated firm or the information gathering institution that decreased
search costs would decrease price dispersion and therefore lower price uncertainty.
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Moreover, a decrease in search costs directly affects the efficiency of transactions
between producers and their buyers.
Kennett et al. (1998) state that two conditions must exist in order for an initiative
in supply chain management to continue. The first condition is that the economic rents
created for the whole system must be greater than the economic rents generated from
alternative systems. The second condition is that each party’s share of the economic rent
must exceed their costs.
The net benefit of vertical integration of the producer and marketing stages or an
information gathering institution depends on the whether market transaction cost savings
exceed internal coordination costs. If coordination costs related to controlling the
marketing agency or information agency and monitoring the agent’s actions are
sufficiently high, or if marketing transaction cost savings are sufficiently low, then there
will be no net benefit to vertical integration. For the case of contracting, the total
transaction costs must be compared.
Vertical Coordination and the Role of the CWB
As mentioned in the background of this proposal, the CWB currently imposes
transaction costs on organic wheat producers. The elimination of the CWB from the
organic wheat supply chain would eliminate this cost on transactions, but it may increase
other transaction costs in transactions where it pays a portion of the total price to the
producer. Producers may perceive that the CWB decreases payment and price
uncertainty by guaranteeing producers a guaranteed base price for their wheat.
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Increasing Producer Returns through Increased Vertical Coordination
The desire to increase the proportion of marketing margins returned to producers
is another reason that producers are interested in vertical coordination. This motivation is
not related to efficiency, but rather to concerns of distribution of the returns in organic
supply chains. Although this thesis does not aim to analyze this issue, the distribution of
the welfare in the status quo and alternative governance structures deserves mention in
the results of the thesis. Given that consumer demand is held constant, efficiency gains at
downstream stages of the organic wheat supply chain will be passed back to producers.
Empirical Theory
TCE has often been criticized for its empirical applicability not keeping pace with
its theoretical developments (Hobbs 1997). A synthesis of TCE with Neoclassical
concepts provides economic welfare as a metric of comparison between alternative
governance structures.
The organic wheat supply chain has several forms, but its structure can be
generalized for the successive stages of production as it occurs within Canada. First the
organic wheat is grown by producers, followed by further value added by marketing
services. Marketing services is defined in this model as the value created by cleaning,
grading, transportation and distribution en route to a processor, namely a flour mill. The
organic wheat then enters the processing market, either in Canada or in another country.
There is always a portion of marketing services performed in Canada, while processing
can occur in Canada or elsewhere. The generalized supply chain can be differentiated
depending on the type of firms performing the marketing service. Grain companies,
brokers, export buyers, (plus foreign distributors) or individual producers can market to
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processors. Marketing value is added by all of these agents, and this thesis does not aim
to compare the production costs of these alternatives. It is assumed that alternative
governance structures will not affect production costs for the various marketing agents at
the marketing services stage. It is also assumed that alternative governance structures
will not affect production costs for the producers at the production stage. This
assumption allows for comparisons between governance structures to be made on the
basis of transaction costs.
The generalized supply chain mentioned above can be illustrated as a model of
variable proportions, pioneered by Muth (1964). Following Muth, the model employed
by this thesis consists of six equations describing the organic wheat supply chain, in
which two factors of production, organic wheat farm output (a) and marketing services
(b) producing an output for use in the processing market (x). The market is described by
a production function, a retail demand equation, two input supply equations and two
equations setting out the marginal conditions for profit maximization. The marketing
industry’s production function is
(1)
x  f ( a, b) .
It is assumed to yield constant returns to scale. The processing demand function for
organic wheat is
(2)
x  D( Px ) ,
where Px is the processor’s purchasing price for organic wheat. For the factor demands,
firms are assumed to want to buy the profit-maximizing quantities of b and a, which
implies that the value of marginal product equals price for both inputs:
(3)
Pb  Px  f b
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Pa  Px  f a
(4)
where f b and f b are the partial derivatives of x with respect to b and a. The factor
supply equations are:
b  g ( Pb )
(5)
and
a  h( Pa )
(6)
The system contains six endogenous variables ( x, b, a, Px , Pb .Pa ) and six equations,
allowing for a unique solution if demand functions have negative slopes and supply
functions have positive slopes.
Assuming that exogenous shifts in the output demand and factor supply curves are
parallel in nature, the changes in economic surplus in each market from shifts can be
measured as
CS   Px 0 x0 E ( Px )   1  0.5E ( x)
PS a   Pa 0 a0 E ( Pa )   1  0.5E (a)
PSb   Pb0 a0 E ( Pb )   1  0.5E (b) ,
where E denotes relative changes (i.e., E(Z) = dZ/Z = dlnZ),  is the absolute value of the
elasticity of demand,  is the vertical shift in the demand function reflecting an increase
in demand,  and  are vertical shifts down in the supply of farm output and marketing
services respectively, reflecting an increase in their respective supply.
The variable proportions model becomes one of fixed proportions if the elasticity
of quantity substitution between the farm and marketing inputs is assumed to be zero.
Such an assumption requires that quantities of farm or marketing inputs cannot be
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substituted for one another. This assumption is challenged by Wohlgenant (1989) and its
effect on welfare measurement is demonstrated by Alston and Scobie (1983). The nature
of organic wheat marketing in the narrow scope examined by this thesis, however, leads
one to expect an elasticity of substitution close zero.
Figure 1 illustrates the model under the fixed proportion assumption. The farm
and marketing input supply curves h( Pa ) and g ( Pb ) and the output demand curve D( Px )
are exogenously determined. The farm and marketing input supply curves represent the
horizontal aggregation of individual firms’ marginal cost curves. These marginal cost
curves include firms’ marginal production and transaction costs. The farm input supply
curve will be upward sloping due to the scarcity of production and transaction resources
as their consumption increases. The marketing services supply curve could be either
perfectly elastic or positively sloping, depending on its underlying assumptions. If
scarcity of marketing services cannot occur as their consumption increases, and if no
market power exists in the marketing services industry, then the marketing services
supply curve is perfectly elastic. This assumption is made by Fisher (1981), Kinnucan
and Nelson (1993), and Martinez et. al. (1998). If market power or scarcity exists, then
the supply curve could be upward sloping.
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Organic
Wheat
Processing
Price
S(Px)
CS
Px0
D(Px)
x0
Marketing
Services
Processing
Quantity
S(Pb)
Pb0
PS
Db
SF0
b0
Organic
Wheat
Farm
Price
Pa0
Marketing
quantity
S(Pa)
PS
Da
a0
Farm quantity
Figure 1. Fixed Proportions Model of the Organic Wheat Supply Chain
The farm and marketing input demand curves and output supply curve are
determined endogenously in the fixed proportions model. The processing supply
function is given as the vertical sum of the underlying factor supply functions so that the
marginal cost of a quantity at the output level is equal to the sum of the marginal costs of
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the corresponding factor quantities. The derived demand function for the farm input, Da,
is given by the vertical difference between the output demand and the marketing services
supply curve. Similarly, the derived demand function for marketing services, Da, is given
by the vertical difference between the output demand and the farm input supply curve.
Given the corresponding prices and quantities in each market, and the amounts of
consumer surplus and producer surplus can be measured in the output and input markets
respectively.
Given that transaction costs are included in the farm product and marketing
services supply curves, then they are shifted by changes in marginal transaction costs.
Governance structures that entail lower marginal transaction costs lower the supply curve
for the markets affected by the change; these supply shifts effect the economic surplus
experienced by producers of inputs and consumers. The “best” supply chain governance
structure for farm-marketer transactions is one that maximizes total economic surplus
after supply shifts for transaction costs are accounted for, holding value added (i.e. the
processing demand curve) and production costs constant.
If an alternative offering substantial cost efficiencies is perceived to be impossible
to create, then the “best” alternative may not be feasible. This is known as the “hold-up
problem.” A hold-up of a cost-saving alternative due to some inability to create the
institution merits further analysis as to the precise nature of the problem.
The above framework allows for the transaction cost effects of alternative
governance structures at the farm-marketer transaction level to be analyzed. The
processing stage of the supply chain is not included for two main reasons. First,
inclusion of processing as a third input in the model creates a less transparent model (See
23
reference for a more detailed discussion). Second, the alternative governance structures
to be examined do not involve the processing sector.
Methodology
The methodology of this study will consist of a survey to measure the transaction
costs for marketers and producers using their own and hypothetical governance
structures. The survey results will quantify marketer’s fixed and variable transaction
costs, and the perceived changes in these costs given the hypothetical alternatives. The
supply and output demand elasticities needed to draw the aggregate farm and marketing
supply curves and the output demand curve will be taken from other studies. In order to
ascertain the market conditions for each actual governance structure, the following
information is needed for each actual governance structure:
1) Producer farmgate prices
2) Producer total costs and marginal costs
3) Producer total transaction costs and marginal transaction costs
4) Producer quantity (that fixed costs are spread over)
5) Marketer prices
Processed organic wheat price must also be ascertained. This information allows for the
system of demand and supply curves to be specified, and the current producer and
consumer surplus in the markets.
At the producer-marketer level, the two current governance structures in the
human consumption organic wheat supply chain are the spot market and the farmerowned marketing firm. There are other governance structures, such as direct to processor
24
or direct to consumers, but they are not included in this analysis. Participants in both
governance structures will be found and surveyed as to their expected transaction costs
from a hypothetical change in governance structure to the other proposed forms. The
governance structures to be evaluated include the spot market, production contracts,
farmers vertically integrating forward into marketing, farmers vertically integrating
forward into processing, and farmers collectively operating a market surveillance
organization. There will be six comparisons, including actual-actual and actualhypothetical types:
1) Spot market vs. Vertical Integration – actual data
2) Spot market vs. Vertical Integration – hypothetical perception by spot market
producers
3) Vertical Integration vs. Spot market – hypothetical perception by vertically integrated
producers
4) Spot market vs. Spot market and information institution – hypothetical perception by
spot market producers
5) Spot market vs. Production Management contracts – hypothetical perception by spot
market producers
6) Vertical Integration vs. Vertical integration and information institution – hypothetical
perception by vertically integrated producers
Marketing firms will also be surveyed or interviewed to ascertain their actual and
perceived transaction costs for all of the above comparisons.
25
Both current supply chain governance structures transact partially through the
CWB and partially outside of the CWB. Farmers and marketers will be asked to identify
differences in transaction costs for transactions within or outside the CWB.
Surveys will be sent out to industry participants using different governance
structures. A large group of industry participants use spot market transactions to grain
companies, brokers, or processors, while some farmers collectively own marketing firms
that market to processors. Differences in actual transactions costs between groups will be
useful because they represent a more true measurement. Differences between actual
transaction costs and alternative transaction costs will be useful in order to measure the
difference between perceived changes in transaction costs due to a governance structure
change and actual transaction costs.
The survey will ask respondents in each group to quantify their various search,
negotiation, and monitoring transaction costs. It is difficult to correctly measure
transaction costs, since they are not separated in the accounting of firms (Hobbs 1996).
One accepted method of measuring these transaction costs at the individual level is by
surveying industry participants and the vertical coordination relationships that exist. A
good example of this type of survey is by Hobbs (1997), where the survey questions
queried the size and importance of specific transaction costs. This thesis will measure the
size of transaction costs in order to impose a monetary value upon them. The survey will
ask for direct dollar values of transaction costs where appropriate. When the transaction
cost used the time of the individual, the time spent will be queried, along with a measure
of the value of their time.
26
It is assumed that the aggregate farm and marketing supply curves effected by an
institutional change will be shifted by the same proportion as the average of the surveyed
individuals’ supply curves. Supply curve shifts will be parallel. The aggregation of the
market will be for the 2002-2003 organic wheat quantity in Canada.
Using the fixed proportions model and assuming a perfectly elastic marketing
services supply curve, the welfare for all six comparisons will be evaluated to provide the
welfare-maximizing actual supply chain governance structure combination, and illustrate
changes in welfare from each comparison. It is expected that there may be differences
between actual and perceived costs.
A simulation of short run versus long run welfare effects will be performed by
determining or assuming a short run and long run elasticity of the supply curves and
calculating welfare for both scenarios. Sensitivity analysis can be performed by
employing a non-zero elasticity of substitution, as well as by imposing an upward sloping
marketing services supply curve. Survey participants will also be queried regarding the
potential for hold-up problems to occur. Given this result, any hold-up problem
associated with achieving the best supply chain setup will be evaluated.
Given the outcome of the model, statistical tests of significant difference can be
performed to test if any of the alternatives are significantly better than the status quo.
Tests can be performed between the groups differences in realized welfare, and the
welfare differences between realized and hypothetical governance structures. A two
sample t-test can be used, as per Lentz and Akridge (1997).
27
Layout of Thesis
The thesis will be laid out in the following manner. Chapter One introduces the problem
situation, the need for the study, the objectives, and the hypothesis. Chapter Two will
provide a background of the organic wheat industry in Canada. Chapter Three develops
the conceptual framework of the thesis. Chapter Four provides the methodology for the
hypothesis to be tested, including the construction of the survey and the interpretation of
its results. Results are presented in Chapter Five, followed by conclusions in Chapter
Six.
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