Optimal Contracting and Vertical Coordination in the Beef Industry: An Assessment of Value-Based Pricing

Abstract

This dissertation explores the nature and scope of vertical coordination in the U.S. beef industry. From the perspective of the incomplete contract theory of the industrial organization literature, this dissertation first provides a theoretical economic explanation for the traditional and emerging governance structure of the U.S. beef industry, and then explains why a complete vertical integration has not yet occurred in the beef sector. Analyzing the organizational details of this industry, the author argues that the degree of idiosyncrasy of transaction-specific investments by each of the vertically-related beef sectors is not high enough that transaction costs could be further reduced by vertical integration.

The dissertation further examines optimal behavior of commercial cattle feeders under alternative cattle feeding contract provisions, and the implications for contract choice by cattle owners and feeders under traditional and value-based pricing methods for fed cattle. The author analyzes optimal incentive structures for cattle feeding contracts under alternative fed cattle pricing methods and risk preferences of cattle owners and feeders using a multitask principal-agent model. In order to evaluate the predictions of the model, a dynamic biophysical growth model for beef cattle from the animal science literature is employed to simulate feedlot and carcass performance outcomes of a large sample of feeder steers for various feeding strategies typically used by cattle feeders.

The main results of this research are as follows. First, carcass yield- and quality-improving inputs are substitutes in the production technology of feedlots. Second, overall beef quality improves under grid pricing with optimal owner and feeder behavior. Third, the power of the optimal incentive scheme for cattle feeding is lower under value-based grid pricing than under traditional live- and dressed-weight pricing methods. Fourth, the power of the incentive scheme increases with the degree of cattle owners' risk aversion. Fifth, compared to traditional pricing methods, value-based grid pricing better aligns the incentives of cattle owners and feeders under feeding contract structures in current use (yardage-fee-plus-feed-cost contracts or cost-of-gain contracts). Sixth, asymmetry in the premium-discount structure in current grids and the additional risk associated with carcass yield and quality under grid pricing are the main reasons for continued use of live-weight pricing and apparent slowness to adopt grid pricing. Seventh, more balanced premiums and discounts in grid pricing may be required to achieve further expansion of grid pricing and overall improvement of beef quality and consistency. Eighth, if cattle feeders can limit the contract parameter space to traditional forms of contracts and owners choose the contract parameters, then typical forms of cattle feeding contracts can be rationalized by optimal behavior under plausible levels of risk aversion. Finally, the introduction of grid pricing decreases (increases) the tendency toward cost-of-gain (yardage-fee-plus-feed-cost) contracts in commercial cattle feeding.