It is sort of a chicken and egg question; but which came first, swine production contracts or the increased concentration in the pork industry? What is your guess? Agriculture changes structurally and in the span from 1992 to 2004, the number of hog farms declined over 70%; while the number of large hog farms increased their share of the swine inventory from 28% to 79%; and at the same time the share of hogs marketed under production contracts rose from 5% to 67%. All of this was happening while the US hog inventory remained somewhat stable. So what is your guess did concentration or contracts come first?

To answer that question, we’ll ask Nigel Key, he is an economist with USDA’s Economics Research Service and studied whether concentration and contracts are related and whether contracts have allowed swine operators who are finishing hogs to expand in their scale of operation. Regardless of the answer, the structural change has drawn the attention of lawmakers who have changed many laws in an effort to provide more protection for the farm operator.

Key says there are three ways a contract environment can help production scale increase:
1) If contractors offer agreements to larger operators, then packers need to regulate their flow of inbound hogs which would increase the scale of operations.
2) Contracts are seen by lenders as guarantees for loan repayment, and they are more willing to finance any expansion.
3) Contracts protect income risk, which allows them to survive longer and grow faster.
Key says, “Contracting may facilitate technological changes that increase the scale at which average costs are minimized. There is evidence that production contracts enhance farm productivity, perhaps by providing access to managerial expertise and high quality proprietary inputs - such as feed and genetic stock – that are not available to independent producers. It is plausible that productivity gains increase the optimal scale of production and promote the growth in farm size.” Key also says, “There is no plausible reason to believe that the availability of contracting should influence the rate of farm growth directly. However, indirectly, contract availability should raise the relative profitability of contracting, increase the likelihood of contract adoption and thereby increase the rate of farm growth,”

When looking at the changes between the 2002 and 2007 agricultural census, Key says the mid-sized hog operations showed growth. “For hog operations (marketing) between 1000 and 5000 head contract operations grew significantly more than independent operations. For these mid-sized operations, those with production contracts grew about nine percentage points more than independent operations (in terms of average percent change) over the five years between Censuses. He says the larger and smaller operations had less statistical significance. And Key adds, “For continuing operations having fewer than 5000 head, use of a production contract in 2002 is associated with greater growth in farm size. Specifically, the use of a production contract was associated with a 15% increase for small farms, an 11% increase for medium farms, and a nearly 10% increase for large farms, compared to observationally similar farms that did not use a production contract.

Interestingly, Key says contracts may help in growth, but not in sustainability, “Contracting was found to be correlated with more growth in the scale of production for farms with fewer than 5000 head, and with an 11% increased likelihood of farm business survival for farms with 5000 head or more. In other words, for small and medium –scale operations, contracting is positively associated with farm growth, but not with farm survival.”

In conclusion, the USDA economist says it is possible that production contracts may help with production financing to grow, and for the medium sized operation, a production contract was associated with greater growth after the contract was signed. However, he also found that many producers with production contracts are also more highly leveraged, and more vulnerable to fluctuations in market conditions. For the largest operations, contracts serve to ensure sustainability.

Summary:
Production contracts in swine production have gone hand in hand with increased production scales for the fewer hog farms that remain. The largest farms have used them to ensure sustainability, while the smaller and medium sized operations have used contracts to grow in size of operation.

Source: Stu Ellis, University of Illinois