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THE ECONOMIC FEASIBILITY OF A COMPUTERIZED

FORWARD CONTRACT MARKET FOR SLAUGHTER HOCS

By

David Lawrence Holder

AN ABSTRACT OF A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY
Department of Agricultural Economics

1970

ABSTRACT

THE ECONOMIC FEASIBILITY OF A COMPUTERIZED
FORWARD CONTRACT MARKET FOR SLAUGHTER HOGS

By

David L. Holder

'Hog production and slaughter is currently coordinated by means
of a bargained exchange system where prices guide the activities of
individual producers and packers. The system was found to have two
basic coordination problems: First, hogs are not allocated to packers
in a way that minimizes the combined cost of transporting hogs and
pork products and the cost of slaughtering: Second, producers of rel-
atively high quality hogs receive less than the value of their hogs,
while producers of relatively low quality hogs receive more than the
value of their hogs.

To alleviate these problems, forward contracting and vertical
integration are receiving increased attention as are methods of carcass
pricing. But the currently conceived methods of forward contracting
and vertical integration seek to diminish the role of the market as a
coordinating mechanism. An alternative approach involves a market for
trading forward contracts. The purpose of this dissertation was to
examine the economic feasibility of such a market.

The analysis involved three steps: (1) identifying the market
coordination problems of hog producers and packers, (2) designing a
computerized contract market capable of reducing the coordination
problems, and (3) evaluating the economic feasibility of the contract

market by comparing it to the market alternatives currently in use.

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David L. Holder

Information needed for each step was obtained from a survey of 50 pro-
ducers and 10 packers in Illinois, Iowa, and Missouri. The contract
market was budgeted after interviews with representatives of the Inter-
national Business Machines Corporation and the Michigan Bell Telephone
Company.

Using information concerning the two basic coordination problems
of producers and packers, the following mechanism was adopted to
operationalize the contract market. A producer or a packer would
telephone a central computer market, identify himself as a member trader,
and transmit his message to sell or buy all by means of a code using
the characters of a conventional touchtone telephone. All trading would
be based on a single contract consisting of a standard hog and a stan-
dardized premium—discount schedule to price hogs deviating from the
standard hog. Payments to the producer would be based on the actual
carcass characteristics of his hogs after slaughter.

Adoption of the forward contract market will depend on how in-
dividual producers and packers weigh the economic advantages and
disadvantages of the contract market when compared with their current
nmrket alternatives. From the analysis it is expected that a forward
contract market would improve the allocation of hogs among packers
because a single market could be used by all buyers and sellers in
the Cornbelt region and because the market would generate new forward
trading information. The market would also improve pricing accuracy
since the contract would require carcass pricing. Prices received by
producers of relatively high quality hogs would tend to increase while

the prices received by producers of relatively low quality hogs would

David L. Holder

tend to decrease. An opportunity to make advanced sales would help
some producers lower production costs through improved planning, but
generally the contracts would not be made far enough in advance to have
a major effect on a producer's allocation of resources.

It is expected that the contract market would enable packers to
reduce the size of their procurement staffs. It would also provide
these packers with increased supply certainty, thereby allowing a more
efficient allocation of labor and other resources. But packers would
also assume new price risks by guaranteeing producers a forward price.
These risks could be hedged in existing futures markets at some
additional cost.

It was shown that the contract market would have lower operating
costs per head than current Spfit markets. Together, producers and
packers presently pay ah HC $1.10 per head to buy and sell in terminal
markets. In auction marktLg they pay a total of $0.65 to $0.80 and
in local markets about $0.35 to $0.55 per hrud. If rost hog producers
and packers were to adopt the contract market, it could handle 50
million head per year for an average cost of only $0.16 per head, 25
million head for $0.22 per head, 5 million head for. $0.43 per head.

0n the other hand, adoption of the contract market would impose
external diseconomies on existing spot markets by reducing their volume
and increasing their operating costs per head. This would have an
adverse effect on the cost of marketing other livestock species.

In summary, this study: (1) explains how a telephone-computer
market could be established and operated in order to reduce the

coordination problems of hog producers and packers, (2) makes a

David L. Holder

number of recommendations for specifying the contract to be traded
in such a market, and (3) makes a preliminary analysis of the economic

implications of the market for hog producers and packers.

THE ECONOMIC FEASIBILITY OF A COMPUTERIZED

FORWARD CONTRACT MARKET FOR SLAUGHTER HOGS

BY

David Lawrence Holder

A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Agricultural Economics

1970

 

 

ACKNOWLEDGMENTS

Foremost, the author wishes to thank his wife, Marcia, for her
encouragement and personal sacrifice and numerous hours of proof-
reading.

Appreciation is expressed to Dr. Harold Riley, major professor,
for his counsel during the research process and the documentation of
the results. To Drs. Marvin Hayenga and David Cole who shared in
this responsibility, appreciation is also extended.

The study was funded by the Michigan Agricultural Experiment
Station through the Department of Agricultural Economics. In addition,
a considerable amount of time was contributed by several hog packing
companies, hog producers, associations of producers and of packers,
and many others. Although the individuals and organizations which
assisted in this endeavor are too numerous to name, the study would
have been seriously impaired without the contribution made by each

one of them.

ii

I.

II.

III.

COORDINATION BETWEEN HOG PRODUCERS AND PACKERS:
AND PROBLEMS I O O O O O O O O O O O O O O O O O O O 0

TABLE OF CONTENTS

INTRODUCTION I C O O O O O C O O O O O O C O O O O C 0

Coordination Problems . . . . . . . . . . . . . . . .
Purpose and Objectives . . . . . . . . . . . . . . .
Research Procedures . . . . . . . . . . . . . . . . .
Preliminary Analysis . . . . . . . . . . . . . .
Testing Alternative Contract Specifications . . . .

Organizing and Operating the Forward Contract Market

Effects of the Forward Contract Market . . . . . .
Organization of the Thesis . . . . . . . . . . . .

Introduction . . . . . . . . . . . . . . . . . . . .
Allocation of Hogs to Packers . . . . . . . . . . . .
Allocation Among Regions . . . . . . . . . . . . .
Fluctuations in Price and Quantity . . . . . . . .

SITUATION

Benefits From Reducing Uncertainty and Fluctuations .

Problems with Existing Marketing Institutions . . .
Rewards and Incentives to Producers . . . . . . . . .
Hogs Differ in Value . . . . . . . . . . . . . . .
The Need for Prices to Reflect Difference in Value
Indications That Prices Do Not Reflect Differences
in Value . . . . . . . . . . . . . . . . . . . . .
Costs of Current Market Institutions . . . . . . . .
Terminal Markets . . . . . . . . . . . . . . . . .
Auction Markets . . . . . . . . . . . . . . . . . .
Local Markets . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . .

FORWARD CONTRACT MARKET . . . . . . . . . . . . . . .

Need for a Contract Market . . . . . . . . . . . . .
Technical Aspects of a Computerized Contract Market .
Basic Trading Procedure . . . . . . . . . . . . . .
The Concept of Making Bids and Offers . . . . . . .
Inter-Connected Trading Zones . . . . . . . . . . .
Forward Contracting . . . . . . . . . . . . . . .
Flexibility for the Producer and the Packer . . . .

iii

15

15
16
18
20
24
3O
41
42
44

48
53
53
55
58
61

63

63
66
67
70
72
72
73

IV. SPECIFICATIONS FOR A FORWARD CONTRACT MARKET . . . . . . 75

Product Description . . . . . . . . . . . . . . . . . . 76
Size and Quality . . . . . . . . . . . . . . . . . . 76
Carcass Versus Live . . . . . . . . . . . . . . . . . 86
Recommendations for Product Description . . . . . . . 92

Premium and Discount Schedule . . . . . . . . . . . . . 96
Standardizing the Schedule . . . . . . . . . . . . . 96
Establishing the Rates . . . . . . . . . . . . . . . 102
Recommendations for a Premium-Discount Schedule . . . 104

Size of Contract . . . . . . . . . . . . . . . . . . . 106
The Quantity to be Delivered . . . . . . . . . . . . 106
Tolerance in the Contracted Amount . . . . . . . . . 109
Head Versus Pounds . . . . . . . . . . . . . . . . . 111
Recommendations for the Size of Contract . . . . . . 113

Day of Delivery . . . . . . . . . . . . . . . . . . . . 118
Contracts Currently in Use . . . . . . . . . . . . . 118
Conflict Between Producers and Packers . . . . . . . 119
Delivery Intervals . . . . . . . . . . . . . . . . . 120
Recommendations for Arranging Deliveries . . . . . . 123

Length of Contract Period . . . . . . . . . . . . . . . 125
Uncertainty Increases as the Length of Contract

Period Increases . . . . . . . . . . . . . . . . . . 126
Recommendations for Length of Contract Period . . . . 129

Trading Zones and Transportation . . . . . . . . . . . 130
Purpose of Trading Zones . . . . . . . . . . . . . . 130
Shape, Size, and Number of Trading Zones . . . . . . 131
Transportation by Producers and/or Packers . . . . . 136
Packer Collection Stations . . . . . . . . . . . . . 137
Premium-Discount Schedules for Transportation . . . . 138
Recommendations for Trading Zones and Transportation 142

Contract Renegotiation and Speculation . . . . . . . . 144
Purpose of Renegotiation . . . . . . . . . . . . . . 144
Renegotiation Procedure . . . . . . . . . . . . . . . 146
Role of Speculators . . . . . . . . . . . . . . . . . 149

Summary of Recommendations . . . . . . . . . . . . . . 150
Product Description . . . . . . . . . . . . . . . . . 150
PremiumrDiscount Schedule . . . . . . . . . . . . . . 150
Size of Contract . . . . . . . . . . . . . . . . . . 151
Day of Delivery . . . . . . . . . . . . . . . . . . . 151
Length of Contract Period . . . . . . . . . . . . . . 152
Trading Zones and Transportation . . . . . . . . . . 152
Contract Renegotiation . . . . . . . . . . . . . . . 153

V. ORGANIZATION AND OPERATION OF THE FORWARD CONTRACT MARKET 154

Potential Size of the Forward Contract Market . . . . . 154
Number of Producers . . . . . . . . . . . . . . . . . 154
Number of HOgs . . . . . . . . . . . . . . . . . . . 155
Number of Packers . . . . . . . . . . . . . . . . . . 156

Market Agency . . . . . . . . . . . . . . . . . . . . . 157

iv

Organizing and Promoting the Forward Contract
Personnel . . . . . . . . . . . . . . . .
Compliance with the Commodity Exchange Act
Market Specifications . . . . . . . . . . .
Trading Rules and Procedures . . . . . . .
Membership Requirements and Privileges . .
Trader Identity . . . . . . . . . . . . . .
Ensuring Fair Evaluation of Hog Carcasses .
Telephone-Computer System . . . . . . . . .
Promotion . . . . . . . . . . . . . . . . .
Trading Fees . . . . . . . . . . . . . .

Cost of Organizing and Promoting . . . . . .
Personnel and Research . . . . . . . . . .
Promotion . . . . . . . . . . . . . . . .
Assistance for the Market Agency . . . . .
Ammortizing the Cost . . . . . . . . . .

Operating the Forward Contract Market . . . .
Tele—Computer Market' . . . . . . . . . . .
Contract Fulfillment . . . . . . . . . . .
Market Revisions . . . . . . . . . . . . .

Cost of Operating . . . . . . . . . . . . . .
Personnel . . . . . . . . . . . . . . . . .
Office . . . . . .,. . . . . . . . . . . .
Telephone-Computer System . . . . . . . . .
Total Operating Cost . . . . . . . . . . .

Summary . . . . . . . . . . . . . . . . . . .

EVALUATION OF THE FORWARD CONTRACT MARKET . . .

Joint Effects: Producers and Packers . . . .
Marketing Efficiency . . . . . . . . . . .
Barometer Market . . . . . . . . . . . . .
Bargaining Positions . . . . . . . . . . .

Effects on Producers . . . . . . . . . . . .
Production . . . . . . . . . . . . . . . .
Marketing . . . . . . . . . . . . . . . . .
Pricing Accuracy . . . . . . . . . . . . .

Effects on Packers . . . . . . . . . . . . .
Procurement . . . . . . . . . . . . . . . .
Production . . . . . . . . . . . . . . . .
Distribution . . . . . . . . . . . . . . .

Other Effects . . . . . . . . . . . . . . . .
Current Hog Markets . . . . . . . . . . . .
Consumers . . . . . . . . . . . . . . . . .

SUMMARY AND CONCLUSIONS . . . . . . . . . . . .

Additional Research . . . . . . . . . . . . .
Including Remarks . . . . . . . . . . . . . .

BIBLIOGRAPI'IY O O O O O O O O O O O O O O 0 O O I O 0

Market

160
160
161
162
163
163
163
165
168
168
169
169
169
170
172
174
174
174
175
176
176
177
180
180
186
187

189

189
189
198
198
199
199
203
204
205
205
209
212
213
213
214

216

223
224

226

APPENDIX A:

APPENDIX B:

APPENDIX C:

The Effect of Volume Changes on a Packer's
Slaughter Labor Lost . . . . . . . . . . .

Sizes of Hog Farms in 1969 . . . . . . . .

Cost of Telephone Computer Systems . . . .

vi

231

234

235

1.1

1.2
1.3

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9

2.10

4.1

LIST OF TABLES

Percentage distribution of hog farms, production,
slaughtering plants, and slaughter, 5 regions of
the United States, mid-1960's . . . . . . . . . . .

Characteristics of producers interviewed . . . . . .
Size characteristics of packing firms interviewed .
Estimated optimum and actual price differences
(dollars per cwt.) for five major stockyards, fourth
quarter, 1955 . . . . . . . . . . . . . . . . . . .
The effect of unplanned volume changes on slaughter
labor costs for hog packing plants planning to

operate at 600 head per hour . . . . . . . . . . . .

Number of open commitment in live hog futures con-
tracts deliverable in 1968 . . . . . . . . . . . . .

Size of pricing error related to method of hog
evaluation 0 C O O O O I O O O O O O O O O O O O O 0

Producer expenses when selling hogs in selected ter-
minal markets, 1969 . . . . . . . . . . . . . . . .

Cost of operating auction markets of selected sizes
for slaughter hogs . . . . . . . . . . . . . . . . .

Minimum estimated cost of operating auction markets
of selected sizes for slaughter hogs in Michigan . .

Operating costs of local markets of selected sizes
for slaughter hogs, Illinois, 1967 . . . . . . . . .

Operating costs of local markets for slaughter hogs,
Indiana, 1950 and 1967 O O O O C O O O O O I O O I 0

Minimum estimated cost of operating local markets of
selected sizes for slaughter hogs, Michigan, 1965 .

The effect of selected hog carcass measurements on
pricing accuracy . . . . . . . . . . . . . . . . . .

vii

page

11

11

20

28

35

50

54

56

57

59

6O

6O

81

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4.2

4.3

4.4

4.5

4.6

4.7

4.8

4.9

4.10

Lil

412

4.13

4.14

4.15

4.16

Grade and weight procurement limits for ten hog
packing firms, Midwest United States, 1969 . . . . .

Packer and producer suggestions for improving Con-
tract B O O O O O O O O O O O O O O O O O O O O O O

Packer preferences for five alternative forward con-
tract specifications . . . . . . . . . . . . . . . .

Producer preferences for live versus carcass selling
Of hogs . C C . O O O O O O O O O O O O O O C O O 0

Producer preferences for five alternative forward
contract specifications . . . . . . . . . . . . . .

log price differentials (dollars per cwt.), Chicago,
1967 and 1968 . . . . . . . . . . . . . . . . . . .

Packer and producer opinions on how often the
premium-discount schedule needs to be changed . . .

Packer and producer opinions on whether tie premium-
discount schedule should be fixed when the contract
is signed or when the hogs are delivered . . . . .

The distribution of producer opinions on a standard
Size contract 0 O O O O O O O O O O O O O O O C O O

The distribution of packer opinions on a standard
size contract . . . . . . . . . . . . . . . . . . .

Producer opinions of the tolerance needed in the
specified quantity to be delivered . . . . . . . . .

Producer preferences for specifying the contract in
terms of head or live pounds of hogs . . . . . . . .

Delivery intervals depending on the length of the
contract period . . . . . . . . . . . . . . . . . .

Producer acceptance of the delivery intervals in
Table 4.14 C O O O O O O O O O O O O O O O O O O O 0

Maximum number of months producers wished to con-
tract in advance of delivery . . . . . . . . . . . .

Maximum number of months packers wished to contract
in advance of delivery . . . . . . . . . . . . . . .

The maximum size of trading zone chosen by pro-
ducers . . . . . . . . . . .

viii

82

85

88

89

90

99

100

103

108

109

110

112

121

121

127

129

133

5.1
5.2

5.3

5.4

5.5

5.6

5.7

5.8

5.9

5.10

5.11

6.1

6.2

6.3

A.l

Producers' opinions about potential market agencies
Packers' opinions about potential market agencies. .

Producer and packer preferences for methods to en-
sure accurate evaluations of hog carcasses . . . . .

Total annual personnel expenses for a telephone-
computer market trading 5, 25, and 50 million hogs
per year 0 O O O O O O O C O O C O O O O O C O C O 0

Total annual office expenses for a telephone-computer
market trading 5, 25, and 50 million hogs per year .

Required daily capacity (number of calls per day)
for a telephone-computer system handling 5, 25, and
50 million hogs per year . . . . . . . . . . . . . .

Proportion of calls coming in the "busiest hour" of
the trading day . . . . . . . . . . . . . . . . .

Required hourly capacity (number of calls per hour)
for a telephone-computer system handling 5, 25, and
50 million hogs per year . . . . . . . . . . . . . .

Required number of telephone lines to trade 5, 25,
and 50 million hogs in a system that operates 2, 4,
6, and 8 hours per day . . . . . . . . . . . . . . .

Minimum cost of telephone-computer systems trading
5, 25, and 50 million hogs per year . . . . . . . .

Total annual cost of operating the forward contract
for 5, 25, and 50 million hogs per year . . . . . .

Producer opinions concerning the effect of the for-
ward contract market on their hog production . . . .

Number of producers who will contract at prices
"less than", "same as", and "more than" their ex-
pected spot prices at the time of delivery when the
contract is offered three months before delivery . .

Brokerage fees for hedging hogs in the live hog,
pork belly, and skinned ham futures markets. . . . .

The effect of unplanned volume changes on slaughter

labor costs for hog packing plants planning to
operate at 300 and 600 head per hour . . . . . . . .

ix

158

159

167

179

181

182

183

183

184

185

186

200

201

208

233

B.1

C.1

C.2

Projected number of hog farms and number of hogs
sold by farms of different sizes for 1969 . . . . . 234

Annual costs of telephone-computer systems for the
forward contract market handling 5, 25, and 50
million hogs per year . . . . . . . . . . . . . . . 235

Annual cost of telephone service: conventional
long distance and inward WATS . . . . . . . . . . . 237

2.4

2.5

3.1

4.1

4.2

LIST OF FIGURES

page
The percentage of hog production, slaughter and

comsumption, by region, United States . . . . . . . l7
Federally inspected hog slaughter and hog prices

by weeks, United States, January 1968 to March

1969 O O I C O I O I O O O O O O O O O O O 23
Fluctuations in hog slaughter volume, a Midwest hog
slaughtering plant, May, 1969 through April, 1970 . 25
Prices of selected live hog futures contracts prior

to delivery, 1967 and 1968 . . . . . . . . . . . . . 38
Relationship between average thickness of backfat,

carcass length or weight, and grade for carcasses

with muscling typical of their degree of fatness . . 45
Producers and packers located in trading zones and
interconnected via telephone to the computer market

center . . . . . . . . . . . . . . . . . . . . . . . 68
Alternative methods of specifying the contract for

a forward contract market . . . . . . . . . . . . . 77-78
Square trading zones "tilted" 45 degrees . . . . . . 135

xi

CHAPTER I
INTRODUCTION

In the mid 1960's in the United States there were approximately
800,000 producers selling 80,000,000 hogs annually for slaughter in
2,200 packing plants. Most of the hog production and slaughter occurred
in the twelve North Central states1 which accounted for 81 percent of
hog production, 66 percent of the hog farms, 68 percent of hog slaugh-
ter, and 33 percent of the packing plants slaughtering hogs. (See
Table 1.1 for a comparison of the different regions.)

The current system for coordinating the thousands of producers
and packers in order to transfer hogs from one to the other depends
primarily on a system of spot markets where prices are determined.

In the twelve North Central States there are approximately 25 public

terminal stockyards, 750 auctions, and 2350 local markets or buying

stations to assist in the price determining and coordination process.

'Hmre is a live hog futures market available for hedgers and specu-

lators, and there are several sources of price and other marketing

hfibrmation. Nevertheless, there appear to be some significant

pmmlems in coordinating producer and packer Operations.

Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri,
Nebraska, North Dakota, Ohio, South Dakota, and Wisconsin.

National Commission on Food Marketing, Organization and Com-
.fltion in the Livestock and Meat Industry, Technical Study No. 1

gzflxington: U.S. Government Printing Office, June, 1966), pp. 125-

2

TABLE 1.1 Percentage distribution of hog farms, production, slaugh-
tering plants, and slaughter, 5 regions of the United States,

 

 

 

mid-1960's.
Hog a Hog b Hog slaughtgring Hog
Region farms production plants slaughter

North Central 66 81 33 68
Northeast 2 1 15 7
Southeast 12 7 15 9
South Central 17 9 23 11
Western 3 2 l4 5
United States 100 100 100 100

 

 

 

 

 

Source: aU.S. Department of Commerce, Bureau of the Census, Census of
AgricultureL 1964, V01. 11, Chapter 2, "Livestock, Poultry,
and Livestock and Poultry Products" (Washington: U.S. Govern-
ment Printing Office, 1967), pp. 155-161.

U.S. Department of Agriculture, Economic Research Service,
Livestock and Meat StatisticsL Supplement for 1968, Stat.
Bul. No. 333 (Washington: U.S. Government Printing Office,
c1969), pp. 35,103.

U.S. Department of Agriculture, Statistical Reporting Ser-
vice, Number of Livestock Slaughter Plants, March 1,,1965
(Washington: U.S. Government Printing Office, June, 1965),
p. 7.

Coordination Problems
Many of the coordination problems center around the pricing
process. The National Commission on Food Marketing has distinguished
two parts in this process and has explained the problems associated
. 1
With each.

Two distinct phases are important in the pricing
of hogs. One is determining the general level of prices
for hogs of specified quality standards at a given time and
place, while the other involves determining the value of
a specific hog or group of hogs relative to the general
market level . .

Historically, terminal hog prices have been re-
ported widely and used extensively as bases for pricing

1 National Commission on Food Marketing, Livestock and Meat, pp.
37-138 a

 

hogs elsewhere. As terminal sales came to represent a
decreasing fraction of hog marketing, the representative-
ness of terminal market prices became a matter of
increasing concern. Hog prices at interior locations have
been reported to some extent. However, covering the
numerous and widely scattered sales in a representative
way has been difficult .

In addition to the continuing need to develop and
communicate improved information about the general level
of hog prices is the persistent, hard problem of accu-
rately compensating individual producers for the actual
quality characteristics present in the hogs they sell .

. . The problem will require continuing efforts by
producer and trade groups, and by researchers and Gov-
ernment . . . . Contract hog production, which has been
insignificant may play an increasing role. Continuing at-
tention will need to be given to marketing procedures and
practices to ensure that effective competition and accurate

pricing are maintained in any new system or systems that
emerge.

One of the consequences associated with the inability of the mar-
keting system to find the general level of prices quickly and accurate-
ly is the fluctuation and uncertainty of volume and price experienced
by individual packers. Several packers concerned with the problem are '
considering forward contracting as an alternative means of timing
and controlling the flow of hogs to their slaughter plants. Vertical
integration (single ownership of hog production and slaughtering) is
also being considered. But vertical integration of a farm and non-
fhrm stage of production is not as likely as other combinations
lmcause (1) there is little technological complementarity between the
tmastages which would improve operating efficiency, and (2) a farm
stage of sufficient size to match the non-farm stage would involve a

Vflw'large investment.1 Clifton Cox of Armour and Company has estimated

Ronald L. Mighell and Lawrence A. Jones, Vertical Coordination
.Elégriculture, USDA, ERS, Agricultural Economic Rept. No. 19 (Wash-
inEton: U. S. Government Printing Office, February, 1963), pp. 32-33.

4“
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4
"that to integrate for a single [packing] plant may take an investment
of $25 million in breeding stock and facilities without any investment
in feed and labor."1

Producers regard forward contracting as a means of reducing price
risk and sometimes as a means of obtaining a higher price for their
hogs. Contracting could also be used to improve the accuracy with
which individual hogs were priced if the contract specified payments
according to carcass weight and grade rather than according to live
weight or live weight and grade as is commonly practiced in many country

markets. However, many producers are skeptical about the net benefits

 

of forward contracting. In a recent survey, 51 percent of the pro-

ducers agreed with the general statement that "hog contracting is a

threat to the independent operator."3 Nevertheless, forward contract-

ing is likely to be used with increasing frequency in the future as

producers and packers seek new methods of organizing and controlling '

the flow of hogs from feedlot to slaughter.
To use contracting to full advantage alternative methods will
have to be explored for (1) specifying the contract, (2) placing

buyers and sellers in contact with each other, and (3) determining

the exchange price. Different kinds of contracts and contracting

ammngements are currently in use, more or less on an experimental

Clifton B. Cox, speech to the National Institute of Animal Agri-
<ndture, Purdue University, April 8, 1968.

See for example, Emer E. Broadbent, A. G. Madsen, and V. I. West, ‘
Pficing Butcher Hogs at Illinois Country Markets (University of Illinois ,
A& Exp. Sta. Bul. No. 714, September, 1965) pp. 6, 31. '

3 . '

Tom Quirk and A1 Oppedal, "Hog Contracting: How Far Has It Gone?,"

.1103 Farm Management (October, 1968), pp. 10-13.

. 5
basis. Packers such as Armour, Wilson, and Schluderberg-Kurdle (in

Baltimore) are offering their own forward contracts directly to pro-
ducers'. The contracts guarantee the producers selling price at the
time the contracts are signed. The packers usually offset the risk
of making the guaranteed price by hedging in the live hog futures
market. At the present time, the above packers are procuring less than
one percent of their volume by this means.

A number of hog marketing firms are offering contract programs to
producers and to packers. A private marketing firm, Reinhold Hog Mar-

kets, which operates a number of local hog markets in Indiana, Illinois,

 

and Iowa, offers producers a guaranteed forward price and offsets the
price risk incurred by hedging in the live hog futures market. The
contracted hogs are sold to packers on a spot market basis along with
the non-contracted hogs bought by the firm's local markets. At least
two producer cooperative organizations, The National Farmers Organi- ’
zation (NFO) and the Interstate Producers Livestock Association),
are contracting with producers, pooling the hogs, and acting as the
producers' bargaining agent in securing contracts with packers.1
Another alternative contracting system not yet in practice but

receiving some consideration in the literature involves a market for

 

1Personal interviews with representatives of Interstate Producers .
Livestock Association, National Livestock Producers Association and
Reinhold Hog Markets Inc.

 

 

 

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1 .
forward contracts. The market would use a standardized contract

'which could be traded in a computerized market mechanism to which
producers and packers would gain direct access by means of telephones.

Shaffer offers the following in defense of such a contract mar-

ket:2

A national market in deliverable forward contracts . . .

would provide the needed coordination and reduce the

stimulus for vertical integration into farming, while

providing the advantages of a competitive market without

the price uncertainty.

Breimyer suggests that the market would operate as an Open com-
petitive market, which he calls "one of the more ingenious institutional
inventions of man."3 The open competitive market has a unique ability
to determine the value of a product on the basis of consumer utility, ‘
to reward producers for their performance, and to be generally self-

4

sustaining and self-regulating once prOper laws are established. It
is also generally agreed in economics that competitive markets have -

the ability to efficiently allocate resources for production.

In short, a tele-computer market, whether for hogs or some other

 

See for example, Harold F. Breimyer, "Agricultural Organization
in the Modern Industrial Economy: The Open Competitive Market Approach"
(paper presented at the NCR-ZO Seminar, Agricultural Organization in
,EkggModern Industrial Economy, April, 1968), pp. 37-39; Lee F. Schrader,
Richard G. Heifner, and Henry E. Larzelere, The Electronic Egg Exchangg;
AEIAlternative System for Trading Shell Eggs, Agricultural Economics
Rewort No. 119 (East Lansing: Department of Agricultural Economics,
Michigan State University, December, 1968); James Duncan Shaffer, "On
Irwtitutional Obsolescence and Innovation," American Journal of Agri-
ctfltural Economics, Vol. 51 (May, 1969), pp. 255-257.

 

ZShaffer, "Obsolescence", p. 257.
Breimyer, "Agricultural Organization", p. 35. '

4Ibid., pp. 35-36.

4 I

mi‘

7
con-odity, could enable a large number of buyers and sellers to inter-

act, regardless of their degree of geographic dispersion. Such a mar-
ket could, therefore, improve pricing efficiency at the market level

inspite of the decentralization of hog production and slaughter which
has so far tended to sacrifice pricing efficiency at the market level

for operational efficiency at the firm level.1

Purpose and Objectives

The main purpose of this dissertation was to evaluate the economic
feasibility of a telephone-computer forward contract market for slaugh-
ter hogs. The electronic technology for computerized markets is
available. When the New York Stock Exchange moves to its new location
in the mid-1970's, it will lack the traditional "trading posts" where
brokers gather to exchange each stock issue. The brokers will sit at
consoles in private offices whereby they will enter the trading "crowd",
of any issue by pressing a few buttons. A computer will synchronize
all the consoles and perform all the necessary paperwork.2 The
technology of using telephones to obtain direct access to a comput-
erized market is also available, and a prototype for shell eggs has
been demonstrated by Schrader, Heifner, and Larzelere.3 The technology
will give hundreds of producers and packers convenient, rapid, and

direct access to the market.

 

1For a discussion of pricing efficiency and operating efficiency,
see Willard P. Williams and Thomas '1'. Stout, Economics of the Livestock
,ygg§_13ggg§gy (New York: 'Macmillan, 1964), pp. 120-123.

zWell Street Journal, may 13, 1969, p. 36.

SSchreder, Heifner, Larzelere, Electronic Egg Exchange.

 

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8
The availability of hog grades and other methods of describing

the product could help to make the market feasible since all trading
could be done by description rather than physical inspection. The
market could Operate without the traditional facilities to handle hogs
during the exchange process and there would be little labor involved.
In addition, most hogs could move directly from the farm to the packing
plant, thereby minimizing transportation costs.

The specific objectives of the study were:

(1) To identify the market coordination problems of hog
producers and packers;

(2) To design a computerized forward contract market for
slaughter hogs capable of reducing the coordination
problems identified;

(3) To evaluate the economic feasibility of a computerized

forward contract market.

Research Procedures

Preliminagy Analysis

A general understanding of the problems of coordinating hog pro-
ducers and packers was obtained from selected references on livestock
marketing, from attendance at two North Central Region (NCR) live-
stock marketing seminars of professional agricultural economists
(November 1968, and April 1969), and from a meeting with the Subcom-
mittee on Hog Production and Procurement of the American Meat In-
stitute consisting of representatives from seven packing firms.

Information about computerized marketing with direct telephone
access to the computer was gained from studying the telephone-com-

puter market for shell eggs, developed and demonstrated by Schrader, 1

 

9

Heifner, and Larzelere.1 It was studied to see how the principles
could be adapted to hog contracting.

Finally, the necessary elements of a forward contract were an-
alyzed. The literature on futures markets and copies of the live hog
and live cattle futures contracts were studied not only because they
are being used successfully but also because the contracts are traded
in formal open markets. Other alternative specifications were found
in contracts being offered by three packers (Armour, Schluderberg-
Kurdle, and Wilson) and by two hog marketing firms (Interstate Live-
stock Producers Association and Heinhold Hog Markets). Informal
interviews with these firms were helpful in learning how the con-
tracts were used. Important elements of a contract market and
alternative specifications were also discussed with eight southern
Michigan hog producers.

The results of the above analysis were used in formulating
preliminary specifications (and alternative specifications) for hog

contracts that might be traded in a computerized market.

Testing Alternative Contract Specifications

To test the preliminary contract market specifications, fifty
producers and ten packers were personally interviewed. A brief
opening discussion of coordination problems was used to set the tone
of the interview as well as to further define coordination problems.
This was followed by a presentation of the mechanics of a computerized
forward contract market and the alternatives for specifying various

aspects of the market. The producers and packers were asked to choose

 

1Schrader, Heifner, and Larzelere, Electronic Egg Exchange.

 

10
the alternatives which they felt should be incorporated in a contract

market as well as to suggest modifications of the alternatives pre-
sented. The results of the interviews were analyzed to learn the
major agreements and disagreements between the producers and the pack-
ers so that suggestions for the specifications of a forward contract
market could ultimately be made.

Producers interviewed. Fifty producers in Illinois and eastern
Iowa were chosen as a purposive sample. The basis of their selection
was: (1) that they be willing to talk about new developments in hog
marketing, (2) that they represent a fairly broad spectrum with regard
to the number of hogs sold per year, and (3) that some have previous
experience with forward contracting while others do not. The latter
condition was added because it was felt that producers with contract
experience would be better able to comprehend and evaluate the pro-
posed forward contract market idea than producers without any forward
selling experience. Nevertheless, it was necessary to interview both
kinds in order to see if in fact there were any differences in their
responses to various questions.

The names and addresses of producers meeting the above require-
nmnts were obtained from the Cooperative Extension Service in Iowa and
Illinois, the Illinois Farm Management Service, packers and marketing
finms making forward contracts with producers, and other producers.
The basic characteristics of the producers interviewed are presented
in Table 1.2. The original plan was to interview about twice as many
producers with contracting experience than those without the experience,
but producers with contracting experience were difficult to find. In

some areas Extension and other farm people could not identify a single

 

11

TABLE 1.2 Characteristics of producers interviewed.

 

 

Number of producers interviewed

 

 

Number of hogs Producers with forward Producers without forward
sold per year contracting experience contracting experience
Less than 500 5 4
500 - 999 7 11
1.000 - 2,999 7 13
3,000 or more 0 3

Total 19 31

 

 

 

TABLE 1.3 Size characteristics of packing firms interviewed.

 

 

 

Tangible N0. of head N0. of
Firm 8 slaughtered plants
assets
per vear opgrated
$1,000's 1,000 head
1 $50 to $100 25 one
2 $100 to $300 90 one
3 Over $1,000 875 one
4 Over $1,000 900 one
5 Over $1,000 1,300 one
6 Over $1,000 b one
7 Over $1,000 b more than one
8 Over $1,000 b more than one
9 Over $1,000 b more than one
10 Over $1,000 b more than one

 

 

 

 

aFrom Thomas Register (Thomas Publishing Co., December, 1968),
pp. 5049-5051.

 

b
Not available from interviewing, but greater than 1,300,000 head.

d-

 

 

12

producer who was selling his hogs by contract. Packers and others
offering forward contracts have had a very light response from pro-
ducers. Of the 19 producers with contracting experience, only 50
percent contracted more than 25 percent of their hogs; only one pro-
ducer contracted more than 50 percent of his hogs.

Packers interviewed. A total of ten packers in Illinois, Iowa,
and Missouri were selected from Thomas Register1 and in consultation
with the American Meat Institute. They were chosen so as to represent

a variety of sizes of operation as shown in Table 1.3.

 

Organizing and Operating the Forward Contract Market

The producers and packers interviewed were asked to recommend an
organization that was capable of establishing and operating the market
successfully. The task of the group that would accept such a position
was developed from the literature on futures markets, interviews at -
the Chicago Board of Trade and the Mercantile Exchange, from firms
that offer forward contracts to producers, and from the development
of the forward contract market itself. Some legal aspects were ob-
tained during an interview at the Chicago office of the Commodity
Exchange Authority and from perusal of the Commodity Exchange Act.

The types of telecommunication and computer equipment needed and
the cost of using them were developed from interviews with represent-
atives of the International Business Machines Corporation (I.B.M.) and
the lfichigan Bell Telephone Company. Since no attempt was made to

writers computer program for the market, cost estimates for the basic

 

1Thomas Register (New York: Thomas Publishing C0,, December,
1968) , pp. 5049-5051.

13
computer equipment were derived from estimates of the computer capacity

needed to handle the several functions which had to be performed.
Parallels were drawn from the equipment needs of the Electronic Egg
Exchange which was programmed and operated. A detailed marginal cost
analysis of variations in contract specifications and programming
variations which would have different computer time requirements was
not possible, but it was possible to say some alternatives were more
or less expensive to use than others because they appeared to use more

or less computer processing time and/or computer memory Space.

 

Effects of the Forward Contract Market

The effect of the contract market on the coordination problems
of producers and packers was measured by comparing it with current con-
ditions under the existing marketing system. The producers and pack-
ers were asked several questions to determine how the availability of
the contract market would change their production practices and costs
as well as their methods and costs of buying and selling hogs. The
producers were also asked a series of questions to determine the value
they placed on a guaranteed forward price. In addition, the operating x
costs of the contract market system were compared with the costs of
the current marketing system.

Many of the effects on producers and packers were inferred from
information contained in secondary sources. For example, the cost of
supply uncertainty for packers was synthesized from estimates of labor
requirements and costs found in several published sources.

Whenever possible, the effects were expressed in monetary terms,

"

but often only the general direction (whether an advantage or dis-

advantage) could be determined.

 

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14

Organization of the Thesis

The coordination problems of producers and packers are analyzed
in the next chapter. Chapter III follows with an explanation of the
potential role of a forward contract market for hogs. It also contains
the procedure for trading in a telephone-computer market. Chapter IV
analyzes the Specifications of a forward contract that could be traded
in such a market. The method and cost of organizing and operating the
contract market are discussed in Chapter V. Chapter VI evaluates some
of the economic effects of the forward contract market on producers
and packers, and Chapter VII provides the concluding observations on

the economic feasibility of such a market.

 

 

 

 

 

 

CHAPTER II

COORDINATION BETWEEN HOG PRODUCERS AND
PACKERS: SITUATION AND PROBLEMS
Introduction

This chapter is concerned with the coordination of several dif-
ferent types of firms involved in the production and marketing of pork
products, but it focuses specifically on the interface between hog
producers and packers. The chapter also focuses on coordination in the
short-term, which includes the nine or ten months from breeding to
slaughter. In this period of time the supply of hogs is relatively
fixed, except for death losses and decisions to hold gilts for breed-
ing purposes.

To gain some insight into the problems of coordinating hog pro-
ducers and packers, the fifty producers and ten packers in the
interview sample were asked to comment on what was wrong with the pre-
sent,hog marketing system and where improvements could be made. This
part of the interview procedure was left largely unstructured. Except
for a few preselected problems, each producer and packer was asked to
discuss the problems with which he was most concerned. As it turned
out, the respondents did little more than identify the problems. The
reasons behind the problems and their interrelatedness had to be
developed from secondary sources.

Most of the problems perceived by the producers and packers fell

into one of two major categories: (1) those involving the allocation

15

16

of available hog supplies to available packing facilities and (2)
those involving rewards and incentives to producers.

After a discussion of these two basic types of problems, there
is a final section in this chapter on the cost of marketing hogs via

the marketing alternatives currently available.

Allocation of Hogs to Packers

 

The major coordination task in the short-term is to effect the
exchange of hogs between producers and packers. The rates of exchange
are the prices established in the market place reflecting the supply
and the demand for hogs. The demand for hogs is derived from the
demand for pork products as well as the supply and demand for services
to convert hogs into pork products. The price that a packer bids for
hogs must be high enough to attract sellers, yet low enough so that he
can profitably cover his costs and still attract buyers in the whole-
sale market. These costs include his slaughtering and cutting costs
as well as his costs for transporting hogs to the plant and trans-
porting pork products to his customers. Changes in these costs affect
the price he pays for hogs, as do changes in the number of hogs avail-
able and changes in the amount or pork consumers want at various prices.

If the prices for hogs accurately reflect all the factors of
supply and demand, the hogs will be distributed to packers in a way
that minimizes the combined cost of (l) transporting hogs to slaugh-
tering plants, (2) slaughtering the hogs, and (3) transporting the

pork products to consumers. Accomplishing such a task means

l7

 

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mm3 .mm .aa .momH How uaoEonmsm .mofiumfiumum umoz mom xooumm>HA .ououasuauw< mo ucoauumaoo .m.D "oopsom

 

mmumum mango: .cofiwmu an .oofiuaeomcou wow .HMuswomHm .cowuuomoua won mo mwmuomoumm use H.m madman

macawou
cofiuaesmooo HmafiucHum \ooo\

 

 

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l8

coordinating individual producers and packers within small regions as
well as among regions. It requires many submarkets related to a na-
tional market for hogs and pork products. The fact that hogs are
produced, slaughtered, and consumed in different places (see Figure

2.1) complicates the coordination process and makes transportation an

important factor.

Allocation Among Regions

 

Rizek, Judge, and Havlicekl make a spatial economic analysis of
the hog—pork subsector to determine the Optimum regional flows of
hogs and pork and resulting prices when transportation and slaughter
costs were minimized.

The optimum results obtained in the study were not necessarily
the optimum for the subsector because the model used could not include
all the factors and relationships that affect the interregional flows
of hogs and pork. But as long as the model included all of the im-
portant factors and relationships, one would expect a fairly close
similarity between the optimum specified by the model and the optimum
for the subsector. Rizek, Judge, and Havlicek included the most imr
portant variables, namely the transportation costs for hogs and pork

and the slaughter labor costs.

 

1R. L. Rizek, G. G. Judge, J. Havlicek, Joint Spatial Analysis of
Regional Slaughter and the Flows and Pricing of Livestock and Meat.
Part III of Spatial Structure of the Livestock Economy, North Central
Regional Research Bul. No. 163 (South Dakota Ag. Exp. Sta. Bul. No.
552, October, 1965).

 

 

 

19

If the model produced a close approximation of what the actual
flows of hogs should have been under the supply and demand conditions
that existed, about 14 percent of the hogs were slaughtered in the
"wrong" region during the last quarter of 1955. In general, the area
east of the Mississippi River did not slaughter enough hogs while the
area west of the river slaughtered too many.1

The misallocation of hogs among regions is the result of the mis—
allocation among individuals. It would be interesting to estimate the
amount of misallocation among individual packers within the regions
but only those misallocations that crossed regional boundaries and
were not offset by a misallocation in the opposite direction could be
measured in an interregional model like the above. Even after the
interregional transfer, it is still not known whether the hogs were
allocated efficiently to the individual packers within each region.
Hence, the extent of misallocation was at least as much as the 14
percent which could be measured between regions.

The Rizek (et.a1.) model also estimated the optimum price differ-
ences between regions. Table 2.1 compares the price differences of
the optimum solution with the price differences that acutally occurred
:in the last quarter of 1955 at five major stockyards in five of the
:regions used in the model. By size of price differences from the
lxowest price market, the model ranked the five markets in the same

order as actual price differences. The only divergence between the

 

llbid., pp. 45 and 56.

20

TABLE 2.1 Estimated optimum and actual price differences (dollars per
cwt.) for five major stockyards, fourth quarter, 1955.

 

 

 

Estimated
Market Optimum
price Actual price differences
differences Oct. Nov. Dec. Averagea

SL Paul $.00 $.00 $.00 $.00 $.00
(Maha .35 -.08 .02 .22 .04
Kansas City .46 .33 .25 .48 .35
Chicago .52 .23 .29 .49 .34
Indianapolis .67 .78 .69 1.05 .84

 

 

 

 

 

 

aSimple average, not weighted by volume.

Source: Derived from R. L. Rizek, G. G. Judge, and J. Havlicek, Joint
Spatial Analysis Of Regional Slaughter and the Flows and
Pricing of Livestock and Meat. Part III Of Spatial Structure

' Of the Livestock Economy, North Central Regional Research Bul.

NO. 163 (South Dakota Ag. Exp. Sta. Bul. NO. 552, October,
1965), p. 45 for actual slaughter, p. 56 for Optimal slaughter;
U.S. Department Of Agriculture, Agricultural Marketing Service,
Livestock Market News Statistics and Related Data, 1955,
Statistical Bul. NO. 178, (Washington: U. 8. Government
Printing Office, 1956), p. 39.

 

 

 

 

two sets Of differences was in the size Of the price differences be-
tween markets. The differences between Chicago and Indianapolis, for
example, was actually about two times larger than that indicated in
the model. Omaha and St. Paul were actually much closer in price than

the model suggested.

Fluctuations in Price and Quantity
The bargained exchange system relies on market prices to accom-
plish the intraregional as well as the interregional allocation Of

hogs to packers. According to classical economic theory, the least-cost

21

allocation is the automatic result of each producer and packer seeking
to maximize his own profits. But the theory assumes perfect knowledge
and foresight on the part of each producer and packer. Fluctuations in
the price and quantity Of hogs limit knowledge and foresight.

Long-term fluctuations are caused by cyclical and seasonal changes
in supply and demand. TO the extent that price and quantity fluctu-
ations reflect actual supply and demand changes, these long-term
fluctuations are desirable because they align consumers' wants with
the ability Of the economy to meet them. To the extent that these
fluctuations cause uncertainty about supply and demand conditions,
they are undesirable because uncertainty requires additional resources
for learning and planning and for facilities to cope with the uncer-
tainty. Uncertainty also results in mistakes in the allocation of
some resources.

For the short—term, the number of hogs available for slaughter is
relatively fixed or predetermined. The coordination task is to find
the most efficient way Of getting the hogs from the producers tO the
packers (and on to consumers). The demand for hogs and pork is pro-
bably known relatively well. That is "there are few surprises on the

I

demand side." It is uncertainty about the quantity of hogs available

on farms and the price that will move them to packers that causes daily

 

1Roger W. Gray, "Why Does Futures Trading Succeed or Fail," in
Futures Trading Seminar, Vol. 111, ed. by Erwin A. Gaumnitz (Madison:
Mirmir Publishers, 1966), p. 136. In response to a discussion
question raised by James Martin.

 

22

prices and volumes to fluctuate both in aggregate and for individual
producers and packers. Because prices and volumes fluctuate, uncer-
tainty is perpetuated. For the short-term, both the uncertainty and
the fluctuations are undesirable. The uncertainty requires additional
resources, as already explained above under the long—term phenomenon.
The fluctuations, which do not seem necessary in the short-term, cause
resources tO be used less efficiently than they could be used without
the presence Of short—term fluctuations in volume.

The short-term and long-term fluctuations in volume and price are
demonstrated by the weekly slaughter and price data in Figure 2.2. The
figure does not cover a long enough period Of time tO show a cyclical
pattern, but a seasonal pattern is evident. There are fewer hogs
slaughtered in the summer months than in the fall, and the winter and
spring are in between the two extremes.

This long-term seasonal pattern appears to be desirable because it
tends to coincide with the seasonality of supply and demand. A study
by B. F. Stantonl has shown that demand in the second and third
quarters (Of the year) are considerably less than demand in the first
and fourth quarters. There is apparently a seasonal supply function
as well since it is more costly to raise hogs farrowed in the winter
Inonths when it is cold. TO a lesser extent, farrowing costs increase

again in the late spring when the labor requirements for cropping

 

1B. F. Stanton, "Seasonal Demand for Beef, Pork, and Broilers,"
Aqgricultural Economics Research, Vol. 13 (January, 1961), pp. 1—14.

 

l. I. Is\ Q

23

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24

enterprise tend to increase the Opportunity cost Of farm labor used
for farrowing.

If the pattern Of long-term adjustment is assumed to follow some
kind of smooth continuous relationship over time as continuous adjust-
ments are made tO the long-term seasonal and cyclical supply and
demand changes, the pattern would probably be similar to the one
estimated in Figure 2.2. The short-term fluctuations would move
above and below that line as producers and packers attempted to co-
ordinate the exchange Of hogs under conditions Of uncertainty.

The effect Of the fluctuations on coordination Of individual pro-
ducers and packers cannot be shown by Figure 2.2 because the figure
aggregates over several packers for an entire week and thereby tends
to "average out" many extremes felt by individuals. Figure 2.3 shows

the volume fluctuations experienced by a single packing plant.

Benefits From Reducing_Uncertainty and Fluctuations

One method Of analyzing the problems Of price and volume uncer-
tainty is to examine the benefits that could be gained if the
fluctuations and uncertainty were reduced.

At thegproducer level. Increased price certainty (not necessarily

 

‘perfect certainty) would improve the ability and/or reduce the effort
(of producers to compare the consequences Of marketing hogs on several
(iifferent days. That is, each producer would have a more certain

zarray Of prices over time from which he could better select a market

(iaq'when the difference between his costs Of production and his expected

25

 

 

 

Hogs
NO. Of Head
30,00q-
25,00dr
20,00qe ‘
Labor
Day
Thanksgiving New Year
Day Day
15,000-
Memorial
Day
Independence
Day
10,000r Christmas
“‘ <-
" Pd :1 o) 'H
>\ u . :1
'3 3 g D u
d W z E 3‘
1 i J l L

 

Figure 2.3 Fluctuations in hog slaughter volume, a Midwest hog
slaughtering plant, May, 1969 through April, 1970

26

revenue was the greatest. And with smaller price fluctuations be-
tween days, the effect Of choosing the "wrong" day for profit
maximization would be smaller than if there were large price changes
from day tO day.

At the packer level. The packers were not asked whether they

 

were more concerned about the price they would receive or the number
Of hogs they would trade. However, one would expect a packer to be>
concerned with both the price and the volume. The live hog price

is important relative to the prices for pork products because the
packer has to allow himself a sufficient margin to cover his costs,
and profit. Six Of the ten packers interviewed (generally the largest
ones) keep informed Of their margin by evaluating each hog carcass,
computing its wholesale value, and comparing it to the procurement
cost. This is all calculated by computer and totaled for all hogs

for each day.

The volume Of hogs slaughtered each day is also important. Long-
term fluctuations in volume prevent most packers from using their full
capacity all year. This phenomenon seems to be unavoidable. But to
the extent that uncertain, short-term fluctuations could be reduced,
packers could reduce some Of their labor costs. The labor costs for
killing, cutting, and packaging hogs account for about 55 percent Of

the total cost Of those operations.1

 

1Derived from Donald B. Agnew, "Meatpackers' Costs for Fresh Beef
and Pork," reprinted from Marketingyand Transportation Situation, USDA,
ERS, August 1965, pp. 37—40.

 

27

Under the present labor contract a packer's labor force is variable
between weeks but fixed once the labor gang for killing and cutting is
called for any given week. Once called to work, a laborer must be
paid his wages for 36 hours and may be asked to work up to 40 hours at
the same hourly wage rate. The labor contract puts a premium on the
packer's ability tO accurately estimate his volume for the coming week
and to increase or decrease his labor force and chain speed to avoid
overtime payments or idle labor.

TO illustrate the effect of unplanned changes in volume on the
cost Of the slaughter labor gang (including the labor for viscera
preparation), a situation was synthesized. That is, the situation
has not been Observed but has been constructed from parameters and
relationships known to exist in the hog packing industry. A packing
plant was assumed to have planned for a kill Of 600 head Of hogs per
hour during a 38 hour week,1 and the cost consequences of receiving 5,
10, 15, and 20 percent more hogs and 5, 10, 15, and 20 percent fewer
hogs per week than expected were calculated. The results are shown
in Table 2.2.

An unplanned increase or decrease in volume Of 5 percent per week
could be slaughtered within 36 tO 40 hour range and would not affect
leaner costs per head. An unplanned increase or decrease Of as much

as 111percent would only increase costs 1 to 5 percent, but as

 

1A 38-hour week assumes the packer is just as likely to be under-
as (Iver-supplied and can Operate between 36 and 40 hours without

"penalty" .

28

larger proportions Of the slaughter were not planned, the rate would

increase, especially when a plant slaughtered fewer hogs.than expected.

TABLE 2.2 The effect Of unplanned volume changes on slaughter labor
costs for hog packing plants planning to Operate at 600 head

 

 

 

 

 

‘ per hour.8
N0. of head slapghtered per week Labor cost 58} head
Actual as Actual as
Planned Actual a percent Planned Actual a percent
ijplanned Of planned
25,560 120 $0.855 105
24,495 115 0.842 103
23,400 110 0.828 101
22,365 105 0.818 100
21,300 21,300 100 $0.818 0.818 100
20,235 95 0.818 100
19,170 90 0.861 105
18,105 85 0.912 111
17.040 80 0.969 118

 

 

aA plant Operating at 300 head per hour exhibited the same results
in percentage terms, but the absolute costs per head were higher, as
were the cost increases related tO volume changes.

Source: Appendix A.

The cost effect Of an unplanned decrease was much more pronounced than
an unplanned increase because the number Of labor hours could only be
decreased to 36, whereas it could be increased to 48. The cost effect
Of paying overtime (1.5 times the normal wage rate for over 40 hours
per week) was much less than the effect Of having to pay for idle
labor. A packer would be better Off planning to Operate for 36 hours
per week if there were an equal chance that he would slaughter more

or less than planned.

.o

.1

 

 

{so

 

\> ‘
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29

The above analysis assumed that: (1) the chain speed and labor
force could always be adjusted to keep the slaughter time within 36
to 40 hours, (2) the average wage rate per worker per hour would re-
main the same, and (3) productivity per worker would remain constant.
In practice these assumptions can be held, or they can be relaxed in
such a way that they Offset each other.1

In short, fluctuations in price and quantity and the resulting un-
certainty are believed to require a large amount Of a packer's resources
for planning and coordinating procurement and slaughtering activities.
Lower levels Of uncertainty would reduce the amount of planning re-
sources needed and/or make planning more accurate so as to avoid

mistakes, such as calling tOO many or tOO few slaughter laborers.

At the hog marketing level. Between producers and packers fewer

 

fluctuations in the volume would result in a better use Of resources.
The use Of physical facilities would not be affected much because
there would be overcapacity most of year in order tO handle seasonal
peaks. However, labor could probably be used more efficiently. TO
the extent that volume would be more certain and tO the extent that
labor could be called or dismissed as volume was expected to change,
there would be a greater chance Of having only the necessary number Of

workers on hand at any given moment. TO the extent that price and

 

1Donald B. Agnew, "Labor Costs Of Killing Hogs From Packers'
Accounting Records" (address at meeting Of Southern Division, NIMPA

Accounting Conference, National Independent Meat Packers Association,
Jacksonville, Florida, October 20, 1962) pp. 8-9.

.o.

..
.5

~‘.

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{a
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30

volume fluctuations cause uncertainty in the market place,.their re-
duction would tend to decrease the cost of collecting and disseminating
information and the cost Of price determination because they would
probably require less effort to up-date them. Or the quality Of the
information and the accuracy Of the price could be improved with the

same effort.

Problems with Existing Marketing Institutions

 

Open competitive markets. The bargained exchange system relies on

 

Open competitive markets such as terminals, auctions, and local markets
to coordinate hog producers and packers. These markets are responsible
for measuring the forces Of supply and demand and determining the rate
Of exchange. Evidence Of short-term fluctuations in price and in the
quantity Of hogs slaughtered suggest much trial and error and mistakes.

The fact that a group Of hogs can be ready for slaughter on any
of several days means that the producer has to make a decision about
when to enter the exchange process. If he enters the market on a day
when there are relatively few hogs being traded, the price will be
relatively high. This is his reward for selling them on a day when
packers are in relatively greater need Of hogs tO maintain their planned
rates Of kill. Conversely, the price is relatively low when a re-
latively high number Of hogs come to market.

Mistakes are made when the producer does not have enough information
about the next several days tO tell when the price will be the "best"
for him (that is, when the price will yield the greatest return above

1113 costs). He may sell his hogs on one day when he feels the price

us

. v

 

31

is as good as he can expect, but a few days later there may he rela-
tively fewer hogs sold for slaughter and the price may be even higher.
The producer will lose added revenue, and some packer will suffer a
reduced rate of kill. On the other hand, a producer may hold his hogs
too long and finally be forced to sell them when there are a number of
other hogs are on the market and the price is relatively low. In this
latter case, he suffers reduced revenue and the packer suffers an in-
creased rate of kill which could have been avoided if the producer had
more foresight.

The day—to-day spot market prices provide some guide to the pro-
ducer and the packer, but because the prices refer more to past
occurrences than to future ones, they are not sufficient to coordinate
the system. According to Wayne Purcell, in a study of the information
system for beef marketing:l

. . . price per se is a result. As such, price is

the culmination Of the complex workings of the system

of action called marketing. . . Price achieves its im-

portance as a referent for the results of such activity.

Because it is an important referent, price at one moment

in time may become an input to later activities, later

patterns of behavior. Other inputs are Often involved,

however, and may on some occasions be more important

than price. At the risk of belaboring the point, it

might be suggested that the role Of price is that of

message component and/or a medium by which important
results of system activity are transmitted.

 

1Wayne D. Purcell, "An Appraisal of the Information System in
Beef Marketing," (unpublished Ph.D. dissertation, Michigan State
University, 1967), p. 137.

32

In other words, buyers and sellers in an Open competitive market must
depend on other information in addition to the prices of past market
conditions when making marketing decisions.

Supplemental infOrmation. Several attempts have been made, both

 

publicly and privately, to improve the level of information available
to buyers and sellers of live hogs. Perhaps the most widely used
source of information about future hog marketing activity is the Hogs

and Pigs report (formerly the Pig_Crop_Report). It is published

 

quarterly by the Statistical Reporting Service (Crop Reporting Board)
of the U.S. Department of Agriculture. The contents include quarterly
estimates Of (l) the inventory of hogs and pigs on farms, reporting
slaughter hogs in five different weight groups; (2) the pig crop for
the quarter just completed; (3) the farrowing intentions Of producers
for the next two quarters.

From this data one could estimate the number Of hogs that will
be available for slaughter each month for the next nine or ten months.
Producers and packers can receive this report and make their own
calculations and projections, or they can rely on the analyses in

several private and public publications which use the Hogs and Pigs

 

report as a base. One Of the public analyses appears in the Livestock

and Meat Situation published six times a year by the Economic Research

 

Service of the U.S. Department of Agriculture. It includes "outlook"

information based on the Hogs and Pigs report and provides information

 

about past production and prices as well. Private analyses of future
market activities are done by such firms as the Doane Agriculture

Service and appear in their trade magazines and newsletters.

 

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33

The reports about past marketing activities are of limited value
in reducing uncertainty and interpreting the future. The Hogs and Pigs
report, on the other hand, seems to be much more pertinent for predict—
ing future volumes and prices. However, this report still does not
help a producer to choose the market day when the price will be the
highest and thereby smooth the daily flow of hogs to packers.

Futures markets. The futures market provide another mechanism to

 

improve inter-firm coordination. Producers and packers can buy and sell
contracts for live hogs, pork bellies, and skinned hams as a means Of
shifting or reducing their price risks.

Price risk is reduced by the process of hedging which involves
assuming a price risk in a futures market to Offset a price risk in
another market where the commodity will be physically exchanged. For
example, when a producer puts hogs on feed, he assumes a price risk
in a spot market where he may be fOrced to sell the hogs at a lower
price than he originally expected. He can fix his selling price and
offset that risk by selling a futures contract for hogs at the same
time he puts hogs on feed.

Inspite of the fact that hedging reduces price uncertainty, few
130g producers have used it for that purpose. Of the 50 producers in-
terviewed only four had ever used the live hog futures for hedging,
rnane had ever used the pork belly or ham futures for hedging, and six
pinoducers had used the live hog futures for speculating.

It is difficult to tell how much hedging occurs in the live hog

ihittnes market because available data do not distinguish speculators

 

 

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a .

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» H

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H.
b.
’u

 

 

 

 

34

from hedgers. Nevertheless, an upper limit on the maximum possible
number of hogs hedged can be estimated. The best way to explain

the estimating procedure is by example. If hedging is used at all,
it is likely that the hogs to be sold in June and early July would

be hedged in the July futures contract (or possibly the June contract
if they are to be sold in early June). It is also likely that all
hedges would be made before June 1. Even hogs to be sold in early
July are likely to be hedged by then if they will be hedged at all.
Consequently, most hedging contracts in the July futures are likely to
be "open commitments" on June 1. Similarly, for any contract month,
most hedging contracts will appear as open commitments on the first
day of the previous month.

Table 2.3 shows the total number of Open commitments on the first
day of three months prior to the delivery month and in the delivery
‘month. Under the above assumptions about hedging, the total number of
open commitments one month prior to the beginning of the delivery
znonth should include most of the hedging contracts. For 1968 there
tqere 1,903 such open commitments. Since each contract represents
.20,000 pounds or about 85 hogs, all the open commitments one month
Iarior to delivery in 1968 represented about 161,775 hogs which was

(1.19 percent of commercial production.1 Of course, the 1,903 Open

 

1The 85 hogs per 20,000 pounds assumes that the hogs weigh an
amnerage of 239 pounds, the 1968 average for commercial slaughter. Total
cu:nunercia1 slaughter was 85,160,000 hogs. U.S. Department of Agri-
culture, ERS, LivestOck and Meat Statistics, Supplement for 1968, pp.

65, 87.

.-

 

 

35

commitments include several-speculative contracts, but even if all of

the Open commitments represented hedging contracts, the proportion

of hogs hedged would be largely insignificant.

TABLE 2.3 Number of Open commitments in live hog futures contracts de-
liverable in 1968.

 

 

 

 

Months
prior to the Number of Open commitmentsa in futures contracts

delivery identified by the month of delivery

month Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec Total
3 37 63 36 117 46 48 319 203 107 6 10 70 1062
2 58 119 63 128 66 68 476 335 142 29 20 73 1577
1 81 150 89 186 95 91 544 403 106 49 24 85 1903
0 97 207 142 187 123 125 464 246 57 44 19 69 1780

 

 

 

 

 

 

 

 

 

 

 

 

 

 

8Number Of open commitments as of the first of the month imme—
diately prior to the delivery month.
contract, there were 81 Open commitments on December 1, 1967 (one month
prior to the beginning of the delivery month) and 97 on January 1, 1968
(the first day of the delivery month).

Source:

For example, for the January 1968

Chicagngercantile Exchange Year Book) 1967-1968 and 1968-1969,
(Chicago:

Chicago Mercantile Exchange, 1968 and 1969), pp.
170-175 and pp. 148-169.

Although no direct attempt was made to identify and measure the

reasons for the apparent lack of producer interest in hedging, the

following impressions were formed.

Producers generally lacked suf-

ficient knowledge about futures trading to use it to their advantage.

()nly 17 Of the 50 producers interviewed had ever traded (hedged or

speculated) in a futures market.

Of those 17, only three seemed tO

lae familiar enough with the futures markets to regularly consider

tiiem as alternatives when buying and selling livestock or grain.

It

113 interesting to note that only one of these three more knowledgeable

36

pmmucers had ever hedged his hogs. Consequently, there must he
mmther reason in addition to a lack of knowledge that makes hedging
(xm's hogs undesirable. That other reason seems to be a lack.of in-
centive .

In a paper given at the Live Hog Futures Study Conference, Gene
hmrelll gave two reasons for the lack of producer interest in hedging
their hogs. First, he said that "hogs have historically been a fairly
consistent profit maker for farmers in the Cornbelt, even though prices
have varied considerably." In other words, producers have generally
made a profit on their hogs even when prices were relatively low. Con-
sequently, there has been little need to hedge. Secondly, he said
that the cost of hedging is probably too high a price to pay for price
certainty which has little value. He cited a study by Kenneth Egertson
which showed that the hedging of 11 consecutive monthly farrowings
Lmtil delivery would have resulted in total returns that were $1.22
per cwt. (about $2.50 per hog) lower than if the producer did not hedge.

In general if futures prices rise more than they fall, as the
delivery month is approached, producers are going to be better off by
not hedging. A few of the producers interviewed believed this to be
true and gave it as a reason for not hedging. Since in hedging the

futures contract is sold first and bought back at a later date, the

1Gene A. Futrell in Live Hongutures Study Conference, sponsored
by the Chicago Mercantile Exchange, Chicago, November 16, 1967, pp.
24-25. (Mimeographed) ' ‘

.94

o

 

5“

 

37

producer would buy the contract for more than he sold it if prices

rose over time. If this happened every time he hedged, a prOducer
would be effectively guaranteeing himself a lower net price every time.
It is unlikely, however, that futures prices would always rise as the
delivery month was approached. As soon as it appeared to occur con-
sistently, speculators would be eager to hold long positions. Their
desire to buy would tend to raise the price in the months prior to
delivery. The fact that futures prices both rise and fall as they
approach the delivery month is shown in Figure 2.4.

For packers the futures market has only limited application in
overcoming price risk and uncertainty. For hogs bought on spot markets
and slaughtered within a few days there is a price risk because the
acquisition price may turn out to be too high relative to wholesale
prices for the pork products. But the risk is not carried long enough
to be offset by hedging in the live hog futures or the pork products
futures (pork bellies and skinned hams). On the other hand some pro-
ducts which are stored for several weeks or months before being sold
are hedged in the futures product markets.

Another type Of long-term commitment where the packer bears the
price risk and can offset it by hedging is a forward contract to buy
liogs from producers at a guaranteed price. Only two of the packers
:interviewed were procuring hogs this way. For both of them it was
lless than one percent Of their kill. Nevertheless, they both were
hedging their price risks in the live hog futures markets. If at

some time they were sufficiently confident that the price would rise

.Iutu.

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38
1967

$25.00
w
u
'3 24.00
a.
a)
.3 23.00
m
o
~+
U 22.00
m
2
g 21.00 . .
o .,
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m
H
93 19.00
<3 0. .

18.00

J ‘— 1 1 ‘L L M—l—L
1968

Average monthly closing price

 

 

]?igure 2.4 Prices of selected live hog futures contract prior to de-

Source:

livery, 1967 and 1968.

Chicago Mercantile ExchanggiYear Book, 1967-68 and 1968-69

 

(Chicago: Chicago Mercantile Exchange, 1968 and 1969), pp.
149-182 and pp. 148-174, respectively.

 

 

 

 

39

rather than fall by the time of delivery, they said they would not
tmdge. More will be said about forward contracts shortly.

It is possible for a packer to take delivery of hogs bought on
zafutures contract, but that is not a feasible alternative. Since
the packer promises to pay a fixed price several weeks or months in
advance of delivery, he takes on a new price risk, and he lacks
mmmher market in which to hedge. (A hedge in a futures of another
umtract month is possible but not likely to be very effective.) In
addition, the live hog futures contract requires the seller (the pro-
chmer in this case) to notify the buyer (the packer) of the day of
mflivery with at least one day's written notice.1 Hence, the packer
would have less control over his supply than he has while trading
in spot markets.

No doubt the live hog futures contract could be altered to encour-
age an orderly delivery of hogs to packing plants, but many believe
dds would detract from its ability to perform other functions.2

Forward contracts. In general a "forward contract" is an agreement

to exchange a commodity at some future date. The contract usually

1Chicago Mercantile Exchange, "Futures Trading in Live Hogs (New
Rules)," (pamphlet), April 18, 1969.

2See for example, Roger W. Gray, "Fundamental Price Behavior
Characteristics in Commodity Futures," in Futures Trading_Seminar,
Vol. 111, ed. by Erwin A. Gaumnitz (Madison: Mirmir Publishers,
1966), p. 75; T. A. Hieronymous, "The Desirability of a Cattle Futures
Phrkets," [A paper with no date or reference to the place given];
Holbrook Working, "Futures Trading and Hedging," American EcOnomic
Review, Vol. 43 (June 1953), pp. 320-327.

 

 

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40
specifies the product, the delivery conditions, and the price (or
formula for determining the price at a later date). A futures contract
is a forward contract, but the term "futures contract" is generally
reserved for those forward contracts which are traded on the major
cmmmodity exchanges and where physical transfer of the product is not
expected. For convenience the term "forward contract" as used here
will exclude futures contracts.

Forward contracts are currently being offered by at least three
pmckers and three marketing firms operating between producers and
packers, and copies of the contracts were obtained from the three
packers and two of the marketing firms. These five contracts use a
similar form of product description which involves a base price for a
standard hog and a method of adjusting prices for hogs that deviate
from the standard.

In four of the five contracts the price is fixed when the con-
tract is signed. The price is based on the current live hog futures
price for the same delivery month with adjustments for differences in
quality and location of delivery between the forward contract and the
futures contract. The buyers in the forward contracts generally turn
around and sell in the futures market in order to hedge the price risks
imich they incur by guaranteeing a price to the sellers. The buyers
vmuld not be willing to contract at a guaranteed price if they had to
bear all the price risks themselves because even a small price decrease
on a large number of hogs could bankrupt them. Hence, the futures

nmrket is a necessary component of forward contracting.

41

In the contract without a guaranteed price, a formula is used
to determine the price in the delivery week from the weekly average
of several spot markets. In the latter contract, the producer con—
tinues to bear the price risk as he has traditionally. Consequently,
there is little incentive to use the contract.

If in the future most slaughter hogs were bought and sold by
means of forward contracts, spot markets would disappear. Most hogs
would be committed to a packer before they were ready for slaughter.
Forward pricing formulas based on spot market quotations would be
unworkable. Instead, they would have to be based on futures markets
or wholesale meat markets. There is little doubt that both of these
kinds of markets would be able to play a major pricing role whether
contract prices were determined at the time of delivery or in advance
of delivery. One remaining problem, however, would be that neither of
these markets provide information about price differentials among dif-
ferent regions. Both the futures markets and the primary wholesale
market are based in Chicago. Information from spot markets is currently
used to establish these regional differentials in the forward contract

prices.
Rewards and Incentives to Producers

In return for the hogs shipped to packers, payments are made to
producers. Two hogs with the same weight will not always have the
same price per pound because hogs differ in the wholesale value of

the pork products they contain. This is usually referred to as the

42

"cutout" value. The carcass cutout value of a hog.depends on the
yield of the various cuts—-loins, hams, butts, picnics, and bellies--
and on the wholesale prices for particular weights and qualities of
cuts.

The emphasis of this section is on whether the payments made to
producers adequately reflect the cutout values of their hogs and there-

by reflect the value that consumers place on the hogs.

Hogs Differ in Value

 

The cutout values vary among hogs because (1) the proportion of a
carcass in the different meat cuts (as well as in lard) varies, and
(2) the size (weight) of the carcass varies. The most accurate method
of determining the value of a carcass is to cut it in parts, weight
them, and price them at current wholesale values. But this would be
expensive process in modern slaughter houses because each carcass and
all the parts would have to be identified until the final value was
calculated. Consequently, methods of estimating carcass value have
been sought. \
Several studies have been done to measure the relationships between
various carcass characteristics (as well as live characteristics) and
the value of a carcass. Of the several variables measured, thickness
of backfat appeared to be the single most important variable for ex-

plaining variations in the percentage of lean cuts or the variation in

 

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43

actual cutout values.1 The studies that related backfat thickness to
percentage of lean cuts found coefficients of determination (r2 x 100)
between 47 and 80 percent.2 The addition of one or two other variables
only made small increases in the amount of variation explained. A
study which used carcass value (instead of percent of lean cuts) as the
dependent variable showed carcass weight and backfat together would
explain 55 percent of the variation. The addition of two more vari-

ables, carcass length and loineye area increased the percentage to

69 percent.3

In recognition of the fact that hogs and hog carcasses differ in
value and that the difference are important in trade, the U.S. Depart-
ment of Agriculture has established carcass grade standards. The
method used to determine the grades was generally consistent with the
research findings. The grades are based primarily on backfat thickness

and also consider the effects of carcass weight and carcass length.

 

lLean cuts comprise about one-half of carcass weight and two-thirds
of carcass value. North Central Livestock Marketing Research Committee,
Objective Carcass Grade Standards for Slaughter Hogs, North Central
Ewgional Publication No. 30 (University of Minnesota Ag. Exp. Sta. Bul.
No. 414, June, 1952), p. 5.

2G. Engelman, A. Dowell, E. Ferrin, and P. Anderson, Marketing
fflgughter Hogs by Carcass Weight and Grade (University of Minnesota Ag.
Ekp. Sta. Tech. Bul. No. 187, April, 1950), pp. 12-15; C. F. Henning
and M. B. Evans, Market Hogs Can Be Accurately Graded (Ohio Ag. Exp.
Sta. Res. Bul. No. 728, June, 1953), pp. 30-34; North Central Live-
tnnck Marketing Research Committee, Grade Standards, pp. 13-16; J. W.
hwnolds and E. R. Kiehl, A Determination of Objective Carcass Grade
figgdards for Slaughter Hogs (University of Missouri Ag. Exp. Sta.
Mm. Bul. No. 507, August, 1952), pp. 13—18.

 

 

3Marvin L. Hayenga and Richard G. Heifner, "The Accuracy of Hog
Ikicing Systems" (manuscript in preparation at Michigan State University).

 

.0.‘

~.u-¢-

 

 

 

 
 

 

 

 

44

Figure 2.5 shows how the grades are specified. The grade.decreases
(increases numerically) as the amount of backfat increases, but for a
given level of backfat, the grade tends to increase as carcass weight
increases. The latter represents a small decreasing proportion of fat
as the carcass size increases and backfat thickness remains the same.
The grades for live hogs are determined by estimating their carcass
characteristics.

Grades provide standardized quality descriptions which help buyers
and sellers describe the hogs to be bought or sold. They also help to
make market news reports of completed sales more meaningful by relating

differences in hog prices to differences in hog or carcass value.

The Need for Prices to Reflect Differences in Value

If the payments to producers consist of the wholesale cutout value
minus the cost of slaughtering and cutting to transform the hogs into
wholesale cuts, the payments to producers are said to "reflect" (or to
correspond with) the wholesale value. The payments to producers are
said to be "refracted"1 (instead of reflected) if the margins on some
hogs are larger or smaller than the packer's costs.

The concern over whether or not hog prices reflect cutout values
seems to have two separate but related parts. First, in "fairness" to

tmth'producers and packers, hogs with relatively high cutout values

1John E. Ikerd and Charles L. Cramer, ("Price Signal Refraction-
h1Pork Processing," American Journal of Agricultural Boonomics, 50:
225—231, May, 1968) have used "price signal refraction" as a parallel

HDthe refraction of light rays. Both cause distortions in the images
Perceived.

45

Figure 2.5 Relationship between average thickness of backfat, carcass
length or weight, and grade for carcasses with muscling
typical of their degree of fatness

Hot Carcass Weight (pounds)b/ Typical

Muscling

  
  
 
  

~slightly
thin

‘ moderately

thick

Average Thickness Backfat (inches)a/

27 28 29 30 3| 32 33 34 3s 35
Carcass Length (inches)_§_/

.a/ An average of three measurements including the skin made
opposite the first and last ribs and the last lumbar vertebra. It
also reflects adjustment, as appropriate, to compensate for variations
from normal fat distribution.

2] Carcass weight is based on a hot packer sytle carcass.

_g/ Carcass length is measured from the anterior point of the
aitch bone to the anterior edge of the first rib.

Source: Donald B. Agnew, Improvements in Grades of Hogs Slaughtered
'frOm 1960-61 to 1967-68, USDA, ERS. Mktg. Res. Rept. No. 849
(Washington: U. S. Government Printing Office, May, 1969),
p. 4.

 

 

46

should be priced above hogs with lower cutout values. On the one hand,
packers cannot afford to pay relatively high prices for hogs with low
cutout values (i.e., low quality) unless they can offset their losses
by paying relatively low prices for hogs with high cutout values (high
quality). On the other hand, producers of high quality hogs should
receive higher prices than producers of low quality hogs. If not,
the producers of high quality hogs are, in effect, subsidizing the
producers of low quality hogs. Such a system of rewards seems unfair.

The second concern is a matter of resource use efficiency. Whole-
sale and retail prices clearly indicate that consumers are willing to
pay more for a pound of pork than for a pound of lard.1 The price sig-
nals producers receive for future production should indicate the
relative advantage of producing meat—type hogs relative to producing
lard-type hogs. If the price for a meat-type hog is not sufficiently
different from the price of a larg—type hog, resources will be mis—
allocated to producing too much lard relative to meat.

If the accuracy of rewards and incentives were the only factors
to consider, one might want all prices paid to producers to reflect car-

cass values precisely. But the level of accuracy is not the only factor.

 

1Wholesale pork prices in Chicago for 1968 averaged from 40.7 cents
per pound for Boston butts to 58.8 cents for smoked hams, whereas lard
prices averaged 6.2 cents per pound. U. S. Department of Agriculture,
ERS, Livestock and Meat Statistics, Supplement for 1968, pp. 135 and
146. '

 

47

One must also consider the cost of providing it. This includes not
only the cost of evaluating the hogs accurately, but also the cost of
transmitting that information to producers. One of the most accurate
methods of evaluation has already been mentioned. That is a complete
cutout of the carcass prior to computing a hog's wholesale value. But
the cost of such a system relative to its value seems to be too high
for anyone to seriously consider its implementation.

One of the least costly methods of evaluating hogs would be to
pay for all hogs on a per-head basis irregardless of their carcass
value. But such a system would probably be the least accurate and
result in a minimum of fairness and a minimum incentive to use re-
sources efficiently in the production of meat-type hogs.

When the tradeoffs are made between the benefits of accuracy and
the cost of achieving it, one would expect to find a method, or combina-
tion of methods, that are between the two extremes mentioned above.

The most accurate method would be unacceptable because the marginal
benefit of accuracy would probably be much less than the marginal cost
of achieving it. The least accurate would be unacceptable because the
umrginal benefit would probably be much greater than the marginal cost.
Although it is beyond the scope of this research effort to establish
the marginal cost and marginal benefits of various methods of hog
evaluation, it is in the framework of marginal analysis that the pro-
blem of accuracy in current methods is discussed. In other words,

can improvements be made in the current methods of evaluating hogs such
that the marginal benefit of the improvement will be greater than the

marginal cost?

 

 

 

 

48

Indications That Prices Do Not Reflect Differences in Value

The producers interviewed for this study were asked if there were
"appropriate price differentials among hogs of different quality."
Forty—two of the fifty producers (84 percent) said the differentials did
not adequately reflect the differences in hog value. Four of the
nine packers (44 percent) responding to the question thought that im-
provements could be made. Three packers (33 percent) thought the
current differentials were a good reflection of cutout values.

There appeared to be some difference of opinion between producers
and packers as to the prevalence of "appropriate" price differentials.
R. L. Kohls offers the following explanation.1

The packer's interest is that the total amount paid for all

livestock is in line with the total value of all livestock.

He can and may ignore the variation in carcass value between

animals and lots of animals if he averages out satisfactorily.

The producer may be content to ignore the value errors made

within his market lot, but certainly not between his lot and

others. The total amount paid for his livestock should be

in line with the slaughter value of his animals.

One reason for the producers' dissatisfaction with the price differ-
entials being paid is that many hogs are bought primarily on a live-weight
basis with little or no regard for quality differences. Several of the

producers interviewed mentioned this practice, and two of the packers

interviewed said they bought hogs on a weight basis. Several researchers2

 

1Richard L. Kohls, Marketing Agricultural Products (3rd et.; New
York: Macmillan, 1967), p. 364.

 

2See for example, Henning and Evans, Market Hogs, p. 12; Broadbent,
Madsen, and West, Pricing Butcher Hogs, pp. 6, 31.

 

 

49

have recorded similar observations, especially in country markets
(packer—buyer markets, order-buying markets, and auctions).

The problem is that live weight by itself is an extremely poor
indicator of actual cutout value. One study by Hayenga and Heifner
has shown that live weight will explain only 9 percent of total varia-
tion in hog value.1 The same study found that if USDA grades were
used to indicate hog quality, the percent of variability explained
would be 21 percent.2 This is still a low level of pricing accuracy,
and in actual practice it is probably even lower since hogs are not
always placed in the correct grade category.

In terms of dollars and cents, the lack of accuracy in evaluating
hogs means that the payments for some hogs are too large while the pay-
ments for others are too small. Table 2.4 shows that the size of the
payment error depends on the method of evaluation. If the average
price were paid for all hogs, 50 percent of the hogs would be either
under or over priced by less than $.50 per cwt. and 50 percent by more
than $.50. If the hogs were priced according to their live weight, 50
percent of the hogs would be no more than $.48 over or under priced._
The use of live weight and grade would only reduce the maximum error on
50 percent of the hogs to $.44 per cwt.-enot very different from the
average price. To get a more dramatic decrease in the size of the

error, more direct carcass measurements would appear necessary. On the

1Hayenga and Heifner, "Hog Pricing System", p. 4.

21b1d., pp. 7-8.

r

 

I“, _
'\ ~
--._

L...“

n...“

I. D».
x‘ _ .
- -._

n-.-

5...
' .
'e‘.

 

\.
u u
..i
. -
7 .
.--
a
‘.

 

In

 

50

basis of live weight, one carcass backfar measurement, and dressing
percentage, the error is reduced to a maximum of $.26 on 50 percent

of the hogs.

TABLE 2.4 Size of pricing error related to method of hog evaluation.

 

 

Maximum amount of

 

Method Standard over or under payment
of hog error For 50% For 68% For 75%
evaluation (6) of hogs of hogs of hogs

(i.6256) (il.000) (£1.156)
(dollars per cwt.)a

 

Average live weight .797 $.498 $.797 $.917
Actual live weight .760 .475 .760 .874
Live weight and grade .708 .443 .708 .814
Live weight, backfat

and dressing percentage .419 .262 .419 .482

 

 

 

 

 

8Based on more than 1,000 hogs weighing 180 to 240 pounds with an
average live value of about $20.00 per cwt.

Source: Derived from Marvin L. Hayenga and Richard G. Heifner, "The
Accuracy of Hog Pricing System" (manuscript in preparation
at Michigan State University), pp. 4—8.

One additional study makes it clear that wholesale prices are not
being accurately reflected to the producer. Ikerd and Cramer have esti—
mated packers' net margins on hogs of different backfat thickness and
carcass weight. The results were that hogs with relatively thick back-
fat had negative net margins while hogs with relatively thin backfat

had positive net margins.1 In order words, Chicago hog prices do not

 

1John E. Ikerd and Charles L. Cramer, "Price Signal Refraction
in Pork Processing," American Journal of Agricultural Economics, Vol.

 

51

accurately reflect wholesale value. Packers are paying too much for
fat hogs and too little for lean hogs to accurately reflect wholesale
value. This result was obtained inspite of the fact that the hogs were
accurately graded before they were priced. If the hogs were not graded
accurately, or if they were bought on a live weight basis with little
concern for quality, the net margins would be even more divergent be-
tween lean and fat hogs.

Pricing accuracy has value to producers, packers, and consumers.
Producers-—at least the producers of quality hogs--want to receive a
fair reward for their performance. Consumers want to give incentives
for efficient allocation of resources to produce pork. Packers want
enough accuracy in order to average gains and losses successfully. The
packers currently bear the responsibility of evaluating hogs; they also
bear the cost if it cannot be passed on to producers or consumers in
hum or lower hog prices or higher pork prices. It is easy for pro-
ducers and consumers to say they want more pricing accuracy if the
packers must pay the added cost. Perhaps the real question is: How
umch more pricing accuracy are producers and consumers willing to pay
for? If a packer were to increase the accuracy with which be evaluated
imgs, he would undoubtedly do so as long as the added cost (less what
ever he could pass on to producers and consumers) was less than the
added benefit of more accuracy.

As the costs and benefits of different methods of evaluating hogs

(mange, new methods are used. The five largest packers interviewed for

52

1

this study, and many other packers, are currently evaluating every hog

carcass, estimating its cutout value and relating the expected revenue

to the cost of the hog. Before on—rail-weighing and computer techno-
logies were available, the cost of evaluating every carcass probably
exceeded the benefit. It can now be done for $.05 to $.10 per hog.2

Hus may still seem expensive, but it is apparently worthwhile for many
makers. At the end of each day, a packer knows exactly how he "averaged
mm”, with respect to his gross margin and some packers send performance
hfiormation back to their buyers.

The carcass evaluation may some day serve as the basis for paying
pnmucers. Currently only a small percentage of hogs (3.2 percent in
IEM73) are bought on a carcass grade and yield basis. One would expect
thm:the hogs being traded this way are above average grade and yield.
Mdow average, and possibly even average hogs, probably receive rela-

thmly higher prices in markets where hogs are bought by live weight.

5*

1Lawrence A. Daellenbach, "Effects of Short-Run Variation in Input
Smwlies on Costs, Profits, and Firm Strategy--The Pork Slaughter In-
dmnry" (unpublished Ph.D. dissertation, Iowa State University, 1969),
PP. 32-33.

2Five packers made the following estimates: $.015, $.020, $.050,
$JD-.15, and $.20 per hog. From a discussion with one packer some
Steater detail was obtained: the grading, weighing, and recording
reQuires 2 men who average $5 to $6 per hour; they can handle 300 to
600hogs per hour depending on chain speed; hence, labor alone costs
$4M] to $.040 per hog. Considering computer time to calculate value
amioccasional cutout samples to check grading accuracy the cost is
Prdnmly closer to $.05, but it is not likely to be more than $.10

3U. S. Department of Agriculture, Packers and Stockyards, Packers
33L§£9Ckyards Resume, Vol. VI (November 8, 1968).

53

Better than average hogs are receiving substantial premiums above
average prices when sold on a carcass grade and yield basis. One of
the producers interviewed volunteered some proof that his hogs often

average more than the "top' price at the Chicago stockyards when de-

livered direct to a packer about 175 miles west of Chicago.

Costs of Current Market Institutions

 

Only four producers and none of the packers complained about the
high cost of selling and buying slaughter hogs, but undoubtedly all
of them would like to see more services and/or lower costs. Cost data
is presented in this section in order that comparisons can be made later
between the costs of buying and selling in terminals, auctions, or local
markets and the cost of using a proposed forward contract market. The
costs given below exclude transportation costs to and from a market as ’
well as any cost implied by the fact that one market may have a lower
price than another. Only the cost of operating a particular type of
market facility and channels of access to the market are included.

Most of the data was obtained from secondary sources.

Igrminal Markets

 

The operating cost of terminal markets is shared by the three
types of firms operating there: the commission firms which act as
Selling agents for producers; the stockyards company which owns and
maintains the physical facilities; and the order buyers which act as A

btrying agents for packers. Together, they perform all the necessary

’4'"

functions for exchanging the ownership of livestock.

54

Each firm charges fees to cover its expenses. The producers pay
both the commission fees and the yardage fees which average a little

more than $1.00 per head (Table 2.5). The packers pay the order

TABLE 2.5 Producer expenses when selling hogs in selected terminal
markets, 1969

 

fl

 

 

 

Charges per head made to producers
Market Commissiona Yardage Total
Chicago $.57 $.48 $1.05
[Mtroit .50 .47 .97
Omaha b b 1.05
Sioux City b . b 1.05

 

 

 

 

8Since the commission charges per head vary somewhat depending on

the size of the consignment, the charges shown are an average based on
SO‘head.

bBreakdown not available from source.

Source: Chicago and Detroit—~from schedules of a commission firm
operating at each market (the charges are standardized for '
all firms in a market); Omaha and Sioux City-~Dr. J. Marvin
Skadberg, Iowa State University, telephone interview, con—
cerning recent research not yet published.

buyers' fees which are about $.08 to $.15 per head.1 But order buyers
are not the only means of access. Some packers use their own salaried

buyers. J. G. Snell estimated that it costs about $.18 per head for a

small packer to maintain his own buyers in Michigan, 2 but this seems

1Interviews with four packers revealed that they pay an average
CE $.08, $.10, $.11 and $.15 per head for order buyers.

2James G. Snell estimated $.11 per head for salary, $.06 for
travel, and $.01 expenses for a total of $.18 in "A Comparative Cost
Analysis of Alternative Marketing Systems for Slaughter Hogs in
MiChigan" (unpublished Ph.D. dissertation, Michigan State University,
1967), p. 114.

‘4‘“.

55

too high for all packers in general. Packers in Iowa, Illinois, and
Missouri pay closer to $.11 per head1 which probably reflects the

economic conditions under more concentrated hog production in the

Midwest.

Auction Markets

The hogs sold in auction markets are usually consigned by the
producer who is charged a single fee to cover the markets' expense for
selling, yardage, and other services.2 Generally the costs decline
am the size of the auction increases (Table 2.6). The cost per head
varies from one study to another because of differences in the method
cw analysis, the market mix (hogs, cattle, sheep), and the cost of the
basic factors. 4

One would probably expect the cost to increase over time, but
apparently the increase has been quite modest if an inference can be
made from increases in the cost of dealer (or local) markets. The
Indiana study reported in Table 2.6 also included dealer markets in
1950. ‘When the latter part of the study was updated to 1967, the ‘

umts per head were only 1 1/2 to 2 1/2 cents per head higher for

1Interviews with three packers revealed that their country buyer
Nflaries averaged $.05, $.06, and $.07 per head. Although other ex-'
Names were not discussed, it is unlikely that they would have travel
expenses greater than half their salary expenses. The total of $.07 ;
flflary, $.03 travel, and $.01 miscellaneous expenses equals $.11. ’

2Willard F. Williams and Thomas T. Stout, Economics of the
livestock-Meat Industry (New York: Macmillan, 1964), pp. 250-252.

 

‘.-.

 

h-

 

56

each size group.1 (See Table 2.9.) Auction costs probably rose a

little more than that because of a higher percentage of labor costs

in auction markets.2

TABLE 2.6 Cost of operating auction markets of selected sizes for
slaughter hogs

 

 

Auction size Indiana Oklahoma North Dakota
(no. of head per year) 1950 (Cox) 1958 (Lindberg) 1964 (Dowell)
- —-dollars per hog——

 

 

 

10,000 $.77 $.65 $.88
20,000 .68 .56 .83
50,000 .52 .51 .72
100,000 .45 .49 .62

 

 

 

 

Source: Clifton B. Cox and Martin A. Blum, Cost of Operating Selected
Indiana Livestock Markets (Purdue University Ag. Exp. Sta.
Bul. No. 618, February, 1955), p. 11; R. C. Lindberg and G. G.
Judge, Estimated Cost Functions for Oklahoma Livestock Auctions

 

 

 

(Oklahoma Ag. Exp. Sta. Bul. No. B—502, January, 1958), pp.
22-23; James I. Dowell, Dennis L. Wold, and Emory E. Anderson,
Cost-Volume Relationships at North Dakota Livestock Auctions
(North Dakota Ag. Exp. Sta. Bul. No. 452, March, 1965), p. 16.

 

All the cost studies reported above are derived from accounting
data (with various modifications). They are the costs of operating
auctions currently in use but not the costs of operating more efficient
‘markets which are possible with current technology. The latter can be

estinmted by using "economic engineering" techniques to synthesize

 

1R. E. Schneidau, Purdue University, personal letter concerning
an unpublished study completed in 1967.

2Clifton B. Cox and Martin A. Blum (Cost of OperatinggSelected
Irldiana Livestock Markets, Purdue University Ag. Exp. Sta. Bul. No.
618, February, 1955), pp. 6-8, found that labor accounted for an
average of 67 percent of the cost for operating an auction and 45
percent for a dealer market. ‘

 

 

57

efficient markets and their costs. Economic engineering is a method
of looking at all the functions that have to be performed by an auction
market and finding the lowest possible cost of performing them, given

1 The method has been used in

current prices of labor and materials.
Michigan by R. D. Gibb and modified and updated by J. G. Snell to
develop the estimates in Table 2.7.

TABLE 2.7 Minimum estimated cost of Operating auction markets of
selected sizes for slaughter hogs in Michigan.

 

 

 

 

Auction size
Total number of Number of Cost per head Cost per head
head per year hogs per for hogs for hogs
(all livestock) year8 1958 (Gibb) 1965 (Snell)
10,000 4,500 $1.50 $.77
20,000 9,000 .97 .56
55.000 24,500 .64 .40
110,000 49,500 .54 .36
247,000 247,000b —-- .32

 

 

 

 

aHogs accounted for 45 percent of the total number of head of
livestock handled.

bLarge specialized hog auction.

Smuce: Derived from James G. Snell, "A Comparative Cost Analysis of
Alternative Marketing Systems for Slaughter Hogs in Michigan"
(unpublished Ph.D. dissertation, Michigan State University,
1967), p. 120 (corrected to agree with page 117); Richard Dean
Gibb, "An Economic Analysis of the Efficiency of Michigan
Livestock Auctions," (unpublished Ph.D. dissertation, Michigan
State University, 1958), p. 124.

All of the above studies indicate that most of the significant

emummies of size are gained with about 50,000 head of hogs (or their

‘—

1For a more detailed discussion of economic engineering as well
as hm application to estimating the costs of operating auction mar-
kets see Snell, "Alternative Marketing Systems," pp. 56-123.

.4..."

58

equivalent) per year, and that additional economies are available with
larger auction sizes. Nevertheless, more than 70 percent of hogs sold
by auction in the North Central Region are sold through facilities
handling less than 50,000 head, and more than 50 percent are sold
fluough facilities handling less than 25,000 head.1 The average cost
of marketing a hog by auction was $.56 in 1955.2

Judging from the available data on auction markets, the current
average cost of selling hogs is probably in the range of $.55 to $.70
per head. This excludes the packer's cost of buying at the market and

the cost of moving hogs to and from the auctions.

Local Markets

 

Local markets include packer buying stations, cooperative markets,
and dealer markets. Packers buying hogs at the plant probably ex-
perience costs which are similar to the cost of operating a packer
buying station. Most of the same functions are performed at the plant
as are performed at the buying station, and the requirements for labor,
facilities, and equipment are probably quite similar.3 4

A recent study of markets in Illinois shows no difference in the

operating costs of packer buying stations and local cooperative markets.

 

1National Commission on Food Marketing, Livestock and Meat, pp.
128-130.

 

2Williams and Stout, Livestock-Meat, p. 253.

 

3Snell, "Alternative Marketing Systems," pp. 114-115.

59

The study also shows how costs per head decrease as volume increases.1
See Table 2.8 for details. A recent Iowa study shows similar cost re—
sults for packer buying stations.2 However, an Indiana study completed
at approximately the same time shows substantially lower Operating

costs for any given market size (Table 2.9). The difference in results
probably reflects the wide differences in facilities and operating pro-
cedures of local markets, even within the same region,3 as all three
studies include capital depreciation and labor and exclude transportation
which are the three major cost items.

TABLE 2.8 Operating costs of local markets of selected sizes for
slaughter hogs, Illinois, 1967

 

 

 

Size of market (head/yr.) Cost per head
Under 25,000 $.95
25,000-50,000 .55
Over 100,000 .35

 

 

Source: Emer E. Broadbent, University of Illinois, telephone inter-
view concerning an unpublished study completed in Illinois
in 1967.

 

1Emer E. Broadbent, University of Illinois, telephone interview
concerning an unpublished study completed in 1967. Cost per head was
based on the total cost of operating a market (labor, capital deprecia-

tion, and feed) divided by the number of hogs bought and sold per year.

2J. Marvin Skadberg, Iowa State University, telephone interview
concerning an unpublished study completed in 1969. Costs ranged from
approximately $.25 to $1.00 per head as volume decreased.

3Williams and Stout, Livestock-Meat, p. 263.

 

60

TABLE 2.9 Operating costs of local markets for slaughter hogs, Indiana
1950 and 1967.

 

 

 

 

Market size Cost per head

Gun head per year) 1950 1967

10,000 .61

20,000 .43

30,000 .35 34.5

40,000 .31 32.5

50,000 .28 30.5

60,000 .26 28.5

70,000 .25 26.5

 

 

Source: Clifton B. Cox and Martin A. Blum, Cost of Operating Selected
Indiana Livestock Markets (Purdue University of Ag. Exp. Sta.
Bul. No. 618, February, 1955), p. 10; R. E. Schneidau, Purdue
University, personal letter concerning an unpublished study
completed in 1967. '

 

 

TABLE 2.10 Minimum estimated cost of operating local markets of se-
lected sizes for slaughter hogs, Michigan, 1965

 

 

 

Local market size:
number of hogs Total Cost per
per year cost head
5,000 $ 2,213 $.44
15,000 5,359 .36
30,000 8,530 .28
100,000 20,657 .21
300,000 42.958 .14

 

 

 

Source: James G. Snell, ”A Comparative Cost Analysis of Alternative
Marketing Systems for Slaughter Hogs in Michigan" (unpublished
Ph.D. dissertation, Michigan State University, 1967), p. 121.
Total cost equals "per unit cost" plus "total joint cost". 4
The latter was corrected to agree with page 118.

61

Departing from the accounting approaches used above, Snelll used
an economic engineering technique for estimating the minimum costs of
operating efficient local markets. His results are shown in Table 2.10.

All of the above studies show that most of the economies of size
in terms of operating costs of local markets are achieved by about
30,000 head per year. Additional economies are also available at
larger sizes. Yet in 1964, about 50 percent of the hogs sold through
packer buying stations and 30 percent of the hogs sold through order
buyer and dealer markets in the Cornbelt were sold through facilities
handling less than 30,000 head per year.2

The average cost of selling hogs by local markets is probably
about $.35 to $.55 per head at the present time. The packer's cost of
entering the market is excluded, but in most instances it consists of
a few telephone calls rather than face-to-face interaction. Transpor-

tation cost for hogs are also excluded.

Summagy

The problems of coordinating producers and packers in the short-
term, given the seasonality of supply and demand and the location of
production, slaughter facilities, and consumption, seem to be as

follows:

lSnell, "Alternative Marketing Systems," pp. 94-123.

2National Commission on Food Marketing, Livestock and Meat,
PP. 130-134. '

 

(l)

(2)

(3)

(4)

62

Lack of information about supply and demand causes
unnecessary price and quantity fluctuations; the
fluctuations create uncertainty. As a result, hogs
are not allocated over time and among packers in a
way that minimizes slaughtering costs and trans—
portation costs for hogs and pork.

Packers facing fluctuating quantities and prices
from day to day and week to week must use resources
to plan for and to cepe with uncertainty. In ad—
dition, packers may make mistakes in allocating
resources, such as calling too many or too few
laborers for a given week. Without the fluctuations
in volume and price, their operating cost could be
lower.

Many producers do not receive "fair” returns for
their hogs. Producers of meat—type often receive
a relatively smaller proportion of the cutout
value of their hogs than producers of lard-type
hogs.

Incentives to producers for future production are
misleading. The price difference between pork and
lard at the wholesale and retail levels is not ac-
curately reflected to producers. Since packers
pay more for lard relative to meat than consumers
are willing to pay, producers do not receive the
proper incentive for allocating their resources in
accordance with consumer preferences.

CHAPTER III

A FORWARD CONTRACT MARKET

Although forward contracts currently in use do not seem capable
of coordinating producers and packers on a large scale, it is believed
that a modified set of contract specifications could be developed which
would not only be more workable but also improve the current hog market-
ing situation. New forward contract specifications could (1) reduce the
problem of timing the flow of hogs to slaughter and thereby reduce some
of the volume fluctuations and most of the uncertainty experienced by
packers if a more precise method of delivery were developed, and (2)
improve pricing accuracy if a carefully designed contract specified a
method of paying producers based on wholesale carcass values.

A major remaining problem with using forward contracts on a large
scale revolves around the price determining process. This chapter will
be devoted to developing a market for forward contracts which will aid
in the price determining process. The next chapter will analyze the

specifications of a contract that can be traded in such a market.

Need for a Contract Market

 

Although the live hog, pork belly, and skinned ham futures markets
and the wholesale pork market could be used to establish a price base,
they have certain shortcomings, such as the lack of regional price
differentials and the fact that the wholesale market is only a spot
Inarket. Unless producers and packers in different regions of the
country have. additional information, they will not know how much to

adjlun:the futures prices or wholesale meat prices for forward contract

63

64

transactions in their areas. If these adjustments are not made, there
is likely to be a spatial misallocation of hogs to packers both within
regions and between regions. For example, a packer in southern Illinois
may decide that he should discount the live hog futures by $1.00 to get
all the hogs he needs for a particular week next month. If he readily
finds that he can buy more hogs than he needs at that price, his price
should have been lower.

Since information about a large number of forward contract trans-
actions is apt to be a good indication of the intentions of producers
and packers, some method of reporting forward contract volumes and prices
would probably be quite useful. With this information, a packer would
have a better idea of local prices, as he would know what other packers
in his area were paying. When the packer made his price bid, he still
might not receive the number of hogs he expected, but he would prob-
ably be closer than if he had no idea about what other packers were pay-
ing. At the same time, a producer would have more information from
which to decide whether to accept a packer's price or to seek a higher
one. In addition, the reporting of forward contract prices could im-
prove futures traders' knowledge of supply and demand and thereby im-
prove pricing in the futures market.

The reported forward contract prices would have to be for a hog
0f standard weight and grade and delivered under a standard set of
conditions. Every firm could offer its own contract, but there would
lurve to be a way of relating each contract to the standard for reporting

INlrposes. Otherwise, the prices reported would have ambiguous meaning.

 

1Wayne D. Purcell, "Improved Communication--The Key to Increased
Efficiency and Coordination in Beef Marketing" (paper presented at the
MGR-61 Seminar, Chicago, November 6-7, 1968), pp. 8-12.

 

I“!

.o n:

 

' u
"‘ nae

~..... '-

‘._.«

e‘.‘

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:
»“'

 

v
P
fl
‘ e
.\ b:
5‘.‘
1.-.-
N o. u.
s
‘\
x
\ ‘JJ
_ .
r‘s“

 

 

 

‘.
. .‘
. 'I _
Nu.
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65
IMyers and sellers would not know if a reported price were for a lot of

210 to 220 pound, No. l hogs or a lot of 230 to 250 pound, No. 3 hogs
(n a mixed lot of hogs. In addition, the amount of transportation
and shrink) and other services included in a price would not be known.

Of course, a market would have already existed, if one defined a
market as buyers and sellers in communication with each other.1 Small
numbers of buyers and sellers would have their own markets. But price
reporting would help to integrate the large number of small, loosely-
connected markets and make a national or regional market more visible
and identifiable.

If the market were further developed——beyond the simple reporting
of prices over a wide geographic area--it might be a very efficient
method of forward contracting. Establishing a mechanism for direct
contact between buyers and sellers of forward contracts would bring
each trader in contact with a large number of other traders. Without
this mechanism it would be difficult to find who, when, where, and at
what price others were willing to trade. Each packer, for example,
might advertise the details of his contract and his price in local pa—
pers, and rely on producers to call him. Or some enterprising firm
might open a central facility for producers and packers to post their
offers to sell and bids to buy. All buyers and sellers would either go
to the central place or have an agent there to post prices and to ob-
serve the prices at which-others were willing to trade. A modification

WhiIHI would simplify the pairing of buyers and sellers would be for

 

lsee Alfred Marshall's citations from Cournot and Jovens concern-
ing the definition of a market in Principles of Economic: (8th ed.;
London: Macmillan, 1925), pp. 324—25.

 

66
everyone to use the same contract (or a limited number of alternative
contracts). This would standardize the product traded and the condi-
tions of trade. Without a standardized contract a seller would have
to be aware of the terms of each buyer's contract before a transaction
could be made.

If the product were well specified in a standardized contract, there
would be little need for buyers and sellers to personally interact. A
seller would want to find the buyer with the highest price bid, and a
buyer would want to find the seller with the lowest price offer (includ-
ing the cost of transportation from one to the other). Under these
conditions, the procedure for listing a bid or an offer, as well as
the process of matching the highest offer with the lowest bid, would
be a fairly mechanical task which could be done by electronic computer.
Access to the computer could be gained by remote devices, such as tele—
phones, so that traders could remain at their places of business and
still be able to make transactions with a large number of others.

Technical Aspects of a
Computerized Contract Market

 

1

A nation-wide, computerized, forward contract market would segment
the country into a number of zones in order to locate the producers and
packers trading in the market. Within each zone there would be a number
(If producers and perhaps a packer or two, depending on the size and
shape of the zones. The producers and packers would be connected to a

computer at a market center by means of conventional "touchtone"

 

lIhe material in this section is adopted from Schrader, Heifner,
and Idarzelere (Electronic Egg Exchange) who designed and demonstrated
a telephone-computer system for trading contracts of shell eggs.

“I

 

67

(pushbutton) telephones. Presently available electronic technology

allows a computer to interpret the touchtone telephone signals directly

so that a human operator would not be needed.1
To enter the market a trader (producer or packer) would call they

computer, establish his identity as a member trader, and transmit

his message to buy or sell by pushing the appropriate telephone buttons.

The identification procedure would enable the computer to recognize

member traders and permit them to trade in the market. The bids to

buy or offers to sell would be received and paired with matching offers

or bids, if available, to complete transactions. The computer would

transmit back to the traders confirmations of completed transactions

as well as other necessary information by means of an ”audio response

unit" which converts computer signals into English words for con-

ventional telephone transmission and receiving.

Basic Trading Procedure

The following is an example of how trading would occur. To
simplify the example, it is assumed that all trading takes place within
one zone, such as Zone No. 10 in Figure 3.1.

Suppose that producers No. 1, No. 2, and No. 3 have each made an
offer to sell one contract (50 head) of slaughter hogs and packers

No. l and No. 2 have each made bids to buy a contract as follows for

 

1Touchtone telephones must be used instead of dial telephones
because the latter do not permit a dialed signal after the other party
reunoves his receiver and completes the connection. Access to the
ccnnputer can also be gained by teletypewriter which sends and receives
messages much more quickly but is much more costly than the touchtone
telephone ($2 versus $75 per month in addition to local telephone
serwrice). Therefore, only a few high volume packers would probably
choose to use the teletypewriter.

‘b-‘

68

 

 

 

Computer
//1 1

/ /

 

 

 

 

 

 

Market tenter

 

Zone No. 13

Zone No. 10

A = producer
[:].= packer

Ifigure 3.1 Producers and packers located in trading zones and inter-
connected via telephone to the computer market center

69

next week:

Producer NO. 1 offers to sell @ $21.50 per cwt.

NO. 2 22.00
No. 3 21.50

Packer NO. 1 bids to buy @ 21.25 per cwt.
No. 2 21.00

Since the bids are all less than the Offers, they remain on the com-
puter's files of Open bids and offers. They are kept on file until
(1) someone is willing to take the other side and make a transaction,
(2) they are withdrawn by the producer or packer that made them, or
(3) the week for which they were made expires.

Suppose further that producer NO. 4 has a load of hogs that will
be ready for delivery anytime next week. He checks the contract market
prices of the last several days in the newspaper or other media. If
the contract market price looks favorable compared with other alterna-
tives, he calls the market center for up-to—the-minute information and
receives the following message:

The lowest producer offer on file is $21.50

The highest packer bid on file is $21.25

The last transaction occurred at $21.50

Today's average transaction price is $21.45
on 13 transactions

Now producer NO. 4 has to make a decision. If he expects the market
price is going to increase, $21.25 would be too low. In that case he
would put a higher offer on file and wait for a packer to bid a higher
price. If on the other hand he thinks $21.25 is an acceptable price
for his hogs, or if he expects the market price will soon decrease, it
would be to his advantage to offer them for sale at $21.25.

Offering them for sale at $21.25 would result in an immediate

transaction with the packer who has already promised to buy at $21.25.

4... . . . ‘Id He .. ..

 
 
 
 

70

The market center would pair producer NO. 4 with packer No. 1 and tell
both Of them that they have made a transaction with the other party so
that direct delivery could be made and accepted.

If producer NO. 5 were next to call into the market, he would be

given up-to-the-minute information as follows:

Lowest producer offer $21.50
Highest packer bid 21.00
Last transaction 21.25
Average price-—14 transactions 21.40

Of course, if producer No. 4 offered his hogs for sale at $21.50 instead
of $21.25 and no transaction was made, producer No. 5 would get this

message instead:

Lowest producer offer $21.50
Highest packer bid 21.25
Last transaction 21.50
Average price--l3 transactions 21.45

A packer would use the market in much the same way. He would call
into the market center to get the latest market picture. Suppose it is
the last one shown above. If he wanted to make an immediate transaction,
he would bid at the lowest producer Offer which is $21.50. If he

believed that price was too high, he would list a lower bid with the

market center.-

Ihe Concept Of Making_Bids and Offers

The forward contract market encourages both producers and packers
to make initial entries and to put them on file. Any buyer or seller
can announce the price at which he is willing to trade and later change
that price if necessary to make a transaction. The same procedure is
comnon in other open markets. It occurs in a terminal market as buyers

travel from pen to pen, higgling with individual sellers; it occurs in a

71

futures market as buyers and sellers announce their intentions in a
trading pit; and to a certain extent, it occurs in an auction market
where the seller offers his hogs at the price of each successive
bidder.

Some empirical work by Vernon Smith demonstrates the characteris-
tics Of a market where both the buyers and the sellers announce prices
in contrast to a market where only one or the other is allowed to do
so. The results show that there is a more rapid convergence toward the
equilibrium price when both buyers and sellers make price quotations.
In addition, the price tends to be lower when only sellers quote than
when both quote, and the price tends to be higher when only buyers
quote than when both quote.l

Allowing both the buyers and the sellers to make price quotations
would seem to be desirable in a forward contract market. The equilib—
rium price would be found more rapidly and accurately then if only the
buyers 2£_the sellers were allowed to list price quotations. As a
result there would be a more efficient pricing process, fairer prices
to producers and packers and a more efficient allocation of hogs to
Inackers over time and space than if only the buyer or the sellers made
‘quotations. The cost Of accepting quotations from both is not likely
tn) be any higher than the cost of accepting quotations from either
(nae or the other. In fact, it may be lower if being able to list a

Iirice saves several calls to check the prices of the bids or Offers

On file.

1Vernon L. Smith, "Effect of Market Organization on Competitive
Equilibrium," The Quarterly Journal Of Economics; Vol. 78, (May, 1964),

"
“

 

W

72
Inter-Connected Trading_Zones

A producer would have to sell in another zone if there we no
packing plants in his own zone. But even if there were a packer in
his zone, he would want to go to another if he could receive a higher
net price, after taking his transportation and shrinkage costs into
account. To trade in another zone, the producer would offer to sell
at the highest price already on the bid list, or he could place a
higher Offer (higher than the highest bid) on the Offer list. At the
same time, he could also place Offers to sell in several zones. As
soon as one was accepted, the market center would automatically with-
draw the producer's offers in the other zones.

A packer could also bid to buy in other zones if he found that
prices elsewhere were lower than in his own zone. Since he would have
to accept the responsibility Of hauling the hogs from other zones to
his own,1 he would want to discount his bids in order to cover his
transportation and shrinkage costs. To accept hogs in another zone,
the packer would have to establish a collection station in the zone,

unless he trucked the hogs directly from the producer's farm.

Forward Contractigg
The above discussion has considered hogs delivered in the very
near future. The same procedure, modified only slightly, could allow

offers and bids to be made for not only next week, but next month or

 

1To greatly simplify the price listing, pairing, and reporting
mechanisms, all prices would include producer delivery to any point
in the zone for which the price was quoted. If a producer made an
«offer in another zone, he would deliver there. If a packer made a bid
in another zone, he would take delivery in that zone.

 

 

 

73

several months in the future. In fact, whenever a producer believed
he would have hogs for sale, he could offer them on the market. The Of-
fer could be either at a price that had already been bid by a packer,
thereby completing a transaction and guaranteeing the producer that
price at the time of delivery, or it could be an offer at any higher price
the producer wished to put on file. Similarily, a packer could use this
market to line up his supply and plan his production from a few days to
several months in advance.

This simple expansion of the trading mechanism allows both very
near future trading, which is almost like spot trading, as well as dis-
tant future trading, to occur in the same market. Both extremes and

all cases between are considered to be forward contracting.

Flexibiligy for the Producer and the Packer

 

Both the producers and the packers would be free to make their
price offers and bids based on what they thought the market price would
be in the future. Of course, nobody would know for sure what it would
be. In addition, producers might be uncertain as to their ability to
deliver a certain number of hogs in a certain weight and quality range
during a specified week, or packers might be uncertain about how many
hogs they will need on a given day.

Because of these uncertainties a producer or a packer could buy
or sell a portion of his eXpected requirements at one time and another
portion at another time when his needs are more certain. For example,
a packer who needed 3,000 head for the week Of February 9, could place
bids at successively lower prices if he thought the market would
decline. As another example, suppose a producer expected to have 600

Imead of hogs ready for delivery in six months. He might believe that

74

the bids currently being made for that time are extremely attractive,
but in six months, because of disease and farrowing problems, it is
possible that he would only have 400 hogs ready for delivery at the
specified time. In such a case he could contract 400 head now and wait
until he was more certain about the exact number he would have before
committing any more hogs. When the exact number became more certain,
as well as the day they would be ready for delivery, another contract
could be made for the remaining hogs. He might contract the remaining
hogs for more or for less than the initial lot, depending on how the
Open price bids had changed.

Another alternative Open to the traders would be the freedom to
change a bid or offer previously listed, as long as it had not yet
resulted in a transaction. As time went on, the traders would revise
their future price expectations and might want to change the prices they
had previously put on file. A packer, for example, might have placed
a relatively low bid because he eXpected the price to decline. At
some later date his bid might still be open and he may wish to increase
it. On the other hand, a producer might start relatively high and

later feel he should lower his offer.

CHAPTER IV
SPECIFICATIONS FOR A FORWARD CONTRACT MARKET

The ability of a forward contract market to improve coordination
effectively and efficiently depends on the specification or design of
a number of important factors. There is the contract itself which
.specifies the number and the kinds of hogs to be delivered, the delivery
procedure, and the method Of evaluating each hog. There is the method
of guaranteeing producers that their hogs will be evaluated according
to the terms of the contract. There is the size and shape of delivery
zones, the question of identifying traders, and the procedure for can—
celing contracts already made.

Many alternative methods can be used to specify these aspects Of'a
forward contract market. Some methods would be more advantageous to
producers, while others would be more advantageous to packers. A market,
however, is the result of compromise between buyers and sellers, not
only in terms of the price agreed upon but also in terms of the condi—
tions surrounding the delivery of the product. Unless the Specifications
of a forward contract market are acceptable to enough producers and
packers, there will not be a market.

Consequently, the several aspects noted above were discussed with
both producers and packers. A number of alternative specifications, for
each aspect of a forward contract market were develOped after a review
of some futures and forward contracts currently in use and preliminary
interviews with some packers and hog producers. The alternatives were
then discussed with fifty producers in Illinois and Iowa, and with ten

packers in Illinois, Iowa, and Missouri. They were all asked to choose

75

76
the alternatives which would best satisfy their marketing needs. They
were also asked to suggest modifications to the alternatives presented.

A discussion of the alternatives and their relative feasibility follows.

Product Description

 

In order for a packer to be certain that he is going to receive
the type and quality Of hogs he wants and is paying for, he must have
some guarantee that they will meet certain specifications. Trading in
a computerized forward contract market would preclude visual inspection
and rely on a description Of the product. The description must be
transferred from one trader to another by the process of communication
which, to be effective, must use unambiguous symbols (words, numbers,
pictures) to generate the same meaning in both the buyer and the seller.
The exact symbols needed to accomplish effective communication in hog
marketing depends on the set of attributes (or physical features) of
the product which seem to be capable of communicating useful information

about the product.

Size and Qualigy

Five different sets of attributes were used to specify five alterna-
tive contracts. The alternatives are presented in Figure 4.1. Two of
the alternatives are based on live characteristics, and three on carcass
characteristics. The combinations of attributes used in the five alter—
mndves are by no means exhaustive. Simpler specifications making no
(Hatinction between hogs of different quality were not considered because
thetywould cause undue uncertainty for the buyer and would probably

thmish prOducer-packer coordination rather than improve it.

II

77

 

F—Contract A: Live Weighg

 

 

$X Base Price per hundredweight (cwt.) for all hogs weighing
201 to 220 pounds.

Premium-Discount Schedule for Other Hogs

 

 

 

 

 

live weight pgice adjustments
(pounds) (dollars/cwt.)
180—200 —$X
201—220 none
221—240 —$X
241—260 —$X

 

 

 

 

Contract B: Live Weight and Grade

$X Base Price per cwt. for hogs weighing 201 to 220 pounds
and grading U.S. No. 2.

Premium—Discount Schedule for Other Hogs

 

 

 

 

 

 

 

 

 

 

 

live weight price live grade price
adjustment adjustment
(pounds) (S/cwt.) ($/cwt.)
180—200 -$X U.S. No. l +$X
201-220 none 2 none
221-240 -$X 3 —$X
241-260 -$X

 

 

 

 

 

 

 

Contract C: Carcass Weight

 

$X Base Price per cwt. of carcass for all carcasses weighing
151 to 165 pounds-

Premium—Discount Schedule for Other Hogs

 

 

 

 

 

 

 

 

carcass weight price adjustments
(pounds) ($/cwt.)
135—150 «$X
151-165 none
166-180 -$X
L__ 181-195 -$X

 

 

FIGURE 4.1 Alternative methods of specifying the contract for a
forward contract market.

78

 

 

Contract D: Carcass Weight and Grade

 

 

SX Base Price per cwt. of carcass for all carcasses weighing
151 to 165 pounds and grading U.S. No. 2.

Premiumeiscount Schedule for Other Carcasses

 

 

 

 

 

 

 

 

 

 

 

carcass weight price carcass grade price
adjustment adjustment
(pounds) (S/cwt.) ($/cwt.)
135—150 ' -$X - U.S. No. 1 +$X
151-165 none 2 none
166-180 -$X 3 -$X
181-19S -$X

 

 

 

 

 

 

Contract E: Measurable Carcass Features

 

 

$X Base Price per cwt. of carcass for all carcasses weighing
151-165 pounds with 1.30—1.59 inches of backfat and
measuring 29.0-29.9 inches in body length.

Premium-Discount Schedule for Other Carcasses

 

 

price price price
carcass adjust- backfat adjust- carcass adjust-
wglght ment thickness ment length ment
(pounds) ($/cwt.) (inches) ($/cwt.) (inches) ($/cwt.)
135-150 ~$X less than 1.30 -$X less than 27.0 —$X _
151-165 none 1.30 - 1.59 none 27.0 - 27.9 -$X
166-180 -$X 1.60 - 1.89 -$X 28.0 - 28.9 —$X
181—19S -$X 1.90 - 2.19 -$X 29.0 - 29.9 none
2.20 or more —$X 30.0 — 30.9 +$X
31.0 - 31.9 +$X
32.0 — 32.9 +$X
33.0 or more +$X

 

 

 

 

FIGURE 4.1-(continued). Alternative methods of specifying the contract
for a forward contract market.

79

The basic format for each contract consists of a standard hog and
specified variations from the standard. The prices that producers and
packers offer and bid in the contract market would be the base prices
for the standard hog. The prices for hogs differing from the standard
would be automatically determined by certain adjustments specified in
a premium-discount schedule.

Under Contract B, for instance, a producer would have to deliver a
load of hogs with each one grading U.S. No. 2 and weighing between 201
and 220 pounds if he wanted to receive the contracted base price per
cwt. for all his hogs. However, he would be free to deliver any and
all of his contracted number of hogs weighing between 180 and 260 pounds
and grading U.S. No. l, 2, and/or 3 for certain established adjustments
above and below the base price.

Contract A is similar to B except that A specifies the base hog
and the premium-discount schedule in terms of weight categories, whereas
B includes weight and grade specifications. Contract C is just like A
but the live weights have been converted to carcass weights (using a
yield factor of 0.75). Similarly, D is like B converted to carcass
weights and grades. (The grades are the same for both live and carcass.)

Contract E is an attempt to get away from the more subjective car-
cass grading that is implied in the U.S. grades. It is designed to rely
on actual measurements of specific carcass characteristics. Studies
show that carcass backfat is the single most important variable for

1
eXplaining the variability in carcass values. One of the studies shows

¥

1Engleman, Dowell, Ferrin, and Anderson, Marketing_81aughter Hogs,
pp. 12-15; Hayenga and Heifner, ”Hog Pricing Systems"; Henning and Evans,
lkuket Hogs, pp. 30-34; North Central Livestock Marketing Research
Cmmfittee, Grade Standards, pp. 13-16.

 

80

that a single backfat measurement (at the last lumbar vertebra region)
is slightly more accurate for estimating carcass value than an average
of three measurements (at the first rib, last rib, and last lumbar).1
Carcass weight and length are also used as indicators of value in
Contract E.

An excellent indicator of carcass value is an estimate of the
loineye muscle area, but available technology does not allow a quick
and accurate measurement; hence, it is not feasible to include it at
this time. Table 4.1 demonstrates the marginal increases in pricing
accuracy as various carcass factors are added to the estimating pro—
cedure. The accuracy of using carcass weight, length, and one backfat
thickness was not given in this particular study,2 but it would be at
least as accurate as weight and backfat alone. The latter can price
fifty percent of the carcasses within plus or minus $.35 of their actual
value per cwt. (The other fifty percent would be in error by more than
$.35) A method for estimating loineye would permit a reduction in the
variation from $.35 to $.30 for fifty percent of the hogs. Also note
that carcass weight and grade is less accurate than carcass weight and
average backfat. This occurs inspite of the fact that carcass grade is
a function of carcass weight, length, and average backfat. Combining
three-tenths of an inch of backfat and three to nine inches of carcass
length into a single grade conceals a considerable amount of variability

in value.

¥

1Hayenga and Heifner, "Hog Pricing Systems," p. 9.

21bid, pp. 9-11.

81

TABLE 4.1 The effect of selected hog carcass measurements on pricing

 

 

 

 

 

accuracy.
Maximum size
Coefficient of Standard of pricing error
Carcass determination error _
measurements (szlOO) (5) For 50% For 68%
of hogs of hogs
(13625 ) (:,l.00 )
---percent———- ———(dollars/cwt. of carcass)a——-
Average price per cwt. -- $.718 $.448 $.718
Carcass weight, car—
cass grade (USDA 47.6 .613 .383 .613
No. 1, 2, 3, 4)
Carcass weight, aver-
age backfat 54.3 .572 .358 .572
thickness
Carcass weight, single
backfat thickness 55.1 .567 .354 .567
Carcass weight, single
backfat thickness, 68.9 .474 .296 .474

loineye area

 

 

 

 

 

3Based on more than 1,000 carcasses with an average value of about

$27.00 per cwt.

Source:

Derived from Marvin L. Hayenga and Richard G. Heifner, "The

Accuracy of Hog Pricing Systems" (manuscript in preparation
at Michigan State University), pp. 9—11.

Before the packers were shown the contract alternatives in Figure

4.1, they were asked to outline the upper and lower limits for grade

and weight which they issue to their buyers.

As shown on the left side

of Table 4.2, most of the packers are willing to take a wide variety

of hogs with respect to size and grade.

Many actually prefer a hetero«

geneous supply of hogs to help them meet their customers' heterogeneous

demand for pork cuts of different sizes.

It is also true that many of

their products are processed enough so that they can be "molded" from a

wide variety of hogs. Generally, the larger packers had a broader range

of acceptable weights and grades than the smaller packers.

4, 5, and 6 had more specific needs than the last four firms.

82

Packer No. 3,

The last

four happen to be multi-plant firms while Packers No. 3—6 are single»

plant firms.
probably more common with very small packers.
4.2), for example, has tangible assets of less than $100,000 and
slaughters only 90 head per day.

market and requires a specific kind of hog.

The more specific requirements for weight and grade are

Packer No. 1 (in Table

The firm has a small specialized

Packer No. 2, on the other

hand, slaughters about 400 head per day and has a fairly heterogeneous

demand for hogs.

thousand hogs per day.

The other packers interviewed slaughter several

TABLE 4.2 Grade and weight procurement limits for ten hog packing

firms, Midwest United States, 1969.

 

 

Current guidelines
to hog buyers:

Acceptable range
of grade and weight

 

 

Firma upper and lower limits in a forward

or grade and.Weight contract market

Weight USDA Weight . USDA

grades grades

(pounds) (pounds)

1 210-230 1 180—240 1,2,3
2 225-300 1,2,3 200-300 "
3 210-240 1,2,3 180-260 "
4 240-270 2,3 180-280 "
5 200-230 1,2,3 200-260 "
6 210-240 1,2 160-260 "
7 180-300 1,2,3,4 180-300 "
8 180-300 1,2,3,4 180-300 "
9 180-240 1,2,3 140-300 "
10 180-300 1,2,3 180-300 "

!

 

 

 

 

 

aSame order as used in Table 1.3.

83

'After the packers had an opportunity to learn about the proposed
forward contract market and were shown the alternative contracts (Figure
4.1), many showed a willingness to go beyond the weight and grade limits
which they were currently issuing to their hog buyers and beyond the
limits suggested in the alternative contracts. The right side of
Table 4.2 shows the weight and grade limits that would be acceptable
to packers in a standardized forward contract market. Only two packers
believe the suggested lower weight limit of 180 pounds is too low; only
one packer believes the upper weight limit of 260 pounds is too high.
All the packers were willing to accept USDA No. 1, 2, and 3 hogs in a
forward contract market.

Some packers showed a willingness to increase their weight and
grade ranges substantially, probably because they actually receive a
number of hogs outside the general guidelines which they give to their
buyers. In a forward contract market, on the other hand, hogs outside
the specificied ranges in the premium-discount schedule would be unde-
liverable.

The packers made a number of suggestions for improving the
standardized forward contract. Their comments were made with respect
to contract alternative B (Figure 4.1) which was used as a basis for
most interview discussions since it was specified in terms that all
producers and packers could readily understand. The suggestions can
be applied to the other contracts as well.

Seven of the ten packers think the 180 to 160 pound weight range
could be widened to include either lighter hogs or heavier hogs or both,
and three think it should be narrowed from one or both.ends. Nine

flunk that the 20-pound intervals are small enough. The other one

84

would prefer lO—pound intervals. All packers interviewed agree that
they take, or would take, hogs grading USDA No. l, 2, and 3. But two
of the packers, who happen to be buying on a grade and yield basis,
believe the number of grade categories for hogs grading USDA No. l, 2,
and 3 should be increased to four or possibly six in order to distinguish
between hogs of different value. At least one other packer (not inter—
viewed) who is buying hogs on a grade and yield basis has set up four
grades within the top three USDA grades. Four packers suggested that
the base weight range be changed from 200-220 pounds to 210-230
pounds. Two suggested that a contract require 80 percent of the hogs
to be in the base weight range, with no more than 10 percent in heavier
categories nor 10 percent in lighter categories. The latter suggestion
came from Packers No. l and No. 5 who have more specific requirements
for their hog supply and do not want a large number of hogs outside of
the base specifications. A similar percentage requirement for quality
was not discussed but would probably be encouraged by the same packers.
The suggestions are summarized in Table 4.3.

The weight and grade ranges were also important to the producers.
The broader the range, the easier it is for a producer to fulfill his
contract. With present technology it is difficult, if not impossible,
to have an entire lot of hogs gain at the same rate so that they will
all fall into a narrowly defined weight and grade category on a given
day. Being able to divide the contract and to deliver on a number of
different days could partially solve the problem, but a large number of
Qupments is impractical from a transportation cost point of view. One
producer related a story about the very uniform supply of hogs in
Denmark. While visiting the country he saw some producers bringing one

or two hogs to a packer in wheelbarrows.

85

TABLE 4.3 Packer and producer suggestions for improving Contract B.a

 

 

 

Suggestions Number of Number of
Packers producers
Concurring Concurringb
Weight Range
Maintain the 180-260 pound range. 1 37
Increase the range from one or both ends. 7 2
Decrease the range from one or both ends. 3 12

Weight Interval

 

 

 

Maintain the 20—pound intervals. 9 48

Change to lO-pound intervals. 1 2
Grade Categgries

Increase the number of grade categories for

hogs grading within U.S. No. 1, 2, and 3

grades. 2 6
Base WeEght Range

Change from 201-220 pounds to 211-230

pounds. 4 6
Uniformity

Require that at least 80 percent of the

hogs delivered be in the base weight

range with no more than 10 percent

below it nor 10 percent above it. 2 3

 

 

 

8See Figure 4.1 for description of Contract B.

bA total of 10 packers and 50 producers were interviewed. Some
made more than one suggestion. Some did not make any.

The producers also made several suggestions for improving the con-
tract. Their responses are shown in Table 4.3. Of the 50 producers
huerviewed, 37 (74 percent) think the 180—260 pound range would be
satisfactory. Twelve producers definitely think it could be narrowed
from either or both ende. Only two producers want to add a 261-280

pound category. All producere feel that the grade range including U.S.

86

No. 1, 2, and 3 hogs would be satisfactory; however, six producers

think that the grades should be redefined to establish four or five
categories within the three U.S. grades. A few producers suggested that
the base weight category be changed from the 201-220 pound range to the
211-230 pound range, which they believe is more in keeping with the
current market. A few also suggested that there be a requirement to
ship at least 80 percent of one's hog contract in the base weight range
because a more uniform supply of hogs would make the contract more

attractive to packers.

Carcass Versus Live

 

The packers and producers interviewed in this study were asked
whether they would prefer to trade hogs on a live basis (Contracts A
and B in Figure 4.1) or on a carcass basis (Contracts C, D, and E) in
the forward contract market. It was expected that the packers would
give strong support to carcass trading1 because it would provide greater
assurance than live trading that they would receive what they eXpected,
and that they would only pay for what they actually received according
to the premium-discount schedule. Six of the ten packers interviewed,
representing all sizes, supported that eXpectation. They believe it is

a way to improve the process of transferring hogs from the producer to

 

1Carcass trading includes all methods of buying and selling hog
carcasses on the basis of eXplicit carcass characteristics. Many dif-
ferent terms are used, often depending on the characteristics used:
'grade and dead weight", "rail grading", "carcass grading", "grade
anm.yie1d". The first three are described by Austin A. Dowell and
Kmue Bjorka in Livestock Marketing (New York: McGraw-Hill, 1941),
P-428. The latter is used today by many packers buying on a carcass
basis. Payments are made according to the grade of the carcass and the
dressing percentage (yield) of the hog.

 

87
the packer because it is more accurate and is fairer to both sides than
buying on a live basis. Three of the ten packers interviewed would be
just as willing to buy on a carcass basis as on a live basis. And one
packer believes the live method should be used in the forward contract
market because it is more familiar to buyers and sellers.

0f the six packers favoring carcass trading, four were asked to
place the five forward contract alternatives into three categories:
"preferable", "acceptable" (but not preferable), and "unacceptable".

Two of them placed Contract D in the preferable category, one placed E
that way, and one placed both D and E in the preferable category. Three
of the four packers believe that live buying would be unacceptable in

a forward contract market and they placed Contracts A and B in the
unacceptable category. The three packers who were indifferent did not
place any of the five alternatives in the preferable category, but

placed A, D, and E in the acceptable category. The packer that pre-
ferred live trading put alternative B in the preferable category. Never-
theless, that same packer would be willing to buy on a carcass basis,

and placed alternative D and E in the acceptable category.

Table 4.4 gives a summary of the packers' preferences for the five
contract alternatives. Contract D was placed in the preferable or the
acceptable category by all of the eight packers asked to place the
alternatives. Contract E was also placed that way, except by one packer
who thought it would be too costly to use. All eight packers placed
Contracts A and C in the unacceptable category because they did not want
u)buy hogs in a forward contract market where no adjustments could be
umde for grade differentials. They felt that good quality hogs should

'Maencouraged and poor quality hogs discouraged.

88

TABLE 4.4 Packer preferences for five alternative forward contract
specifications.

 

 

Contract Number of packers responding
alternativesa

 

b

Preferable Acceptable Unacceptable TotalC

 

A: live weight 0 0 8 8
B: live weight

and grade 1 4 3 8
C: carcass weight 0 0 8 8

D: carcass weight
and grade 3 5 0 8

E: measurable
carcass features 2 5 l 8

 

 

 

 

 

3See Figure 4.1 for descriptions.

b"Acceptable" does not include those that are "preferable".

COnly eight packers were asked to respond to this question; all
eight packers ranked all five alternatives.

It was expected that producers would be quite skeptical of carcass
trading because they would not be present when their hogs were evaluated
and might doubt that their hogs would be evaluated fairly. However, 33
producers (66 percent) prefer carcass selling to live selling. (See
Table 4.5) An additional 14 producers (28 percent) are indifferent.
Only three producers (6 percent) think hogs should be sold on a live
basis in a forward contract market. Of these three, no one is opposed
to carcass selling. Hence, all 50 producers would accept it and would
rmt turn down the forward contract market just because carcass selling

was required .

89

TABLE 4.5 Producer preferences for live versus carcass selling of hogs.

 

 

 

 

Producer preferences No. of producers
Concurring
Prefer carcass selling 33
accept live selling 25
refuse live selling 8
Prefer live selling 3
accept carcass selling 3
refuse carcass selling 0
No preference for carcass selling or
live selling (will accept either) 14
Total 50

 

 

Looking at the data another way shows that three producers prefer
to sell on a live basis and 25, who prefer to sell on a carcass basis,
would accept live selling. Adding the 14 producers that have no pre-
ference for either live or carcass selling means that 42 producers (84
percent) would not hesitate to use the forward contract market if it
involved live selling. However, eight producers (16 percent) would
refuse on that basis.

The reasons that the producers gave for favoring carcass selling
above live selling centered around the concepts that (1) it is fairer
to both producers and packers, (2) it is more accurate, and (3) it
increases understanding among producers and packers.

The producers were shown the five alternative ways of Specifying
a forward contract. They were asked to indicate (a) which ones were
preferable, (b) which of the remaining ones were acceptable, and (c)

‘Mfich were not acceptable. Their responses are shown in Table 4.6.

 

90

TABLE 4.6 Producer preferences for five alternative forward contract
specifications.

 

 

Contract Number of producers responding
alternatives

 

b

Preferable Acceptable Unacceptable TotalC

 

A: live weight 1 11 38 50
B: live weight

and grade 4 38 7 49
C: carcass weight 0 11 38 49
D: carcass weight

and grade 17 32 0 49
E: measurable

carcass

features 27 18 3 48

 

 

 

 

 

8See Figure 4.1 for descriptions.

b"Acceptable" does not include those that are "preferable".

cTotals across do not add to 50 producers because some did not rank
all five alternatives. Totals down do not add to 50 because producers
could place more than one contract alternative in each category.
Twenty-seven producers placed Contract E in the preferable category
and 17 producers placed D in that category. Since a producer could
place more than one alternative in the preferable category (or in
either of the other two categories), there were actually only 32 pro-
ducers Opting for D and/or E, as 12 producers1 placed both D and E in
the preferable category. Those producers perferring D and/or E prefer

carcass selling.

___

1Seventeen "preferable votes" for D plus 27 for E equals 44; but
mfly 32 producers "voted", hence 12 "votes" were for both D and E.

.
‘v~»

. u
‘e..‘

M
um
(I-

a.“

.~..:

 

91

Alternatives D and E are similar enough that twelve producers
placed them together in the preferable category; 13 producers placed
them together in the acceptable category. None of the producers found
D unacceptable and only three objected to E. All three of those pro-
ducers prefer carcass selling but feel that E is too detailed or too
complicated and hence too expensive to be feasible.

Contract B was the best one available for selling hogs on a live
basis. It appears in the "preferable" category four times: twice by
producers who prefer live selling and twice by producers who prefer
either live or carcass selling. Contract B often appeared in the
"acceptable" category because all but one of the producers who preferred
carcass selling, but would accept live selling, chose B as acceptable.
The seven producers who found B unacceptable did not think the forward
contract market should adopt live selling.

Contract C, and similarly A, are generally unacceptable to producers
because they only make adjustments according to weight differences from
the base Specification. Most producers think that quality should also
be considered. The general lack of quality considerations in many spot
markets is why 45 of the producers interviewed think that price
differentials for different quality hogs could be improved. For many
of them, this was their biggest complaint about hog marketing.

Like many packers, many of the producers said that carcass selling
is the only way to sell hogs in the future. They said that the increas-
ing consumer demands for quality will not be met consistently unless
tmoducers are paid according to the quality they produce. It seems

leely that relatively high rewards for high quality and relatively

lmarewards for poor quality will help to change the quality of hog

92

supply. But it could also be true that higher quality hogs are
generally more thrifty grain converters, which in and of itself would

encourage increased quality production.

Recommendations for Product Description

Based on the interviews with producers and packers and information
from other sources, the following recommendations are made concerning
the product description for a forward contract market.

(1) That Contract E be used as the basis for developing a formal
forward contract. Evaluating the carcass instead of the live hog is a
more acceptable method of determining value to both producers and packers.
Carcass trading was acceptable to all of the ten packers and fifty pro—
ducers interviewed; live trading was unacceptable to three packers and
eight producers. Consequently, Contracts D and E were more preferable
and more acceptable than A, B, and C. In deciding between D and E, it
was found that more producers preferred E than D and about as many
packers preferred E as preferred D. However, E was found to be unaccept—
able to three producers and one packer whereas D was at least acceptable
to all producers and packers. Those that rejected E generally thought
it was too complicated and too eXpensive to use relative to D.

Actually, Contracts D and E are quite similar, and the use of E
does not appear to be more complicated or more expensive than D. Under
both contracts packers would be evaluating hog carcasses according to a
uniform set of characteristics related to carcass value. Most of the
differences between D and E are minor: (a) D allows room for some
subjective judgment (within its grade specifications), whereas E has

no room for subjective judgment; (b) E relates different levels of the

93

characteristics directly to carcass value whereas D combines the
characteristics at different levels to establish grades and then uses
the grades to calculate value. If the grade intervals in Contract D
and the measurement intervals in E were as broad as those specified in
the examples in Figure 4.1, one would expect an experienced grader to
take very few actual measurements of a carcass. An experienced grader
should be able to measure carcass backfat and length by eye. One
packer who uses a system like that in Contract E claims that his graders
can usually tell backfat thickness, for example, within plus or minus
one-tenth of an inch without measuring. (The intervals in D and E are
for three-tenths of an inch for backfat.) Under both contracts the
grader would be expected to carefully measure several carcasses only
as a check on his grading performance.

The important difference between Contracts D and E is in their
flexibility relative to accuracy. In D, accuracy can be increased by
decreasing the size of the grade intervals thereby increasing the number
of grades. (The USDA No. 1, 2, and 3 grades would be subdivided.) The
same thing can be done in E by increasing the number of intervals for
each carcass characteristic. But in both contracts the intervals will
soon be too small to be able to classify hogs by eye and each
characteristic will have to be measured. In that situation Contract E
will give a more accurate measure of carcass value because it can use
a continuous function rather than discrete grade intervals. For example:
cv = 32.59 — .019cw - 2.088Fl
vmere CV is carcass value, CW is carcass weight and BF is backfat at the

last lumbar vertebra.

F

1Hayenga and Heifner, ”Hog Pricing Systems," p. 9.

94

Contract E can also include more carcass factors than D, thereby
enabling greater pricing accuracy in E. And there is no reason to
assume that the characteristics currently in E have to remain fixed for
all time. As new developments are made, the agency responsible for
the forward contract market should be able to substitute more accurate
attributes for estimating carcass value, taking full consideration of
the incremental costs and benefits of making such substitutions. Cer-
tainly one of the most promising additions would be loineye area if
an accurate yet efficient estimating technique could be found.

Whether Contract E uses a discrete function (such as shown in
Figure 4.1) or a continuous function (as above) depends on the cost of
estimating characteristics by eye and measuring with a ruler relative
to the benefit of the increased pricing accuracy. It was shown in Table
4.1 that 50 percent of the carcasses will be under or over-priced by at
least $.38 if paid by weight and grade (grade as a discrete function)
and by at least $.35 if by weight and backfat (both as a continuous
function). The relevant question is: Is the added $.03 accuracy worth
the added cost of being able to use the continuous function? The
question must go unanswered at this time except to note that six
producers and two packers suggested an increase in the number of grade
categories in Contract D. USDA grades currently include 0.3 inches of
backfat within each grade category. If each grade, or at least the No. l
and No. 2 grades, were split in half, there would be 0.15 inches within
each grade and that might be too close to distinguish hogs of different
backfat thicknesses by eye.

(2) That the acceptable weight range for carcasses be 135 to 195

 

carcassgpougds (180*59 260 livegpounds) and the acceptable quality rangg

 

95

be the equivalent of USDA No. 1, 2, and 3. These are the same ranges

 

proposed in the contract examples of Figure 4.1. The grade range

is acceptable to all packers. The weight range is acceptable to all
but three packers who would like it to be 20 pounds narrower from
either one end or the other. Although seven packers would like to see
the weight range broadened, especially on the upper end, the proposed
limit of 260 pounds is not likely to affect their participation in

the market. On the other hand, broader limits would likely discourage
packers who want to be guaranteed a more uniform supply. Only two
producers said they would want to market heavier hogs, hence it does
not seem as if many heavier hogs would be available to packers.
Although data on weight distribution is not available, data on grade
distribution is available and shows that 86 percent of all slaughter
hogs fall into a USDA No. l, 2, or 3 grade (under the 1968 standards).1

(3) That one generalized contract be offered. A single contract

 

capable of trading a range of weights and grades is currently used in
the live hog futures market and in all five of the forward contracts
which were reviewed for this study. A broadly specified contract seems
to be desirable since (1) most packers are willing to take a wide vari-
ety of hogs; (2) producers do not have the technology to be able to
meet rigid weight and grade specifications, at least not for very far
in advance of delivery. From the point of view of a forward contract
contract market a broad contract is desirable because it would be
costly to operate a market with several specific but different con-'

tracts to cover all weight and grade combinations, as numerous prices

 

1U. s. No. 1, 8.1%; No. 2, 42.1%; No. 3, 35.7%; No. 4, 12.2%;
Utility, 1.8%. Donald B. Agnew, Improvements in Grades, p. 12.

 

96
would have to be entered, compared, and reported. In other words,
a fairly broad contract (like those in Figure 4.1) is compatable with
all three parties directly involved in the market—-the producers, the
packers, and those that Operate the forward contract market. Hence,
there is no good reason at this time to make the contract more specific
and thereby have many contracts. If technological developments in hog
production, slaughtering, and processing make a uniform supply more
desirable, the added benefits of trading a number of specific contracts

may outweight the added costs.

Premium and Discount Schedule

 

Once the characteristics for evaluating hogs are chosen, and the
intervals are established, the size of the premiums and discounts for
each interval has to be decided. This section will consider alterna-
tive ways of specifying those premiums and discounts. The main concern
expressed by both packers and producers is that the premiums and dis-
counts reflect carcass value: that no packer pay more than a produc-
er's lot of hogs is worth and that no producer receive less than his

lot of hogs is worth.

Standardizing the Schedule

If each packer were allowed to set up his own premium-discount
schedule (hereafter referred to as P—D schedule), a packer, who believed
a No. 1 hog was worth $1.00 more per cwt. than the No. 2 hog in the
base specifications, would be free to pay a $1.00 per cwt. premium
above the base price for the No. 1 hog. At the same time, another
packer who thought a No. 1 hog was only worth $.25 per cwt. premium

would be free to pay only a $.25 premium.

97

The problem with allowing each packer to establish his own P-D
schedule is that it would greatly complicate the process of pairing
a producer and packer. If a producer's hogs were mostly No. 1's, he
would want them to go to a packer promising to pay $1.00 above the
base price instead of to the packer paying a $.25 premium, assuming
the base prices were the same. Instead of requesting the highest
base price bid by a packer, a producer would first have to give the
expected composition of his lot of hogs and then request the highest
total payment. The computer, instead of searching for the highest
base price bid, would have to calculate the expected total payment for
each packer based on the producer's expected lot composition. Another
alternative would be to relay several base prices and related P-D
schedules to the inquiring producer who would make the calculation
himself. But given the relative high cost of telephone time relative
to computer time (see Chapter V), this alternative is too expensive.
Actually, both alternatives are likely to be quite expensive relative
to the cost of operating a market with a standardized P-D schedule for
all packers.

A standardized P—D schedule will be a distinct disadvantage for
packers who might want to use a schedule that was different from the
standard. The significance of this disadvantage will depend on how
different the P-D schedules of packers really are, but it is not known
at this time.

There are a number of ways to standardize the P-D schedule. The
live hog futures market does it by establishing a standardized set of
premiums and discounts--which are actually all discounts-that are

binding on all buyers and sellers. The base price is for hogs weighing

98
200 to 230 pounds. Hogs weighing 190 to 199 or 231 to 240 pounds are

priced at $.50 per cwt. below the base price. In addition, there is
a discount of $.50 per cwt. on the base price for the entire contract
if more than 60 head grade U. S. No. 3 or less.1

The fixed P-D schedule seems to be too rigid because it cannot
fluctuate over time to keep up with the supply and demand of different
sizes and grades of hogs which fluctuate relative to one another in
the market. Table 4.7 shows how the price differentials change over
time. A fixed P-D schedule over—prices some hogs part of the time
and under-prices them at other times. For example, if USDA No. 1—2,
180-200 pound hogs were discounted by $.50 per cwt. in 1967, they
would have been under-priced in January, April, and October and over-
priced in July if the 200-220 pound hog was neither under- or over-
priced.

Both packers and producers agree that a forward contract market
should include a mechanism to change the P-D schedule over time, as
market conditions among different sizes and qualities of hogs change.
The packers generally fear that they may have to pay too high a pre—
mium or will not be able to make a large enough discount to keep their
procurement costs in line with their revenues. They desire to have
a P-D schedule that can be adjusted frequently so that any one sche-
dule will apply to only a short period of time. One packer said it
would have to be changed almost daily, yet another said change is
insignificant over a six-month period. Five packers (50 percent),

representing all sizes interviewed, would be satisfied if a schedule

 

1Chicago Mercantile Exchange, "Live Hogs," p. 4.

99

TABLE 4.7 Hog price differentials (dollars per cwt.), Chicago,
1967 and 1968

 

 

 

 

"Standard": Price differentia‘s from the standard

Year Month U.S. 1-2 U.S. 1-2 U.S. 1-2 U.S. 2—3 U.S. 2-3
200-220 lbs. 180-200 220-240 ZOO-220 220-240

1967 Jan. $21.22 $-.24 $-.49 $-.10 $-l.39
April 18.80 -.32 -.24 -.84 -.95

July 23.91 —.55 -.24 -.83 -.95

Oct. 19.34 -.15 —.22 -.45 -.81

1968 Jan. 19.64 n.a. n.a. -.06 -.98
April 20.12 n.a. n.a. -.07 -.92

July 22.80 n.a. -.44 -.58 n.a.

Oct. 19.67 n.a. -.29 -.53 n.a.

 

 

 

 

 

 

 

Source:

n.a. = not available.

U. S. Department of Agriculture, Economic Research Service,

Livestock and Meat Statistics, Supplement for 1967 and

Supplement for 1968, Stat. Bul. No. 333 (Washington: U. 3.
Government Printing Office, 1968 and 1969), p. 123, p. 125,
respectively.

100
were allowed to be set for a three or four month period. But to
include 90 percent of the packers interviewed, the P-D schedule
could be applied to no more than a one-month period. That is, from
one month to the next, they believe there is enough change in the
relative prices of different kinds of hogs to warrant changing the
P-D schedule. (See the center column ot Table 4.8 for summary of
the packers' responses.)

TABLE 4.8 Packer and producer opinions on how often the premium-
discount schedule needs to be changed

 

 

 

Duration of a given No. of packers No. of producers
premium-discount concurring concurring
schedule without an (accumulative (accumulative
opportunity to downward)a upward)a
change it ‘

6—12 months 1 44

3-4 months (seasonally) 5 31

1 month (monthly) 9 18

2 weeks 9 10

1 day 10 0

 

 

 

aPackers wish to change it as frequently as possible. Packers
"voting" for an upper category would also agree with those voting in
a lower category. Producers generally wish to change it as little as
possible. Producers in a lower category would agree with those in an
upper category. Ten packers and 44 producers responded.

The producers, on the other hand, are not in the same cost-price
squeeze as the packers. The producers are not as concerned about the
length of time over which a given schedule is fixed. Most producers

said that the packers should be the ones to make this decision. Of

course, the producers do not want the period to be too short because

101

it would take a certain amount of management time to keep up with the
changes. Only 18 (about 40 percent) of the 44 producers responding to
the question think the P-D schedule needs to be different for each
month (Table 4.8); but most of them would probably go along with that
decision if the packers thought it was necessary.

Originally it was assumed that the rates in the P-D schedule would
have to be part of the contract that was fixed at the time the base
price was negotiated in the contract market. But this is not necessary.
The schedule could still be uniform for all traders contracting for a
particular delivery period and not be determined until after all of
the contracts had been made. For example, on July 15, 1969 a producer
might complete a transaction to deliver hogs to a packer in January,
1970. The P—D schedule could be left open until the middle or the end
of December. One would expect a P-D schedule for January to be more
accurate if it was determined in December instead of in July or earlier.

Thirty producers were asked whether they thought their hogs
should be evaluated under a P-D schedule in effect when they entered a
contract or when they delivered the hogs. Fourteen (47 percent) of
the producers thought it should be known at the time they entered the
contract. Six producers (20 percent) said it should be determined at
the time of delivery with no prior notice about the rates, and ten
producers (33 percent) said it did not matter as long as it was done
consistently one way or the other (Table 4.9).

These last ten producers generally believe that they would "win
a few and lose a few" no matter which way it was decided and that they
would not change their production and marketing decisions based on the

schedule. The fourteen producers that said they wanted the P-D

102

schedule to be part of the contract from the beginning were probably
assuming that the more they know when they entered a contract the
better. For many of them it probably does not make much difference.
Their herd quality is fairly well fixed in the relatively short term
of a year or so, hence they could not change the quality of hogs being
produced even if the price of lean relative to lard were changed
dramatically. They could, however, change the weight at which they
sold their hogs if they knew the relative prices for different weight
intervals in advance of delivery.

Since deliveries have to be committed to a specific delivery day
at least one week prior to the beginning of each two-week delivery
period (see the next section on "Day of Delivery"), a P-D schedule
announced two to three weeks prior to a delivery period would allow
producers to plan to delivery hogs at their most profitable weight.
P-D schedules announced after that would not help producers plan, as
they would already be committed to deliver on a specific day.

Only four packers were asked the question about when the schedule
should be determined. Two of them said that it should be at or close
to the time of delivery; one said when the contract was signed, and
one said it did not matter as long as it was done consistently one way

or the other. (See Table 4.9)

Establishigg the Rates
The method of determining the rates to use in the P-D schedule
was not discussed with the packers and producers, but there seem to be

three basic alternatives:

103

TABLE 4.9 Packer and producer Opinions on whether the premium-
discount schedule should be fixed when the contract is
signed or when the hogs are delivered

 

 

 

 

 

Time when the premium- No. Of NO. of
discount schedule should packers producers
be fixed
When signed 1 14
When delivered 2 6
Either when signed or delivered 1 10
Total8 4 30

 

 

 

8This question was added after the interviewing began. Six
packers and 20 producers were not asked to reSpond.

104

(1) Use a formula based on historical data for various parts
Of the year. Wholesale prices and cut-out values would
undoubtably receive major consideration.

(2) Have the market agency responsible for operating the for-
ward contract market survey the packers periodically for
their opinions or forecasts about the future. The agency
could then use a formula to aggregate packers' responses,
or use its judgment in setting the schedule based on
packers' reSponses.

(3) Let the market agency use its own judgment, which would be
based on anticipated wholesale prices and related to cut-
out standards.

The first method would result in a high degree of certainty about
each successive schedule change because the rules and the data for
developing each new schedule would be clearly established. This would
result in a minimum or argument about any change in the schedule. The
second and third methods would not enjoy this protection, but they
would be much more adaptable to changing conditions in the economy.
They would also require a more talented group of managers that could

be accurate enough to maintain the confidence of_both the producers

and the packers.

Recommendations for a Premium-Discount Schedule

The following recommendations are made with reSpect to a premium-
discount schedule for hogs that vary from the base size and quality
Specified in the forward contract.

(1) That the premium-discount schedule be standardized. In order
to Operate a computerized forward contract market it seems likely that
the P-D schedule will have to be the same for all packers. This will
pose some disadvantage to packers who would want to make non-standard-

ized adjustments but the extent of the disadvantage is not known.

1';

L1

)_ ‘9

0‘“

105

There was at least a tentative willingness to use a standardized P-D
schedule by all but one of the packers interviewed, especially if the
schedule was altered frequently to keep it current with changes in
the wholesale market.

(2) That the premium-discount schedule be established relatively
close to thefgime of delivery. The closer to delivery time that the
final decision is made on prices in the P-D schedule, the more informa-
tion is likely to be available and the more accurate the price differ-
entials are likely to be. If the P-D schedule cannot be announced
with sufficient accuracy at least two weeks before the delivery period
begins, there is little need to announce it until the week that the
deliveries occur because producers will be already committed to a Speci-
fic day for delivery. It should be noted, however, that knowledge of
the exact P-D schedule before being committed to a specific delivery
day may be of little value to producers. In spite Of the above advan-
tage with respect tO market weight, as many as half the producers (16
out of 30 in Table 4.9) would be willing to deliver hogs without any
prior knowledge of the P-D schedule. Apparently, they did not believe
the advantage of delivering a hog of one weight relative to another
*would change much from.one delivery period to another. Perhaps, then,
hte PdD schedule could be announced just prior to the next delivery
*week. (Some sort Of Official approximation might be given five to six
‘weeks in advance as a guide to producers.) The P-D announcement could
also be made at the end of the week with even greater accuracy, as
vflualesale prices would be known, but this would lag payments to pro-

ducers. Producers delivering early in the week would not be paid until

106

near the end of the following week. This may be unnecessary if P-D
schedules announced before a delivery week began were almost as accur-
ate as those announced after a week ended.

(3) That the market agency estimate and announce the premium-
discount schedule. This method appears to be more accurate than
either Of the others. They Would probably use an estimating model to
determine expected wholesale prices and then calculate the appropriate

P-D schedule.

Size of Contract

 

How many head or how many pounds of hogs should be Specified in a
single contract, and how much tolerance above and below the specified

amount should be given to a producer in making delivery?

The Quantigy to be Delivered

A contract which is too large will exclude small producers who
cannot have that many hogs ready for delivery at one time. On the
other hand, a contract which is too small will mean a reduction in
efficiency for large producers and for packers who would be forced to
execute a large number of contracts and handle the resulting paperwork.

The live hog futures contract, like all other futures contracts,
Specifies a uniform quantity of the product to be delivered in order
to capture certain efficiencies: (1) it simplifies the matching of
buyers and sellers since they are all trading in units of the same
size; (2) it standardizes one more variable that buyers and sellers

would otherwise have to consider; (3) it eliminates a possible point of

107

confusion and error for buyers, sellers, and the market agency. A
single live hog futures contract requires 20,000 pounds of live weight.1
Among the five forward contracts reviewed for this study, one
specifies the size at 20,000 pounds. The other four leave the size open

for the producer to fill in (with the buyers' approval). Two of these
"variable size" contracts specify a minimum number of head (25 and 45
head). The other two have no minimum; however, one might expect that
the buyers have a minimum in mind when they make the contract available.
Some of the buyers with variable size contracts also said that they en-
courage the sellers to deal in multiples of five head.

The producers and packers in the survey were asked to state their
preferences for a "standard size" forward contract which would be the
same for all traders. Table 4.10 shows the distribution of responses
by the producers. The most common response was 50 head, chosen by 18
of the 46 producers answering the question. Relatively more of the
producers who have contracting experience than producers without such
eXperience prefer 50 head. And the distribution for non-contracting
producers is more skewed in the direction of smaller contracts than the
distribution for contracting producers. One might expect an upward
movement in the number of head preferred in a contract as the number
of head sold per farm increased. A slight movement in that direction
did exist for non-contracting producers, but for contracting producers
the median was fairly stable at 50 head, regardless of the number sold

per farm.

 

1Chicago Merchantile Exchange, "Live Hogs."

108

TABLE 4.10 The distribution of producer Opinions on a standard size

 

 

 

 

 

 

contract
W W
Number of head Number Of producers
per contract
Contractigg Not contracting» Total

25 O 3 3

30 l 5 6

403 1 6 7

50 ll 7 18

6O 1 2 3

70b 0 1 1

80 0 0 0

90 0 0 0

100 5 2 7

120 0 1 1

Total 19 27 46

 

 

 

 

aIncludes two producers who chose 45 head.

bIncludes a producer who chose 75 head.

After a producer was asked about a standard size contract, he was
asked to consider a contract of variable size. The variable size con-
tract would allow each producer to choose the number of hogs he wanted
to sell rather than be forced to sell in multiples specified by a
standard size contract. It would allow a producer to contract for
the number of hogs that was convenient and economically efficient for
him, and would allow him to contract a different number of hogs each
time he entered the market. The variable size contract would allow the
producer to make only one contract for all the hogs he had available
for slaughter at one time. All 50 producers thought the variable con-
tract was a good idea. Several of them even mentioned it before it was
suggested in the interview. A few others were a bit skeptical about
whether it would work or not, but wanted a variable size contract if

it would work.

109

The packers' most common reaponse to the question Of a standard
contract size was 100 head. The distribution is shown in Table 4.11.
The suggestion for 50 head came from the smallest packer interviewed.
The suggestion for 25 head came from one of the largest packers who
thought it would have to be that small to encourage a large number of
smaller producers to participate. All ten packers favored the variable
contract size. They also favored a system.which would allow packers
to make large contracts and allow the market center to subdivide those
contracts into a number of smaller contracts for producers. For example,
a packer could make a contract for 400 head and have several producers
fill the contract. Five producers might sell 50 head each and two more
producers might sell 75 head each. As long as the price bid by the
packer matched the price offer of the sellers, the computer would pair
the seven producers with the one packer.

TABLE 4.11 The distribution of packer opinions on a standard size
contract

 

 

Suggested number of head Number of packers
Ayper contract

 

25 1
50 1
100 5
7150 1
200 1
Total 9

 

 

Tolerance in the.antr§cted Amount
After discussing the size of contract, it was necessary to find
out if the producers would need any margin above and below the exact

number Specified, and if the packers would be willing to accept any.

ll

110

The live hog futures contract sets a limit of ”not in excess of 5 per-
cent of 20,000 pounds.”1 The packers interviewed (except one major
packer) were willing to accept plus or minus 5 percent leeway in the
contracted amount, and five of the ten packers would accept plus or
minus 10 percent.

Forty of the 48 producers responding (83 percent) said they could
manage with as little as plus or minus 5 percent leeway. The 5 percent
figure is more acceptable to a larger percentage of the producers with
contract experience than without (Table 4.12).- Plus or minus 2 percent
leeway (or less) would be acceptable to 61 percent of the contracting
producers and only 33 percent of the non-contracting producers. The
difference between the responses of the two types of producers is prob-
ably due to the fact that four of the five contracts being used did not
allow any tolerance.

TABLE 4.12 Producer Opinions of the tolerance needed in the Specified
quantity to be delivered

 

 

Number of producers requesting
various percentaggs of leeway

 

 

 

Producer + + + + More than
classification 0% f 2% - 4% - 5% - 10% 10% Total
With contracting 6 5 4 l 2 O 18
experience
Without contract- 7 2 5 10 5 1 30
ing experience
Total 13 7 9 11 7 l 48

 

 

 

 

 

 

 

 

 

1Chicago Mercantile Exchange, ”Live Hogs.”

'h‘.’

 

 

lll

.gead Versus Pounds

A variety of terms can be used to describe the quantity of hogs
to be delivered: number of head, number of carcasses, or number of
pounds of either live hogs or hogcarcasses. The terms used to des-
cribe the quantity do not have to parallel those used to describe
the size and quality of the animals to be delivered. For example,
the live beef futures contract of the Chicago Mercantile Exchange
describes the quality of the product in terms of carcass grade and
yield, while the quantity to be delivered is Specified in terms of the

live weight and grade.1

For the live hog futures contract, the prod-
uct specifications are in terms of live weight and grade and the
quantity to be delivered is specified in terms of live weight.2

The producers and packers in the survey were asked if they pre-
ferred a contract specified as a number of head or as a number of
pounds. Twenty-eight of the 50 producers (56 percent) preferred the
quantity to be Specified in terms of head; 9 producers (18 percent)
preferred the Specification to be in pounds; and 13 producers (26 per-
cent) were indifferent. Actually, those that preferred pounds were
mostly producers who were contracting in terms of pounds and were famil-
iar‘with how it worked. The producers contracting in terms of head or

not contracting at all definitely preferred to sell in terms Of number

of head (Table 4.13).

 

1Chicago Mercantile Exchange, "Rules and Regulations for Trading
in Beef Cattle (Live) Futures Contract on the Chicago Mercantile
Exchange" (November 4, 1964).

2Chicago Mercantile Exchange, "Live Hogs."

112

TABLE 4.13 Producer preferences for specifying the contract in terms
of head or live pounds of hogs

 

 

 

 

 

 

 

 

 

Number of producers preferring
Producer classification

Head Pounds Either Total

Contracting by pounds 3 6 6 15
Contracting by head 4 0 0 _____

Total contracting 7 6 6 19
Not contracting 21 3 7 .JlL.

Total (all producers) 28 9 13 50

 

 

 

 

 

From the packers' point of view the contracted quantity should be
specified in number of head. A packing plant Operates in terms of so
many head or so many carcasses per day and per hour. The chain speed
throughout the plant is set by the number of head of hogs and the num-
ber Of workers available. Labor contract terminology and plant pro-
duction data are largely in terms of the number of head. Whether the
hogs ready for slaughter on a particular day average 210 pounds or
230 pounds, the technology is such and the characteristics Of the main
input are such that the plant still moves so many head of hogs per hour.
Of the eight packers reSponding, seven preferred head, and one said
it did not matter. Nevertheless, all but one packer said they would
accept a contract which Specified a number of live pounds instead Of
a number of head to be delivered. But most of them would prefer to

have it in number of head.

113

Recommendations for the Size of Contract

The following recommendations are made with respect to contract
size.

(1) That the amount to be delivered inig:contract be Spegified
in termgyof head. The whole trade is more familiar with planning by
the head: producers' facilities handle SO many head rather than pounds;
trucks are described as holding so many head within a certain broad
'weight range; packing plants process so many head per day whereas the
pounds processed depend upon how heavy the hogs are. Most producers
and packers would prefer to trade in terms of number of head and those
that would prefer to trade in pounds were willing to accept a contract
specified in number of head.

(2) That the contract size be allowed to vary from a minimum of
3912939 to a maxgmum of 500 head. The variable contract size is more
flexible as it would allow producers as well as packers to choose the
size that was most efficient for them. In other words, it would not
force a relatively small Operator to function beyond his otherwise most
efficient level, nor would it force a larger Operator to repeat the
trading procedure a number of times in order to maintain his volume.

One might think that the numbers given by the producers were for
a maximum size of contract and that a contract of 50 head, for example.
would be acceptable to all who chose one larger than 50 head, but this
is not entirely true. The producers each had their own reasons for why
they preferred a certain Size of contract. The most common reason
centered around their methods and costs of transportation. Many pro-
ducers transpOrt hogs in their farm trucks which commonly hold 30 hogs.

This is the reason for the minimum number of 30 head. Others use

114
semi-trailer trucks which hold 125 to 150 hogs. These producers would

not be encouraged to use the contract market if the contract was set at
50 head. Some producers picked the number 50 because they felt they
only had the capacity to provide that many at one time. Their on-the-
farm limitations rather than available transportation is the more
important consideration. Other producers preferred other numbers be-
cause for one reason or another they felt a certain number was the most
convenient and/or the most efficient for them.

Packers also had a variety of reasons for choosing certain numbers,
but because of their larger scale, they were generally more flexible on
the size of contract they could handle. When packers were asked to
state the size of contract they preferred, many limited the size to what
they thought a single producer could provide. Packers were not asked to
specify the largest Size of contract they would like to be able to make
if a number of producers were allowed to fulfill a Single packer contract.
Perhaps they would want to ge beyond 500 head. The choice of 500 head
is quite arbitrary, but some limit will be needed for computer programming
It is not likely, however, that a packer would want to make only one
contract for all his supply for any one week because this would force
him to bid the same price on the whole lot.‘ He might want to be cer-
tain of part of a week's supply and pay a higher price for it than he
hOped to pay for another part at a time closer to the delivery week.

Packers' operating costs are not expected to be much higher for
a variable Size contract than for a fixed size contract. Under both
systems the packerS'would tatoo each hog as it arrived and would weigh

and grade each hog carcass as it passed along the production line.

115

The packer would then calculate the value of each carcass, total the
value of each producer's lot of hogs, and write the check. Under both
systems a packer's computer (or clerk in small plants) would have to
count the number of hogs in each lot, because even under the fixed size
contract there would be some tolerance for variation in lot size, and
calculate the value of each lot. The major cost of evaluating a lot of
hogs would be about the same per hog, regardless of the size of the lot.
However, there would be certain fixed costs in evaluating hogs such that
the cost per hog would increase as the lot size decreased. These would
be the costs of: (1) changing the tatooing device, (2) making book-
keeping entries, and (3) preparing and sending checks. But the total of
these relatively small costs is not likely to make much difference in
the average cost of handling hogs in lots of 50 head instead of in lots
of 150 head. In addition, the little extra it might cost to handle a
relatively small lot would have a good chance of being offset by the
savings on a larger lot, such that the overall cost of working with the
variable contract size would not be any different from that of working
'with a fixed contract size. This would be especially true if the fixed
contract size was set relatively low--around 30, or possibly 50 head--
in order to get a large number of producers to participate.

The variable contract Size will undoubtably increase the costs of
operating the market center which must sort out bids and offers of
differing sizes. But even here there can be some offsetting economies
by traders who deal in relatively large contracts. Larger contracts
can, in fact, be encouraged by reducing the marketing fee per head as

the number of head in a contract increases.

116

(3) .Th§§_the variation in quantity ofghogg be limited to multiples
of 10 head. Fixed increments are suggested because they reduce the
number of different size contracts in the market and simplify the match-
. ing of producers and packers. The lO-head increments instead of single-
head increments reduce the number of possible contract sizes from 471
to 48. The lO-head increments will probably be as acceptable as 5 or
single-head increments, for only six producers said that they preferred
a number that did not end in 0. Three of these producers chose 25 head
and one chose 75 head which probably represent "nice" numbers rather
than something of deep economic Significance. The other two were for
45 head which is approximately one-half of a futures contract. It does
not seem as if any of themuwould mind adjusting their preferred number
up or down by 5 head.

(4) That a producer be allowed to deliver up to 5gpgrcent more
or less than his contracted number of head. There does not seem to be
much dispute over this figure. It does not appear to be too high for
packers nor too low for producers. It could be made smaller, but this
would probably discourage more volume from producers than it‘would
encourage from.packers. Mbst packers appear to be flexible enough that
they could handle this much variability without a significant effect on
their costs. Their labor contract forces them to guarantee 36 hours of
work.per week, but they can have up to 40 hourS'without overtime pay.
Hence, there is no increase in labor costs per unit (a major variable
cost item) for essentially a 10 percent change in volume. The 5 percent
allowance above or below an expected quantity of hogs to be delivered
would give that 10 percent change if all producers went one way or the

other.

117

There was some concern on the part of the packers not to make the
tolerance too large because they would expect to be consistently over-
supplied when their fixed contract price was above the spot price at
delivery time, and consistently under-supplied when the spot price was
above the contract price.

(5) That (a) producers be allowed to subdivideypacker contracts
but that (b) packers not be allowed to subdivide producer contracts.
(Actually the computer market will do the subdividing and be responsi-
ble for pairing buyers and sellers.) It is more likely that producer
contracts will be smaller than packer contracts because Of the vastly
smaller economies of size of producing firms. Part (a) will allow
packers to make large efficient contracts of up to 500 head, and if
there are not any producers willing to sell that many at once and at
the same price, the computer market will be able to combine a sufficient
number of producers to fill the packer's contract. There would not be
any reason to split a producer contract until a situation arose where
a large packer contract needed only a small number of hogs to be com-
pleted and there were not any producer contracts that small and at
the same price. But if a producer were accepting the responsibility for
transportation to the packer, he would not want to have an efficient
size lot subdivided and sent to more than one plant, thereby reducing
his transportation efficiency and lowering the effective price he was
planning to receive when he entered his price offer in the contract
market. Part (b) will prevent a producer's contract from being sub-
divided.

Packers that desire to provide the transportation will bid on

contracts in specific producer zones. If producers delivered to a

A

.I

 

e

”‘1

On

(A

-.r

u.

(a-

‘4

118
collection point (rather than the packer transporting the hogs directly
from individual farms), it would make little difference whether one or
ten producers were combined by the market to make delivery to the

collection point.
Day of Delivegy

Contracts Currently in Use

An inspection of five forward contracts currently being used for
hogs shows a variety of ways for specifying the day that the hogs are
to be delivered. One contract, which does not specify the price in
advance, says that hogs will be delivered when ready for slaughter and
when the agency offering the contract has lined up a packer to buy them.
The other contracts are more specific about the delivery because they
guarantee a price to be paid. One allows delivery within a two-month
period (with a different price for each month); another one allows
delivery during the first twenty days of a contract month; another
Specifies the contract week; and still another says "on approximately"
a specified day.

There are two reasons why these contracts are quite broad in
Specifying the time for delivery. First, the producers cannot tell
‘very far in advance just when their hogs will attain their most profit-
able slaughter weight. Unless the producers have sufficient leeway on
delivery, they will not Sign a forward contract. To do otherwise would
increase their price uncertainty, for even though they are guaranteed
the base price, there is a good chance that they will suffer large
discounts according to the premium-discount schedule. Second, the

'parties on the buying side of these contracts rarely have more than

119

a few percent of their volume under contract.‘ Hence, they can be quite
flexible as to the days on which they will accept delivery. Nevertheless,
they request a notice of delivery a day or two in advance, or they have
the option of requesting delivery on a certain day in the Specified
delivery period (with consent by the seller).

The reasons for using these contracts are: (l) to experiment with
forward contracting in order to gain some experience for future use;
(2) to offer producers another alternative for selling their hogs as a

method for the buyer to solicit more sellers.

Conflict Between Producers and Packers

In contrast with current forward contracting, the proposed forward
contract market would be a system whereby a packer or a producer could
complete a large proportion, if not all, of his buying or selling by
contract. A producer will only consent to such a commitment if the
delivery terms are flexible enough. A packer, on the other hand, can
see no advantage to extensive forward contracting unless he can be
guaranteed a certain number of hogs on each day that he wants to oper-
ate his plant.

A solution would be to let the producer have a broad time interval
within which to make deliveries, but prior to the beginning of that
interval, require him to arrange a specific day for delivering his
hogs. Under this arrangement, the packer would always have an advanced
guarantee of how many hogs were coming within a certain period of days
and'would know how many more he needed to secure in order to Operate
efficiently. The packer‘would not know which producers would deliver
m1a.particu1ar day until the producers called into the market center

and agreed to deliver on a particular day. When the producers called,

120

they would have a choice of delivery days within the delivery interval
to which they originally agreed. But as a packer's requirements for
particular days were filled, those days would be closed to subsequent
producers that called to choose a delivery day. As much as possible,
this mechanism would enable each producer to deliver his hogs when he
thought they would bring the highest net return, considering the terms
of the contract (the base price and premium-discount schedule) and his

own production costs.

Delivery Intervals

The allowable delivery intervals suggested to the producers are
shown in the middle column of Table 4.14. AS the length of the contract
period (this is, the length of time between when the contract is made
and when delivery is expected) increases, the length of time allowed
for delivery increases. Table 4.15 shows that 31 out Of 49 producers
(63 percent) thought the suggested intervals would give them enough
time within which to make deliveries. The producers with contracting
experience were more likely to accept the suggested intervals than
producers that did not have contracting experience. The number of

hogs sold by a producer had little influence on whether or not he
thought the intervals were large enough.

If the suggested intervals were enlarged to those shown in the
third column of Table 4.14, 9 of the 18 dissenting producers would be
satisfied for a total of 40 producers (82 percent). 0f the 9 re—
maining dissenters, all but one did not have any contracting

experience.

121

TABLE 4.14 Delivery intervals depending on the length of the contract

 

 

 

period

Suggested Modified

Length of contract delivery delivery
period interval interval

1 week or less 1 day 1 day

2 weeks 1 day 1 day
1 month 5 days 7 days
3 months 11 days 14 days
6 months 21 days 30 days
10 or more months 21 days 30 days

 

 

 

TABLE 4.15 Producer acceptance Of the

delivery intervals in Table 4.14

 

 

 

 

 

Interval With contracting Without Contracting Total
acceptance experience Experience
Suggested Interval
Accepted 14 17 31
Rejected __,'5_ _1_§ _1§
Total 19 30 49
(Proportion of producers
accepting) (.74) (.57) (.63)
Modified Interval
Accepted 18 22 4O
Rejected _l_ '__8_ __9_
Total 19 30 49
(Proportion of producers
accepting) (.95) (.73) (.82)

 

 

 

 

122

The fact is that producers who contract are willing to accept
smaller delivery intervals. This suggests that those who contract are
either more aware of the progress their hogs make before they try con-
tracting or that contracting forces them to be more aware of how their
hogs perform. It is likely to be a combination of the two. This sug-
gests that the intervals do not have to be as loose as many would desire,
and that those in the last column of Table 4.14 would be acceptable once
a producer became accustomed to forward trading.

The length of the delivery interval was not discussed with packers
because at the time of the interviewing it appeared as if this topic
was only of interest to producers having to make deliveries. On second
thought, however, it is apparent that the producer and the packer are
agreeing on one base price for the length of the delivery interval. If
they complete a transaction three months prior to the scheduled delivery
period, the price would be the same for hogs delivered at any time
within the 14 days allowed for delivery.

From the packer's point of view as well as the producer's, the
size of delivery interval should increase as hogs are promised for more
distant future deliveries because the estimates of supply and demand
become less accurate over longer periods of time. A trader may be able
to say that hogs delivered this Tuesday are worth $.50 per cwt. more
than hogs delivered on Thursday. But as a particular Tuesday and
Thursday are located further into the future, the distinction between
them becomes smaller, and there is less basis for pricing one above
or below the other. Similarly, even weeks become less distinct over

time.

 

 

 

123

With respect to a minimum size of delivery and pricing interval,
most of the producers (96 percent) and the packers (100 percent) inter—
viewed said that daily price fluctuations, such as found in current
spot markets, are unnecessary and often confusing and that one week
would be a satisfactory minimum interval. In other words, a contract
price could be the same for any day of the week. Whether the contract
was made three weeks in advance of the delivery week, or just the
Friday before the week began, or even :he Tuesday of the delivery week,
the price paid would be the base price each individual producer agreed
upon with each packer for the entire week.

The maximum size of a delivery and pricing interval was not dis-
cussed with the packers and producers, but one month would seem to be
sufficient. The futures markets have adopted intervals of one month
and traders seem to be able to make a distinction between months--
even for months that are eight or nine months away. In addition, most
producers are able to predict the month their hogs will be ready for

slaughter from several months in advance of delivery.

Recommendations for Arranging Deliveries

 

(1) That the Wednesday prior to the beginning of a delivery

 

interval be the deadline for making delivery appointments. In order

 

to assure packers that they will receive the number of hogs they
expect each day, there will have to be a deadline for making delivery
appointments. Although producers would generally want to call well
before such a deadline in order to have a broad selection of days

on which to deliver, it is possible with an interval as long as one

124

month that some of the earlier days in a delivery period would pass
without being completely filled. In order to schedule the delivery
of a sufficient number of hogs in the earlier delivery days of an
interval, all commitments to deliver would have to be made before the
delivery interval actually began.

Although the deadline could be the last day before the delivery
interval began, the contract market agency would probably want at
least a couple of days to contact producers who forgot to make appoint-
ments. If appointments could be made or if packers could be notified
in advance of failures to deliver, packers would probably have more
confidence in the market and be more willing to use it. The cost of
following up on delinquent producers could be charged against them as
an added incentive to make delivery appointments before the deadline.

Very short-term contracts could still be made after the Wednesday
deadline, but producers would be required to make delivery appointments
the same day they entered the contract.

(2) That one-, twoe, and four—week pricing and delivery intervals
be established. The producers and packers almost unanimously agreed
that one week should be the smallest interval. It a contract were
made in one week for delivery the following week, the producer could
deliver on any day that week at the same price, as long as the packer
had unfilled capacity on the day when the producer wished to deliver.
The producers said they could make contracts for a specific week up
to about one month in advance of delivery. From one month to three

months in advance, a two—week interval would be needed. 0n two-week

125

contracts they would not be required to choose a specific delivery day
until the Wednesday before the two—week period began. If a producer
waited until the deadline, he would be choosing that day from one-half
to two and one-half weeks in advance of delivery. Producers contracting
more than three months in advance would be given a full month to de-
liver. Having to make a delivery day commitment on the Wednesday

before the delivery month began would cause some producers to choose

a delivery day as much as four and one-half weeks prior to delivery.
That is well beyond the limits of Table 4.14. If those planning to
deliver in the last two weeks were allowed to adopt a new two—week de-
livery interval, they could wait two more weeks before making a delivery
appointment. The maximum length of time before delivery would then be
only two and one-half weeks.

Since calendar months contain fractions of weeks, the contract year
could be divided into thirteen, full, four-week months. These could
easily be subdivided into two—week and one-week delivery intervals.

The use of months containing full weeks will simplify the operation of

the market and enable it to process data on a week-by-week basis.

Length of Contract Period

 

How far in advance of an expected delivery period do packers and
producers want to make forward contracts for butcher hogs? To answer
this question each trader must consider the benefits and the costs of

making short-term contracts in comparison with long-term contracts.

126
Uncertaintinncreases as the Length of Contract Period Increases

Producers must consider two sets of certainty and uncertainty con-
ditions when deciding on how long to contract. One set involves conditions
on the farm; the other set involves conditions in the market. The
forward contract being developed in this chapter will increase producer
certainty about what kinds of hogs to produce in order to maximize net
returns. He will be given, in advance, prices for different weights
and qualities of hogs against which he can compare the costs of pro-
ducing them. At the same time, however, the producer's price uncertainty
increases because he may not be able to produce the most profitable
kinds of hogs on time. He may be forced to take discounts and/or pay
penalties for not delivering on time or for delivering hogs in poor
condition. This uncertainty about being able to meet contract specifi-
cations increases as the length of the contract period increases
because the growth performance of hogs becomes less predictable. During
the interviews producers often said "more things can go wrong over a
longer period of time" with disease, bad weather, and other things.

The uncertainty is also a function of how narrowly the specifications
in the contract are established.

On the market side there is price uncertainty for the producer.
Although there is price certainty in the form of a guaranteed price,
there is the added uncertainty of whether or not the spot price at
delivery time will be significantly higher than the contracted price.
This kind of uncertainty increases with the length of the contract
period as there are more prices to choose from, and a producer is less

shit: to predict the future for the time of delivery.

127

Producers were generally cautious in estimating the maximum length
of time they would contract into the future (Table 4.16). Only six
said they would contract for 10 or more months which is the length of
time necessary if one is to contract before breeding sows. A number of
producers chose 5 to 6 months, by which time they would have a good idea
of how many pigs had been farrowed. But most producers preferred to
contract no more than 3 to 4 months, by which time the pigs would be
weaned and the producers would have a good idea about the future per-
formance of their pigs-—when they would reach slaughter weight and
their likely grade. The distribution of producer responses was not
much different for those who had contracting experience than for those
who had none. One might expect producerSyfluabuy feeder pigs to be
more cautious than producers raising their own because the former pro-
ducers would not know as much about the future performance of their
pigs. But these producers made the same response reaction since by 3
or 4 months they too could tell how their pigs would perform.

TABLE 4.16 Maximum number of months producers wished to contract in
advance of delivery

 

 

Number of producers selecting contracts

by months in advance of delivery
1-2 3-4 5-6 7-9 10 or more

 

 

Producer Classification mos. mos. mos. mos. mos. Total
Contracting producers 1 ll 5 0 2 l9
Non—contracting pro-
ducers 2 12. _§ 1 a 2.9.
Total 6 3 13 l 6 49

Producers with feeder
pigs (both contract-
ing and non-contract-
ing) 1 10 3 l l 16

 

 

 

 

 

 

 

128

The packers were not so concerned about "things going wrong" within
their own firms. Very rarely would they face an unexpected situation
where they could not physically handle the hogs as they arrived. The
packers were more concerned about the uncertainty of their product mar-
kets and the possibility of contracting for more hogs than they could
sell. They were even more concerned about the price risk they would
be incurring since by contracting they would be guaranteeing a price
to producers, and that price might be too high when it came time to
sell the finished product in the wholesale markets. Some of this price
risk could be hedged in the live hog, skinned ham, or pork belly futures
markets since hog prices and wholesale pork prices, both spot and
futures, would tend to fluctuate up and down together. Of the nine
packers that said they would use the futures market, only two said
they would do it routinely. The others thought there would be times
when they could make larger returns by not hedging and by assuming the
responsibility for price changes themselves. Or they might try it and
later hedge if the market looked as if it would "go against them".

Many packers thought there would be little question about taking the
risk themselves if the contracts were for the short-term of one month
or less.

For the packer there does not seem to be much advantage to long-
term contracting since it might only take a few weeks to line up their
supply for any given week. Five of the ten packers saw no need to con-
tract for more than a month in advance of delivery. The remaining five,
Imowever, were willing to contract up to three, six, and even ten months
111 advance (Table 4.17). The forward market price relative to the ex—

-permed spot price will have a significant effect on the length of

129
contracts made. If the forward prices prove to be fairly accurate for
long periods of time (6 to 12 months), forward contracting for long
periods-will be more likely, and packers not contracting for long periods
may have difficulty in procurring a sufficient numbers of hogs.

TABLE 4.17 Maximum number of months packers wished to contract in
advance of delivery

 

 

Number of packers selecting contracts by months in
advance of delivery

 

10 or
1-2 mos. 3-4 mos. 5-6 mos. 7—9 mos. more mos. Total

 

5 l 2 O 2 10

 

 

 

 

 

 

Recommendations for Length of Contract Period

 

(1) That packers and producers be permitted to make contracts up

to 12 months in advance of delivery. Even though a minimum contract

 

delivery interval of one week has already been proposed, contracts could
still be made after that week had begun. Conceivably, a producer could
deliver the same day on which he contracted, but that would seem like
insufficient time to arrange for transportation, sort and load the

hogs, and move them to the packer. It seems likely, however, that hogs
could be contracted one day and delivered the next.

As for a maximum length of contract, there does not appear to be
any need to provide contracts beyond 12 months at this time. None of
the packers and only five producers wanted to contract for as long as
12 months prior to delivery. Only one producer wanted to contract
beyond 12 months.

The producers will not be interested in longer contracts until

they have better control over, and knowledge about, their individual

130

output. The packers will not be interested until they can reduce price
risks by making advanced commitments to retailers and other buyers.
Neither producers nor packers will want to contract further into the
future until they feel as if they can do a better job at predicting
future prices so they can be reasonably sure they are not reducing their
profit potentials by contracting.

The market agency should remain sensitive to the needs of their

clients and extend the time limit when the industry is ready.

Trading Zones and Transportation

 

Purpose of Trading_Zones

 

The effective price that a seller receives or a buyer pays depends
on the amount of transportation to be provided and which party (buyer
or seller) pays for it. If a truck load of hogs has to travel 100
miles from the farm to the packing plant, transportation will cost about
$.35 per cwt.1 If the producer pays for the transportation, he is
effectively receiving $.35 less per cwt. than he would receive if the
packer paid for the transportation. Consequently, a producer will want
to take transportation costs into account when choosing the packer with
the highest price bid. A packer 600 miles away might be bidding $1.00
more per cwt. than a packer 100 miles away, but if the difference in
transportation costs is $1.25 per cwt. it will be more profitable for

for the producer to contract with the nearer packer.

 

1Daellenback ("Variation in Input Supplies," p. 52) has estimated
transportation cost per head as .173 + .0054 d where d is distance in
‘miles. For 100 miles the cost would be $.7l3 per head, or $.324 per
cwt. for a 220 pound hog. Snell ("Alternative Marketing Systems," p.
102) has estimated the cost to be about $.74 per head (for 150 head)
to $.97 per head (for 30 head) which is $.336 to $.44O per cwt. for
220 pound hogs.

131

In a forward contract market, a producer trying to find the packer
with the highest effective price would want to know the distance to each
packer as well as the base price of each packer. Similarly, if the
packer were providing the transportation, he would want to know the
distance to each producer.

Trading zones can be used in the forward contract market to locate
producers and packers in order to allow the comparison of price bids
and offers over space. If there are a number of producers willing to
sell in one zone or a number of packers willing to buy in the zone, the
transportation cost to all of them will be approximately the same. It
can be estimated by computing the cost of moving hogs to the center of
that zone. The smaller the zones the more accurate will be the trans-
portation cost estimates between any given pair of traders, but the
greater the number of zones to which to estimate transportation costs.
The tradeoffs between the benefits of accuracy and the cost of additional
calculations will be a part of the following discussion on the size and

shape of trading zones and methods of calculating transportation costs.

Shape, Size, and Number of Trading Zones

 

Shape and Size. The following guidelines are designed to help

 

choose a "good" size and shape for trading zones. The term "good"
nmans that some sizes and shapes are definitely better than others
but that there may be a number of them that appear to be equally as
good for any given set of criteria. The guidelines are: (1) that
alJ.traders be treated as equitably as possible; (2) that the dis-
tances between traders be calculated as accurately as possible; and

(3) that the cost of using the zones be as small as possible.

132

The first two guidelines could best be met if each zone included
only one trader, but the cost of using such small zones would outweigh
the benefits of having zones. One of the reasons for proposing zones
is to enable traders to approximate the distance to a large number of
other traders. The distance estimates would be more accurate if the
center of each zone was placed where production or slaughtering was
most concentrated because it would minimize the sum of the differences
between actual and estimated distances. But if there were several
hundred zones the cost of locating zone boundaries would be much higher
than if zones were drawn systematically, such as every fifty miles.
Besides, with a large number of small zones there is likely to be a
fairly uniform distribution of producers and packers within each zone
and the centers can be the geographic centers. Zones of uniform size
and shape have another advantage in that a simple system of coordinates
can be used to locate zone centers and to calculate distances between
centers.

In short, if there are a few large zones, they should be irreg-
ularly placed and centered around areas of concentrated production
and slaughtering, whereas if there are many small zones, they should
be uniformly placed.

The producers interviewed said they wanted small zones. They were
asked: How wide should the zones be if you had to deliver anywhere
within the zone at the same price but would receive a transportation
adjustment if you went outside the zone? The distribution of responses
is shown in Table 4.18. Only 36-percent of the producers responding

would want the zones as large as 100 miles wide, but 83 percent would

133
accept them as large as 50 miles wide. The major difference between
those that contract and those that do not is the larger proportion of
non-contracting producers choosing a zone less than 50 miles wide. Al-
though not shown in the table, larger producers were willing to accept
larger zones than were smaller producers. For example, only 33 percent
of those selling less than 500 head chose zones of 75 miles (or more)
wide whereas 67 percent of those selling more than 3000 head chose 75

miles (or more).

TABLE 4.18 The maximum size of trading zone chosen by producers

 

 

Number of producers choosing the maximum
size of zone

 

 

Classification of Less than More than Total
4producers 50 mi. 50 mi. 75 mi. 100 mi. 100 mi. responses
Contracting producers l 9 O 6 0 l6
Non—contracting
producers 1 .z 2 _9_ l .22

Total 8 l6 5 15 l 45

 

 

 

 

 

 

 

With the use of a computer to quickly and efficiently calculate
transportation costs, it seems as if a large number of small zones
could be used, and they would give more accurate estimates of dis-
tances than larger zones. The additional cost of using zones that
are 50 miles wide instead of 100 or 200 miles wide is unknown at this
time and can best be estimated after a computer has been programmed for
the market. The producers were not asked to consider the costs of
operating the market with zones of different sizes. If, for example,
they knew it might cost another couple of cents per head to operate a

market with zones of 50 miles across instead of 200 miles, the small

134
zone of 50 miles would have been less desirable than it was. However,
there is a difference in transportation costs between hauling hogs 25
miles (half way across a SO-mile-wide zone) and 100 miles which amounts
to about $.31 per head versus $.44 per head.1 Producers may be willing
to pay a little more to have this difference taken into account by the
contract market.

Whether small zones or large zones are actually used, a square zone
"tilted" 45 degrees is often the recommended shape.2 (See Figure 4.2.)
Since most roads in the Midwest run north-south and east-west, the road
distance from the center of such a zone to any place on its perimeter
is always the same. In Figure 4.2 line WX equals W2 and WXZ is an isos-
celes triangle; hence, all lines VY (drawn horizontally between X2 and
W2) equal all lines VZ, as all triangles VYZ are also isosceles tri-
angles. Then the distance WV + VY will always equal WV + VZ (or WZ).
Consequently, tilted square zones are able to approximate distances more
accurately than untilted square zones.

Number. The number of zones needed depends on the size of each
zone and the proportion of the country to be included in the market.

I A square zone which is tilted 45 degrees and measures 50 miles wide
at the diagonal includes 1,250 square miles. Doubling the diagonal
distance to 100 miles quadruples the area 5,000 square miles. If the

forward contract market were designed to operate in the thirteen states

 

1See footnote on page 130.

2Karl A. Fox and T. K. Kumar, "The Functional Economic Area:
Delination and Implications for Economic Analysis and Policy,"j§hg
Regional Science Association Papers, Vol. 15 (1965), pp. 62-68;
Ben C. French, "Some Considerations in Estimating Assembly and Cost
Functions for Agricultural Processing Operations," Journal of Farm
Economics, Vol. 42 (November, 1960), pp. 771-772.

 

135
of the North Central Region where 84 percent of all hogs are raised,
approximately 400 zones of 50 miles across or 100 zones of 100 miles
across would be needed.1 A few additional zones would be needed to
locate packers in other regions who currently slaughter about 17 percent

of the hogs raised in the North Central Region.2

 

 

Figure 4.2 Square trading zones "tilted" 45 degrees.

 

1The 13 states (Ohio, Indiana, Illinois, Michigan, Wisconsin,
Minnesota, Iowa, Missouri, North Dakota, South Dakota, Nebraska, Kansas,
and Kentucky) include 805,000 square miles of which there are about
500,000 square miles where the density of hog marketings is greater
than 25 hogs per square mile. (The 500,000 square miles excludes most
of North Dakota; western South Dakota, Nebraska, and Kansas; northern
Minnesota, Wisconsin, and Michigan.) Derived from Gordon W. Erlandson,
"Geographic Changes in Livestock Production" (paper presented to the
NCR-61 Seminar Farm Foundation, Chicago, November 6-7, 1968), Figure 14;
Rand McNally New Cosmopolitan World Atlas, 1967 Edition, p. 217.

2Figure 2.1 shows that the 13 NCR states produce 83.5 percent and
slaughter 69.4 percent of all hogs. For every 83.5 hogs produced in the
region, 14.1 are slaughtered outside the region (assuming none enter the
region for slaughtering); 14.1 is 16.9 percent of 83.5.

136
Transportation by Producers and/or Packers

For maximum flexibility each contracting pair of producers and
packers should be allowed to decide among themselves how much of the
total transportation package each will provide. The producer could
provide all of it from the farm to the packer's plant, or the packer
could pick up the hogs from the farm and take them to the plant. It is
also possible for the packer to have a collection station where the
producer would deliver the hogs and the packer would transport them to
the plant.

The producers were all willing to use the first and third methods
whereby they would at least be responsible for getting the hogs off
their own farms. However, 15 producers (about 1/3) did not believe the
packer should pick up hogs from the farm. The producers were concerned
that packer's trucks would bring diseases to their farms. In addition,
they were concerned about timing the sorting of hogs and the arrival of
the trucks. They said they could do the timing better by themselves or
with local hired truckers. Some producers also believed that if they
provided thetxansportation,their'hogs would be treated better and
shrink less.

Packers showed very little interest in picking up hogs from the
farm. Of the eight packers responding, five thought that producers
should provide all the transportation, keeping the packer out of it all
together. The other three packers said they might operate collection
stations, but did not think they would want to truck many hogs right
from the farm. It would be costly if their driver had to spend time
finding a farm, and if he had to wait for a producer to get his hogs

sorted and ready to load.)

137

If some producers and packers were willing to have the packer truck
hogs directly from the farm and others were only willing to use packer
collection stations, there would have to be a method of distinguishing
between price quotations offered under the two situations. Another bit
of information would have to be transmitted and interpreted in the
forward contract market. On the other hand, if packers only trucked from
collection stations, the problems would not arise. Producers would truck
from their farms to collection stations or directly to the packing
plants; packers would only truck from collection stations to the plants.
All price quotes for a particular zone would be F.O.B. at some place off
the farm-~either a packing plant or a collection station--and producers
would be responsible for the transportation.

Because most packers and several producers currently lack interest
in the alternative delivery system whereby packers would truck directly
from the farm and because it would complicate the operation of the

market, the alternative has been omitted from this study.

Packer Collection Stations

 

Each collection station will require land as well as holding pens,
scales, loading and unloading facilities, and labor. If there were
one collection station in or near the center of each trading zone,

a considerable amount of resources would be involved--resources

that would not be needed there if all producers made direct deliveries
to packing plants. On the other hand, it might be more efficient to
maintain these stations if packers could transport hogs in larger more

efficient loads than producers. Packers might use "possum belly" (three

138
tier) semi—trailers which hold 175 to 200 head. Few producers have that
many hogs available at once.

The cost of maintaining the collection stations could be sharply
reduced by reducing their number. This could be done if a station were
located in the corner of one zone and the boundaries of the other three
zones sharing the corner were allowed to overlap. Note point (t) in
Figure 4.2. Another way to reduce the number of collection stations
would be to locate one every 16 zones so that in addition to the four
zones sharing the station, there would be a secondary ring of 12 zones
only one full zone away (from zone center to center) which would also
use the station. Efficiency could be further improved if packers were

able to share the collection stations with other packers.

Premium-Discount Schedules for Transportation

 

When a seller contacts the market center for the highest packer bid
in each zone, he knows how far he must transport his hogs to make the
required delivery. Discounting the bid by the approximate transporta-
tion charges, the seller knows what his effective price is for hogs
delivered to that zone. By comparing the highest discounted prices for
all the zones, he knows which price bid to accept to maximize his net
return. Similarly, a packer willing to take delivery of hogs at a col-
lection station can add a preimum to the lowest price offer in each zone
(in order to cover the transportation costs back to his plant) and find
which offer to accept to minimize his procurement costs.

To facilitate the process by which producers and packers take trans-
portation costs into account, the computer market can automatically

adjust (discount or premium) the highest bids and the lowest offers in

139
all other zones to make them comparable (after transportation costs) to
bids and offers in a trader's own zone. The computer market can also go
one step further and pick the highest effective bid for the producer or
the lowest effective offer for the packer. Such an "automatic trans-
portation adjustment" would greatly simplify the searching process for
the trader and reduce his costs of using the contract market.

In addition, the automatic transportation adjustment will reduce
the cost of operating the telephone-computer market. The cost of
operating the computer will probably increase as it is asked to perform
more tasks than it would if producers and packers calculated their own
adjustments. However, the computer cost increase will be more than
offset by a decrease in telephone costs. The ratio of cost for computer
time to telephone time is about 1 to 8.1 This ratio makes it desirable
to use computer time whenever possible to reduce the amount of time that
traders spend on the telephone. Without the automatic transportation
adjustment it will take a few minutes to transmit information about
several zones. With the automatic adjustment, it will take a few
seconds to transmit information about the one zone with the best price
(adjusted for transportation cost).

To make the automatic transportation adjustment a "transportation
schedule" will be needed to convert the miles between zones into dollars.
The transportation schedule could be a simple flat rate per mile or a

more complicated equation (either linear or curvilinear). A special

 

1A computer processor capable of handling 100 telephone lines simul-
taneously costs about $150 per hour, whereas "WATS" telephone service
for 100 lines costs about $1230 per hour (if used eight hours per day).
More detailed information about computer and telephone equipment and
,costs will be given in Chapter V.

140

schedule of transportation costs between every pair of zones would be
needed if the rate per mile depended significantly on the region of the
country, the direction of shipment, and other factors.

The transportation schedule used by the computer market could
either be fixed for all traders or variable among traders. A fixed
schedule would not be workable if individual traders had widely dif-
ferent transportation costs between any two given zones. When the trader
received the single highest bid or lowest offer determined by the fixed
schedule, he could make an adjustment to the standard schedule to
account for his difference from it if he knew the location of the zone
the quotation came from. However, that quotation may still not be the
most favorable one available to the trader because different transporta-
tion rates will show different zones as having the most favorable prices.
If only one quotation for one zone were transmitted to the trader he
would not know whether or not other zones had more favorable prices at
his transportation rate (if it differed from the standard one). If,
for example, the standard rate were l.0¢ per mile (per cwt.) and a trader
had a rate of 0.5¢ per mile, the former would choose a closer zone than
the latter (if the further zone had a higher price than the closer zone).
Suppose the closer zone was 100 miles away and the highest bid was
$22.00 per cwt., and another zone was 300 miles away where the highest
bid was $23.50. The closer zone would have the highest effective bid
if the transportation cost were l.0¢ per mile ($21.00 versus $20.50),
but the further zone would have the highest effective bid if the trans-
portation cost were 0.5¢ per mile ($21.50 versus $22.00). Hence, an

automatic transportation adjustment will be of little value to a trader

141
if a standard schedule is employed and a trader's own costs are quite
different.

If the transportation schedule of producers is significantly differ-
ent from that of packers, a different schedule could be used for each
of the two groups. But if the schedule among producers and among packers
is different, each should be allowed to choose his own. The choice could
probably be narrowed down to a number of standard schedules which could
be on file in the computer. A trader could use a simple code number of
call the schedule he preferred when he entered the market.

Although the option to call a particular transportation schedule
would require an added bit of information to be transmitted to the com-
puter and processed, the expense of operating the market is not likely
to be much different than using a single standard transportation schedule.
The transportation calculations will have to be rerun each time a
trader enters the market because the highest bid and lowest offer in
each zone keeping changing. The computer program designed for the task
could use either the single standard schedule or an individually chosen
standard schedule. The only added expense for the individual schedule
instead of the single standard would be the cost of transmitting an
additional code number to the computer and having it interpretted. To
offset that added expense, which is not likely to be very much, there
would be a better spatial allocation of hogs to packers and perhaps a
larger number of participants in the market to reduce per unit trading
costs.

So far the discussion has been in terms of producers and packers
soliciting bids and offers that have already been made. It is also

possible for a producer Or a packer to list an offer or a bid in many

142
zones in the hope of contracting later at a higher bid price or lower
offer price than currently available in the market. The process of
listing an offer or a bid could be done almost the same way as check—
ing the bids and offers already entered in various zones. A producer,
instead of discounting the bids in other zones, would add a premium to
the price he wanted to offer in his own zone in order to include the
cost of transportation. The producer could add the appropriate pre-
mium and enter his offer singly in certain zones, or he could take
advantage of an automatic adjustment mechanism that would place his
offer in a number of zones simultaneously.

When a packer lists a price bid in another zone, he accepts the
transportation responsibility from that zone to his plant. He would
want to discount the price he bid in his own zone in order to cover
the transportation cost. Like the producer he could list the bid in
selected zones or he could list it in a number of zones simultaneously

by means of a transportation adjustment mechanism.

Recommendations for Trading Zones and Transportation

 

Trading zones will allow producers and packers to take transporta-
tion costs into account while trading in the forward contract market.
The following recommendations are made about trading zones.

(1) That the zones be sqpare and "tilted" 45 dggrees. These zones

 

can estimate distances more accurately than square zones that are not
tilted. In the tilted zones the corners are no further by road from the
center than any point along any side because most roads in the Midwest
run in a north-south or east-west direction. Consequently, an estimate

of the distance within zones and between zones will be more accurate.

143

(2) _That 100 to 400 zones be established in the North Central
Region. If the zones are 50 miles wide (measured across the diagonal),
400 will be needed in the l3-state area; whereas if the zones are 100
miles wide, only 100 will be needed. Whether or not there will be a
significant difference in the cost of operating a market with 400 rather
than 100 zones cannot be accurately determined at this time. It is
also uncertain whether the cost difference will be large enough to
alter producers' preferences from SO—mile-wide zones to lOO-mile-wide
zones.

Although the distance from each producer to the local market where
he traded was not recorded in the survey, it was often mentioned by the
producer in determining how large a trading zone should be. If a for-
ward contract market made producers less dependent on these local
markets, perhaps they would be willing to accept larger zones. Thirty-
six percent of the producers indicated that the larger (lOO-mile-wide)
zones were acceptable.

(3) That producers be responsible for transportinglhogs off the
'fgrm. If packers provide any of the transportation, one-third of the
producers and all of the packers thought the packer should not truck
hogs directly from the farm. The producers were concerned about the
spread of disease; packers were concerned about finding individual
farms; both were concerned about timing the arrival of the truck and
having hogs ready to load. Sixty percent of the packers said they
would prefer to have the producers do all the trucking directly to
their plants.

(4) That the computer market calculate the transportation costs

between zones and adjust bids and offers accordingly. Since computer

144
time is less expensive than telephone time (about $1 to $8) any sub-
program in the computer which can save traders time on the telephone
will increase the Operating efficiency of the market. One such program
would automatically adjust bids and offers in other zones and transmit
only the lowest effective offer and highest effective bid (after trans-
portation costs) rather than the lowest offer and highest bid in each
zone. The same mechanism could also be used to automatically list bids
and offers in several different zones after adjusting the packer's bid
or producer's offer by the transportation cost to each zone. Whether
receiving a quotation already on the file of bids and offers in each
zone or placing a new quotation on file, a trader would only have to
receive or send one quotation instead of one for each zone.

Since all producers and packers cannot be expected to have the same
transportation rate (or schedule), a number of alternative rates could
be put on file for a trader to call. The availability of alternative
rates would help to assure a better spatial allocation of hogs among
packers, and perhaps it would encourage more producers and packers to
use the forward contract market because the transportation adjustments

would be more realistic.

Contract Renegotiation and Speculation

 

Purpose of Renegotiation

 

One way to reduce the risk of forward contracting is to allow
traders to cancel their contracts. Of four forward contracts with a
fixed forward price which are currently being used by producers and
packers, none make an explicit statement allowing either party to cancel

the contract. In practice, however, there have been cases where by

145
mutual agreement the seller was allowed to cancel his contract. Usually
he was required to pay any difference between the current forward price
and the one he agreed to in the contract if the original price was lower.
The futures markets allow traders to cancel contracts by simply taking
an opposite position in the market. Traders either buy back contracts
they originally sold, or they sell contracts they bought.

A similar procedure to the one used in the futures market will be
necessary in a forward contract market. A trader will cancel his con-
tract by making an opposite transaction in the forward contract market.
In effect he will find someone else to take his place in the market and
deliver or accept delivery of the hogs contracted. If traders were
allowed to simply void their contracts, as is done in the forward con-
tracts currently in use, the certainty of a place to deliver and of a
price to producers, as well as the certainty of delivery of hogs for
packers, would be eliminated. Producers and packers could not count
on the forward contracts in the forward contract market.

There are three distinct advantages for a producer allowed to cancel
his contract. First, he will not have to pay a stiff fine if, for
example, his hogs all get cholera and must be destroyed and he cannot
make the promised delivery. Second, he will not be fined if his hogs
gain more slowly or more quickly than he first anticipated and have to
be delivered in another delivery interval. Third, he will be able to
liquidate a contract when new information leads him to believe that
the price in the delivery month will be significantly higher than the
one at which he contracted. In all three instances the producer will be
better off by canceling one contract, and perhaps entering another, if

the forward market price has not risen much since the time he first made

146
the contract. The producer will suffer a substantial loss by selling
at one price and buying back at a significantly higher price. In
either case, there is no inconvenience to the packer because another
producer has agreed to fill the contract. But there are some added
costs for the market agency in rehandlinga contract and they will have
to be assessed to the producer.

The same advantages are also available to the packer. One would not
expect him to cancel a contract for the first two reasons because he
does not face so much uncertainty as to whether or not he will be able
to accept delivery. He may, however, wish to cancel if he foresees a
significant decline in the price from the one at which he contracted,
however, the loss can be prevented or curtailed by hedging in the live
hog or pork products futures markets. Hence, a packer is not as likely

to want to cancel a contract.

Renegotiation Procedure

 

The procedure for allowing traders to take an opposite position in
the forward contract market in order to cancel a contract will have to
be more complicated than in the futures market, largely because of the
multitude of delivery points and transportation arrangements in the
former. Since live hogs futures contracts are all deliverable in only
two places, and because only a few contracts result in actual delivery,
location and transportation are not significant variables in pairing
buyers and sellers. But suppose trader A and trader B have made a con-
tract in the forward contract market. In order for A (either the
producer or the packer) to cancel the contract, he must assume the

trading position that B took and renegotiate the contract. By so doing

147
A hopes to find another trader to uphold his end of the contract with
B. Since B chose the zones in which he wanted to trade and the trans-
portation rate he was willing to pay, A can only be permitted to
renegotiate the contract under those same conditions.

Two examples follow to illustrate how contracts can be renegotiated.
For the first example, suppose that on September 15, producer No. 4
sold 100 hogs to be delivered to packer No. 3 in April. On February 15,
producer No. 4 seeks to cancel his contract because his hogs have been
sick and will not be ready for delivery in April. (Figure 3.1 may help
the reader visualize the problem.) The producer bids to buy hogs from
another producer in order to make the April delivery as promised. Sup-
pose further that producer No. 8 offers to sell his hogs and is paired
with producer No. 4 (on the basis of a matching price bid and offer).
But producer No. 4 does not want the hogs delivered to him; he wants
them delivered to packer No. 3. Since packer No. 3 is in a different
zone than producer No. 4, producer No. 8 will not get the appropriate
transportation adjustment for delivering his hogs to the packer. This
problem is solved by allowing producer No. 4 to bid to buy the hogs in
packer No. 3's zone instead of his own. When producer No. 4 buys the
hogs from No. 8, the market center will automatically make the transfer
of responsibility and actually inform producer No. 8 that he has made
a contract to deliver to packer No. 3.

As another example, suppose packer No. 2 is allowed to cancel a
contract with producer No. 6 by reselling the hogs to packer No. 4.
Since packer No. 2 is located in a different zone from packer No. 4,
producer No. 6 will not have the same transportation cost which he was

originally planning to pay. To avoid this, packer No. 2 must offer

148
the hogs for sale from producer No. 6's zone and use No. 6's trans-
portation adjustment schedule. If producer No. 6 used the automatic
transportation adjustment, the original completed contract will show
which alternative adjustment schedule he chose. If instead, he only
entered his offer selectively in a few zones, only the zone of delivery
will be shown. If by chance producer No. 6 did not use the automatic
adjustment mechanism, packer No. 2 will not be permitted to renegotiate
the contract with packer No. 4 because No. 4 is in a different zone from
No. 2.

It is unlikely that the price of these renegotiated contracts will
be the same as the price of the original contract. In the first example,
producer No. 4 may have sold the hogs for $25.00 per cwt. and be forced
to buy hogs for $27.00 per cwt. in the renegotiated contract. But
packer No. 3 still expects to buy the hogs for $25.00 while producer No.
8 expects to receive $27.00. Producer No. 4 must pay the difference.
The amount of the payment by producer No. 4 will depend on the total
weight of the hogs that No. 8 delivers. If No. 8 delivers 50 hogs and
the average weight is 230 pounds, the difference in base payments will
be $230 (50 x 2.3 x $2.00). Whether or not the hogs delivered are above
or below the base hog will be a matter of concern between the two final
parties in the contract, producer No. 8 and packer No. 3, as if they
originally made the contract together. In addition to the $230 the
market agency will have to charge a fee to cover its expenses in hand-
ling the transfer.

Producer No. 4 may make the payment directly to producer No. 8 or
he may forward it via packer No. 3 or the market center. In the case

where the price went down, say from $25.00 to $23.00, producer No. 4

149
would gain $230 minus the trading fees. The excess between what packer
No. 3 had contracted to pay and what producer No. 8 contracted to re-
ceive would be collected and sent to producer No. 4. Perhaps all such
adjustments should be channeled through the market center to ensure

that they are handled accurately and promptly.

Role of Speculators

 

Allowing traders to cancel and renegotiate contracts allows people
to buy or sell hogs for which they have no intention of taking or making
delivery. Some people, acting as speculators, may wish to buy and sell
for the purpose of making a profit on the price changes in the market.
Speculators could play an important role by adding liquidity to the
contract market. They could also help to keep the contract market con-
sistent with other hog markets, as well as cattle and grain markets. In
short, they could improve the pricing process in the contract market.

However, there is likely to be little speculative trading in the
forward contract market. The fact that the forward contract market is
designed to facilitate the transfer of hogs from producers to packers
will limit its ability to attract speculators. Since the market is
divided into a number of submarkets and allows deliveries to take place
in a number of places, speculators are apt to find little of the liquidity
they need to quickly cancel a position profitably in one of the sub-
markets. Most speculation is therefore expected to remain in the live
hog futures market which is more general and more liquid and which is

likely to closely parallel the forward contract market.

150

Summaryiof Recommendations

 

Based on the interviews with producers and packers and information
from other sources, the specifications for a forward contract market are

as follows:

Product Description

 

(1) That hogs be described and evaluated in terms of their measur-

 

able carcass characteristics, as in contract example E (Figure 4.1). A

 

carcass evaluation was more preferable and more acceptable than live
trading to both producers and packers.

(2) That hogs acceptable under the contract be limited to those

 

_producingicarcasses of 135 to 195 pounds (180 to 260 live pounds) and

 

_grading USDA No. l, 2, and 3. A single contract covering such a broad

 

range of weights and grades is acceptable and considered desirable by

most producers and packers.

ZPremium-Discount Schedule

 

(3) That the premium-discount schedule be standardized. All

 

lpackers will have to use the same premium-discount schedule when making
leadjustments for hog carcasses that vary from the standard carcass..
(4) That the_preimum—discount schedule be left undetermined until

jggelatively close to the time of delivery. There will be more information

 

éavailable to determine a more accurate schedule when the delivery in-
‘terval is only a few weeks off than when it is a few months off.
(5) That the forward contract market agency estimate and announce

_thejpremium—discount schedule. The organization operating the forward

 

I

contract market would be responsible for determining the schedule to be

used by packers in pricing the hogs that differed from the standard hog.

151

Size of Contract

 

(6) That the amount to be delivered in'a contrast be specified
in terms of number of head instead of number of pounds. Number of head
is a more common unit of measure both on farms and in packing plants.
(7) That contract size be allowed to vary from a minimum of 30

head to a maximum of 500 head. A contract of variable size allows each

 

producer and each packer to trade in lots that are convenient and

efficient for their particular firms. Increases in the size of the

contract between 30 and 500 head are restricted to multiples of 10 head.
(8) That a producer be allowed to deliver up to Sjpercent more or

less than his contracted number of head. This much variation was well

 

siccepted by both producers and packers.

(9) That producers (yia the contract market) be allowed to sub-
cijlvide packer contracts,,but that packers not be allowed to subdivide
groducer contracts. Packers can order up to 500 hogs with one call to
the computer market and one contract, but since few producers have that

many hogs to deliver at once, the market can combine many producers
(iir:llling to sell at the same price the packer is bidding) to meet the
Packer's contract. On the other hand, if a packer's contract needs
On 1y a few more hogs to be completed, a producer's contract will not
be subdivided as it would be costly for the producer to ship a few hogs

to one packer and the rest to another.

D‘a-L of Delivery
(10) That one-Ltwoa and four-week pricing and delivery intervals

‘32 established. One week was recommended by both producers and packers

 

88 the minimum nunber of days which should be considered for pricing

152
and delivering hogs. A one-month interval is needed for contracts made
four or more months in advance; a two-week interval is sufficient for
contracts made more than one month but less than four months in advance.
(11) That each producer make an "appointment" for a specific de-

livery day. In order for packers to be certain of having a planned

 

number of hogs each day within a delivery interval, producers will have
to make their deliveries on specified days. The Wednesday of the week
before an interval begins has arbitrarily been chosen as the deadline

for making delivery appointments.

Length of Contract Period

(12) That producers and packers be permitted to make a forward con-
tracts from one day to 12 months in advance of delivery. The forward
contract market can include very short-term transactions, which are like

spot transactions, as well as longer-term forward contracts.

Trading: Zones and Trangortation

(13) That trading zones be square and "tilted" 45 degrees. Since
moat roads in the Midwest run north-south and east—west, tilted zones
will give more accurate distance estimates than zones that are not
tIllited.

(14) That 100 to 400 zones be established in the North Central
£8332, Eighty-four percent of hog production and 70 percent of hog

81Las‘ughter occurs in the 13-state North Central Region. If the zones
are only 50 miles wide (across the diagonal of the square), 400 will be
needed; if they are 100 miles wide, 100 zones will be needed. In either
‘Case a few extra zones outside the region.will be needed for outside

Packers who wish to participate in the market.

153

(15) That producers be responsible for transpprting_hogs off the
£352. Packers will transport hogs trucked from collection stations where
producers make deliveries, or producers will make direct deliveries to
packing plants.

(16) That the computer market calculate the transportation costs
between zones and adjust bids and offers accordingly. Since computer
time is less expensive than telephone time (about $1 to $8), it will
be more efficient to have the computer make adjustments in price
quotations for the traders in order to reduce the time they use the

telephone.

Contract Renegotiation

 

(17) That producers and packers be permitted to cancel a con-
tract by finding another trader to fulfill their end of the contract.
The trader canceling the contract will be expected to pay the difference
if he buys a contract for more than he sells it. If he buys for less
than he sells, he receives a trading profit.

(18) That_§pecu1ators be permitted to buy and sell forward con-
tracts. Speculators seeking trading profits can help to keep the
forward contract market consistent with related markets as well as to
keep the subsectors of the forward contract market consistent with
each other. However, little speculative activity is expected in the

market.

CHAPTER V

'ORGANIZATION AND OPERATION OF THE
FORWARD CONTRACT MARKET
Potential Size of the Forward Contract Market

The purpose of this first section is to estimate an upper limit on
the number of producers and packers that could be coordinated and the
number Of hogs that could be traded by the forward contract market.
Whether or not they all participate will depend on the relative advan-
tage of the contract market to other alternatives and on the number Of
traders that know about the market.

It is assumed that the forward contract market would concentrate on
the producers and packers in the North Central Region where 81 percent
Of the hogs are produced and 68 percent are slaughtered.1 The market
would also be extended to several packers in other regions who buy a

large number of hogs from the Cornbelt.

Number of Producers

In 1964, there were 526,600 farms selling hogs in the North Central
Region. Only 225,700 Of them sold 100 or more hogs.2 It is assumed that
these larger farms will be the primary users of the forward contract mar-
ket. If the trend in the number and size of farms from 1959 to 1964 is
extended to 1969, the 1969 Census Of Agriculture will show a total of

415,220 farms in the region with 227,500 farms selling 100 or more head

 

1See Table 1.1.

2Derived from U.S. Department of Commerce, Bureau of the Census,
Census of Agriculture&;l964, pp. 155-161.

154

155

per year.1

Number Of Hogs

 

In 1964, the 225,700 farms (selling 100 or more hogs) sold 56.5
million hogs, or 81.5 percent of all hogs sold in the North Central Re-
gion.2 In 1969, it is projected that farms of that size will sell 65.0
million hogs, or 88.0 percent, and that all farms in the region will pro-
duce 74.0 million hogs.3 The projection is probably a little high since
the North Central Region only sold 71.0 million hogs in 1968 and which
was about 81.4 percent Of U.S. production4 instead Of the projected 84.7
percent.

If 71.0 million hogs are produced in the region it appears as if
48.3 million could be traded on the forward contract market. This es-
timate assumes that 85 percent of the hogs are from farms selling 100 or
more head per year. It further assumes that 93 percent are barrows and
gilts5 of which 86 percent grade USDA NO. 3 or better,6 as required by
the contract market specifications. Data on the weight distribution of

hogs is not available, but most of the barrows and gilts probably fall

 

1See Appendix B.

2Derived from_ggnsus Of Agriculture, 1964, Vol. 11, Chapter 2, pp.
155-161.

3See Appendix B.

“U.S. Department of Agriculture, Livestock and Meat Statistics, Supé
plement for 1968, pp. 34—35.

51bid, p. 79.

6Agnew, Improvements in Grades, p. 12.

156

within the specified 180 to 260 pound weight range.1

Number of Packers

There will probably be a minimum volume restriction on packers trad-
ing in the forward contract market because of the cost of spot checking
the performance Of packer graders. The cost of spot checking each pack-
er will be roughly the same regardless of the number of head bought which
means the cost per head will rise as the number of hogs bought declines.
The minimum may be specified by the market agency, or it may be self-
imposed by each packer if the trading fees vary with volume and a low
volume packer finds that the cost of trading in the contract market ex-
ceeds the benefit.

In 1965, there was a total of 2,199 plants slaughtering hogs in the
continental United States: 262 federally inspected plants (of all sizes),
647 non-inspected large commercial plants, and 1290 non-inspected medium-
size commercial plants.2 The last group Of plants each slaughtered less
than 200 hogs per week and can probably be excluded from the market.

Many Of the remaining 909 plants could also be excluded for slaughter-
ing less than 200 head per week, but the available data do not permit

them to be identified. None of the federally inspected plants are re-
corded by size, and classification as a "non-inspected large" plant re-
quires an annual slaughter of more than two million pounds of combined

live weight Of all species. A plant would have to slaughter at least

 

1Interviews with hog producers, August-September, 1969. Only two
producers out Of fifty wanted to market barrows and gilts heavier than
260 pounds, and none of the producers wanted to market hogs lighter than
180 pounds.

2U.S. Department of Agriculture, Statistical Reporting Service, Nume
ber of Livestock Slaughter Plants, March 1, 1965. (Washington: U.S.
Government Printing Office, June, 1965), p. 13.

157

2 million pounds of hogs to slaughter 200 head Of hogs per week. It is
interesting to note that only 112 of the 909 plants (12.3 percent)
slaughtered 86 percent Of all the hogs in 1965. Only 108 Of these fed-
erally inspected plants were in the cornbelt states1 where 68 percent of
all hogs were slaughtered.2

In light Of the fact that a large proportion Of hogs are slaughter-
ed by a few hundred plants, it seems as if the forward contract market
could sell 48.3 million eligible cornbelt hogs tO about 300 plants. Per-

haps 400 plants would be an upper limit on the number participating.

Market Agency

 

The market agency is the group Of people or the organization which
assumes the responsibility for organizing and operating the forward con—
tract market. This group must be competent and must be capable Of se-
curing the confidence Of a large number Of producers and packers in or-
der to have a successful market.

During the interviews, producers and packers were asked to indicate
which organizations have the potential for acting as the market agency.
They were shown the following list of possible organizations and were
encouraged to add any Others which they felt should be considered.

(1) Chicago Board of Trade

(2) Chicago Mercantile Exchange

(3) National Farmers Organization (NFO)

(4) American Farm Bureau Federation

(5) Other farm group (specify)

(6) American Meat Institute (packers' trade association)

(7) Other packer group (specify)

(8) Packer and Stockyards Administration (Of USDA)

(9) Some other USDA or government agency (specify)
(10) Other (specify)

 

 

 

 

lIbid.

2U.S. Department of Agriculture, Livestock and Meat Stapigtics, Supt
Element for 1968, p. 103.

158

They were asked to rate as many of these organizations as they wished
as either "preferable", "acceptable" (but not preferable) or "unaccept-
able".

As a general guideline, most producers (46 of the 49 responding)
thought the market agency should be impartial. Table 5.1 shows that
the most common suggestion by producers was to create a joint producer-
packer board which would be fairly representative Of both sides. Poli-
tically based farm groups (such as the NFO and the Farm Bureau) were
almost unanimously rejected by producers as not being able to generate

widespread support, either singly or cooperatively.

TABLE 5.1 Producers' Opinions about potential market agencies.

 

 

 

 

Numbera ijproducers rating agenciesas:
Potential market
agency Preferable Acceptableb Unacceptable

Political farm organization 3 2 39
Packer organization 1 1 0
Joint prOducer-packer group 20 2 1
Commodity exchange 11 10 6
Stockyards company, commission

firm, order buyer firm, etc. 2 2 1
USDA or other government

agency 6 0 10
Other 8c 0 0

 

 

 

 

3Since the producers were not required to rate every alternative as
preferable, acceptable, or unacceptable, the number of responses varies
and does not add to 50 producers.

bAcceptable but not preferable.

cMostly for some impartial agency which was not named.

When the packers rated the various organizations, they also showed
strong support (7 Of the 8 responding) for an impartial agency. Table

5.2 shows that they were not as unified as the producers in preferring

159

only one or two of the agencies suggested, but a joint prOducer-packer

group was at least as desirable as any other alternative.

TABLE 5.2 Packers' opinions about potential market agencies.

 

 

 

 

Number8 Of packers ratin agencies as:
Potential market
agency Preferable Acceptableb Unacceptable
Political farm organization 0 2 l
Packer organization 2 O 1
Joint prOducer-packer group 3 1 0
Commodity exchange 2 O 4
Stockyards company, commision
firm, order buyer firm, etc. 3 O O
USDA or other government
agency 0 O 3
Other 1 O 0

 

 

 

 

3Since the packers were not required to rate every alternative as
preferable, acceptable, or unacceptable, the number Of responses varies
and does not add to 10 packers.

bAcceptable but not preferable.

In order to organize the joint producer-packer agency, many produc—
ers suggested that the National Pork Producers Council be used to gener—

ate interest among the producers. They were consistent with an editor—

 

ial in Hgg Farm Management which said:1
The Council appears tO be the only mechanism around right
now that has the potential Of funneling the interests and ener-
gies of producers from all over the nation into a long—range
program that has direction and purpose.
Perhaps the American Meat Institute could serve to organize the packers.
After that, some organization will have to be formed which will acquire

the necessary financing and direct the organization of the forward con-

tract market. The risks will be high and the capital may not be easily

 

1Hog Farm Management, VOl. 5 (October, 1968), p. 7.

160
found.

Although the commodity exchanges, such as the Chicago Mercantile
Exchange and the Board Of Trade, were not as popular as a prOducer-pack-
er group, they appear to be the next best alternative. They were rated
either "preferable" or "acceptable" by 21 producers and 2 packers. The
four packers that rated the commodity exchanges as unacceptable were the
smallest packers interviewed. The exchanges seem to have both the ex-
perience in establishing forward markets and the resources to do it.
They would be able to establish the Operation with less risk to theme
selves than a newly formed group representing producers and packers.

The argument that active forward trading must precede active futures

trading1

may provide an added incentive for the Mercantile Exchange tO
sponsor a forward contract market, as it would probably increase trad-

ing volume in the relatively new live hog futures market.

Organizing and Promoting the Forward Contract Market

 

Personnel

In the beginning the market agency would probably need three men to
manage the organization process. One Of them would probably be familiar
with computer programming. Together they would work under the direction
Of the owners gathering additional information, making prOposals on a
number of decisions which had to be made, and implementing those deci-
sions when approved. Later, when the contract market was ready to begin
Operations, these men would also be responsible for hiring a sufficient

number Of secretaries, keypunch operators, and packing plant inspecfbrs.

 

1Roger W. Gray in Live Hongutures Study Conference, sponsored by
the Chicago Mercantile Exchange, Chicago, November 16, 1967, pp. 19w20.

161

Compliance with the Commodity Exchange Act

Like the futures markets, the forward contract market will come un-
der the purview of the Commodity Exchange Act which covers all livestock
(as well as other commodities) sold by means of a contract for future de-
livery.1 Before the market agency can Operate the forward contract mar—
ket it will have to be approved as a "contract market" by the Secretary
3f Agriculture. In making application to the Secretary (via the Commod-
ity Exchange Authority), the market agency will have to demonstrate that
it x _ m: t, and continue tO meet, the several requirements specified
by the Commodity Exchange Act and summarized below.2

_) Facilitate the filing of trading reports by the market agency
as well as by individual traders.

(b) Prevent the dissemination of "false or misleading or knowingly
inaccurate reports concerning crop or market conditions."

(c) :revent the "manipulation of prices."

{0) Keep certain business records and minutes Of all m etings and
"allow inspection at all times" by authorized government
personnel.

(e) Specify the terms and conditions Of delivery.

(f) Require sellers to give advanced notice Of intent tO deliver to
buyers, and allow sufficient time for delivery after trading
ends.

(g) Require all commodities delivered to conform to U.S. grade
standards.

(h) Provide the Secretary with COpies of all "bylaws, rules, regu-
lations, and resolutions" including all changes and proposed
changes.

 

1Interview with John Carpenter, Commodity Exchange Authority, Chicago,
August, 1969.

2U.S. Department of Agriculture, Commodity Exchange Authority, Com—
modity Exchange Act, As Amended, revised edition (Washington: U.S. Govern-
ment Printing Office, August, 1963, with inserts through July, 1968),
pp. 1-20. .

 

162

(i) Enforce all "bylaws, rules, regulations, and resolutions made
or issued."

(j) Establish minimum financial requirements and reporting require-
ments for traders. (In addition, all traders must be required
to register each year with the Commodity Exchange Authority).

The entire Commodity Exchange Act will have to be carefully studied

by the market agency, and direct consultations with the Commodity Ex-
change Authority will also be necessary in order to meet "the letter and
the intent" of the law. Many of the requirements are not specified in
minute detail such as a procedure for preventing price manipulation or
the dissemination Of misleading information. Instead, the law relies

on the interaction Of the exchange and the Commodity Exchange Authority
to develop a workable procedure.

Within the boundaries set by the Act, the market agency will have

to make a number Of decisions and execute them. Much Of the information
for decision making is already available because of this research pro—
ject. Additional information will be available from meetings with re-
presentatives of the Commodity Exchange Authority, members Of the Nation-
al Pork Producers Council and packers Of the American Meat Institute

and other groups, and representatives Of firms in the telecommunication
and electronic computer industries. Particular attention will have to

be directed to decision making in the areas discussed in the following

subsections.

Market Specifications

In Chapter IV an analysis was made Of the product description, de-
livery day mechanism, size of contract, length Of contract period, trad-
ing zones and transportation mechanism, and the process of contract re-

negotiation. The market agency will have to decide exactly how these

163

several aspects of the market will be specified.

Tradinijules and Procedures

A set Of trading rules and trading procedures will have to be de-
veloped and must complement the specifications decided above as well as
be acceptable to the Secretary of Agriculture. In addition, there will
have to be a system of penalties to be applied to those who would vio—

late the rules.

Membership Requirements and Privileges

In addition to the financial and reporting requirements established
by the Secretary Of Agriculture, the market agency might wish to specify
other requirements as well as the privileges of the traders. In many
commodity exchanges, like the Chicago Mercantile Exchange for example,
the members not only have exclusive trading privileges but also own and
govern the exchanges. If the forward contract market were to have thou-
sands Of producers and hundreds Of packers with trading privileges, it
might not be practical to have them all own and govern the market. Or
if the Mercantile Exchange or the Board Of Trade were to provide all the
capital for organizing and Operating the market, they might wish to bar
producers and packers from owning any equity or having any voting pri-
vileges in the market (except as they be regular members of the Exchange

or the Board Of Trade).

Trader Identity

Knowledge of the person with whom one is trading is often valuable
information to producers and packers, but providing the information be-
fore a transaction will increase the cost of Operating the forward con-

tract market, and it also appears that it will be illegal.

164

Economic Considerations. Buyers know that certain producers usually
have better than average hogs. Producers, on the other hand, may be—
lieve that certain packers usually pay them a relatively high price for
their hogs. If a trader does not know with whom he is dealing, he will
generally want to have certain assurances that his transactions will still
enable him to achieve his goals (profit maximization, quality control,
and others). The cost Of providing these assurances is not small. The
product to be delivered has to be clearly specified, as does the time of
delivery and the number to be delivered, and these specifications have
to be enforced. The carcasses have to be graded uniformly by all packers,
and the proper payments have to be made promptly. On the other hand, an
impersonal market where the product and the terms of trade are well spec-
ified, like the forward contract market, allows efficient computerized
pairing of buyers and sellers. Buyers and sellers can be matched sole-
ly on the basis Of the prices they bid and Offer. This will save time
for the market agency in trying to pair up "compatable" traders. It
will also save time for buyers and sellers in trying to find a "part—
ner". They know that the best transaction for them is the one where they
buy at the lowest price or sell at the highest price. Impersonal trad-
ing also makes possible automatic adjustments Of bids and offers in oth-
er zones so that they correspond with bids and Offers in one's own zone.
In a sense impersonal trading increases the amount Of information avail-
able since everyone knows the commodity being traded as well as the con—
ditions Of exchange. It also improves the functioning of the market be-
cause traders can trade over long distances solely by description.

Only after a transaction has been completed will it be necessary

for the identity of the traders to be known to each other so that the

165

contract can be fulfilled. Producers, for example, must know where to
deliver their hogs.

Legal Considerations. Schrader, Heifner, and Larzelere have inter-

 

preted a Federal Trade Commission advisory Opinion to mean that identity
would have to be withheld in a computerized contract market until after
a transaction was made.1
A recent Federal Trade Commission advisory Opinion rela—
tive to the use Of a computer system to collect and disseminate
data on ice pack broiler marketing stressed the point of protect-
ing the identity of buyers and sellers. If this Opinion were
applied tO a trading system, it would preclude trader identifi-
cation until a trade is completed. The same advisory Opinion
stated: ". . . experience in other cases indicates that a price
reporting plan which involves future or advance prices, parti-
cularly when that plan invites an industrywide pricing policy,
may provide the basis for an inference of an agreement or col-
lusion to fix prices in violation Of section 5 of the FTC act.
The same authors in an interview with the Commodity Exchange Authority
were led to believe that ”permitting traders to accept or refuse trades

with certain other traders" might be in violation Of current laws and

regulations.2

Ensuring Fair Evaluation Of Hog Carcasses

The fact that many more producers prefer carcass selling than pre-
fer live selling (66 percent to 6 percent, with 28 percent indifferent—-
see Table 4.5) does not mean the producers are willing to give packers
the full responsibility for accurately determining the value of their

hogs. The problems of arranging a "fair" method of evaluation, which is

 

lSchrader, Heifner, and Larzelere, Electronic Egg Exchange, pp. 15-
16. Their Federal Trade Commission citation is from Advisory Opinion
Digest NO. 205, "Use Of a Computer System to Collect and Disseminate Mar-
keting Data," April 18, 1968.

21bid., p. 16.

166
acceptable to both the producers and the packers, has undoubtably been

a major roadblock tO carcass selling and buying.

In spot markets where hogs are bought on a live basis, buyers bid
for hogs on the basis of the expected value Of the hogs. The packers
cannot afford to pay more than the lot Of hogs is worth in wholesale
cuts (after deducting a slaughtering and cutting margin). But if one
buyer bids a relatively low price on a lot of hogs, the seller can ac—
cept a higher bid from another buyer. Even though the live evaluation
is not as accurate as a carcass evaluation, there is competition to en-
sure a fair evaluation of the hogs.

When value is not fully determined until after the hogs are slaugh—
tered and hanging on the rail in the packing plant, there cannot be any
competition in evaluating the hogs unless the producers own the plant
cooperatively and sell hog carcasses. But given the fact that packers
own and Operate the plants, another method Of assuring an accurate e-
valuation Of the carcasses is needed. In the forward contract market,
only the base price is subject to Open bidding and competition. Al-
though a packer might have a relatively high base price and the premiums
and discounts were standardized for all packers, he could underrate the
carcasses and the producer would effectively receive an average or be-
low average price for his hogs. Unless the producers feel confident
that their hogs will be evaluated fairly, they will not wish to use the
forward contract market. ‘

The market agency will have to develop a method Of supervising the
grading. Only one Of the producers interviewed really felt that packers

- could be trusted to consistently evaluate carcasses fairly on their own.

Table 5.3 shows that eight producers out of 50 would prefer to have an

167

TABLE 5.3 Producer and packer preferences for methods to ensure accu—
rate evaluations Of hog carcasses.

 

 

 

Number of producers Number Of packers
Method preferreda concurring concurring
Packer 1 3
Independent 8 0
Co-grading 5 0
Spot checking __;g* ._Q_
Total 50 9

 

 

 

aggekep: packer would hire his own graders and would be the first
and final judge of carcass value; Independent: either federal govern-
ment employees or employees Of a private organization Of graders formed
for this purpose would do all the grading; Coegrading; a {acker and a
producer representative would grade each carcass; Sppf checking: the
packer would do all the grading and an independent inspector (govern-
ment or private) would periodically check the packer's accuracy and re-
port all deviations for prosecution.

 

 

impartial, independent agency (such as the federal government or a spec-
ial private organization developed for the purpose) perform the carcass
evaluations. Five producers would prefer to have the hogs graded by
both a producer and a packer representative. The method which received
the most support (by 36 producers) was one which allowed the packer to
do all the grading and relied on an independent agency to "spot check"
a packer's accuracy about three or four times a month (at random). Only
three packers felt that they should be trusted to do the evaluations un-
assisted and without spot checking. Six packers thought that spot check-
ing was a reasonable solution tO the problem Of aSsuring accurate eval-
nations.

Spot checking will cost less than two full-time graders, One repre-

senting the packer and one representing the producer. The spot checking

168

can be done either by government graders or by a group of privately em—
ployed graders. The private group met with greater approval from both
producers and packers because it did not cause the federal government to
become more directly involved in the industry than it is already.
Control Of the spot checking will be a way for the market agency to
maintain control over its market specifications and to assure traders
that the market will perform as specified. The agency will have to es—
tablish the procedures for conducting the spot checks and for handling

any violations Of the grading specifications.

Telephone-Computer System

 

A major task of the market agency will be to engage members Of the
telecommunications and electronic computer industries to assemble a work-
able system consisting Of a central computer capable Of handling remote
telephone and teletypewriter access. An important part Of this system
will be a carefully tested computer program capable Of handling the bids
and Offers Of buyers and sellers according to the published market spec-

ifications and within the rules and procedures established.

Promotion

The market agency will have to develOp and execute a program for in-
troducing the forward contract market to producers and packers and for
persuading them to use it. The mass media, especially the many trade
publications available, could be used to introduce the market by ex—
plaining its advantages and how it will work. This will probably have
to be followed by face-to-face meetings with producers and packers. Per-

haps the services Of a professional promotion firm could be used.

169

Trading Fees

The market agency will have to charge traders a fee which will cover
all the expenses incurred in Operating the forward contract market, in-
cluding the expenses of organizing and promoting it. (Some budget es-
timates are made later in this chapter). Once the total cost is known,
the market agency will have to decide now much Of the cost to charge to
producers and how much to charge to packers. It will also have tO decide

on a basis (such as cents per head) f" assessing the traders.

Cost of Organizing and Promoting

 

Personnel and Research

 

The three men responsible for managing the organization process can
probably be hired for a total Of $55,000 per year. They will probably
need a secretary which will cost $6,500 per year, and an Office and sup-
plies for an additional $5,000 per year. If the organization process
lasts for a full year, the personnel cost, including office expenses, will
be about $66,500, but the process could take twice as long and involve
twice the cost.

It is difficult to estimate how large the research budget will have
to be. If it included travel expenses for the three managers, a few con-
sultant fees for certain economic analyses and for computer programming,
and research for other information, and if it included computer time
used in develOping and "debugging" a program for the market, the budget
might total $30,000.

For the Electronic Egg Exchange it was originally estimated that the

start-up cost, including salaries, programming, and additional research,

170

would be $75,000.1 When the market was later presented to a commercial
firm for possible implementation, the estimate was increased to $150,000.2
Although the egg exchange was designed tO handle 25,000 transactions per
year and the hog exchange could be faced with 100,000 to 1,000,000 trans-
actions per year, the start—up cost would probably be quite similar. The
cost Of programming the computer, establishing the trading rules and Op-
erating procedures, gaining the approval of the Secretary of Agriculture
and performing )ther tasks are not likely to be a function Of market

1

“. “HUIL .

Ereeesiec

Prom:tioz costs ar' not easy to estimate. The costs are largely a
function Of the quality of the job to be performed and are also a func-
tion of the number Of potential participants to be contacted. One firm
thought it would cost $50,000 to $100,000 to effectively promote the
egg exchange to approximately 500 potential traders.3 The average cost
per trader would be $100 to $200. Although this may be an appropriate
estimate for promoting a market to handlers and processors of shell eggs,
and may also be appropriate for hog packers, it will probably be impos-
sible to realize a sufficient return from the 227,500 hog producers to
justify an average expenditure of even $100 per producer. The average
volume of farm firms is much less than the average volume of processing

and handling firms.

 

1Schrader, Heifner, and Larzelere, Electronic Egg Exchange, p. 26.

 

2Richard G. Heifner and Henry E. Larzelere, personal interviews af-
ter they had visited the Autex Corp.

31bid.

171

A less expensive strategy for promoting the market to hog producers
might combine a program Of general advertising with public meetings for
all producers, followed by personal on-the-farm visits with large pro—
ducers. Such a strategy might involve 100 public meetings (an average
of more than eight meetings in each of the 12 Cornbelt states) and per—
sonal visits to the 125,000 producers selling 200 or more hogs per year
(a total of 69 percent Of the Cornbelt hogs).1 The promotion could prob-
ably be accomplished with a task force of 170 man years and a budget of
$3.54 million (about $15.50 per producer).2 Including another $0.04
million to promote the market to packers,3 brings the total tO $3.58
million.

A still less aggressive strategy Of on—the—farm visits to only the
28,000 producers selling 500 or more head per year (a total of 30 per-
cent Of the Cornbelt hogs)4 would reduce the cost by $2.34 million to
$1.24 million. But the volume Of hogs traded by the market is likely

to be much lower if the personal visits are very effective in stimulat-

ing prOducer participation.

 

1See Appendix Table B.l.

2It is assumed that the men would work in teams to give a presenta-
tion on one night followed by several days Of on—the-farm visits with
each man covering 3 farms per day; the public presentations would include
an actual demonstration of the telephone—computer market and each would
cost about $200 for computer and telephone time and meeting facilities;
the men would require $18,000 per year in salary and personal expenses;
advertising and literature would cost $2.00 per producer; the total would
be $3.06 million for manpower, $0.02 million for demonstrations, $0.46
million for advertising and material.

3$125 per packer seems reasonable if one assumes a two-man team with
a total cost Of $100 in salary, $75 in personal expenses, and $75 in
material, demonstrations, and miscellaneous expenses. The team would
visit an average Of two packers per day; there are 350 packers.

“See Appendix Table 3.1.

172

Finding the Optimum advertising program and the amount to spend for
it is not an easy task because the benefits of any program are unknown
until sometime after the expenditure has been made. The last plan dis-
cussed above, with on-farm visits to large producers selling 500 or more
head per year, would seem like a minimum program. NO funds were allo-
cated to organizing the program and designing the material to be used as
it was assumed that these tasks would be done by the three management per-
sonnel hired to organize the market. Hiring the services Of a promo-
tion firm would raise the cost but would probably improve the quality and

the effectiveness of such a program.

Assistance for the Market Agency

 

 

Public Assistance. Because the market has the potential for serving
a large segment of the economy through improved performance in the hog-
pork subsector, public funds might be justified in helping to organize
and promote the market. One source of support could be publicly support-
ed economists made available for consulting and for research. Of partic-
ular value would be certain agricultural economists at Land Grant In-
stitutions. Some of them are quite familiar with livestock marketing
while Others are familiar with computer programming and technology. An-
other source Of support could be local and state Cooperative Extension
personnel who chould be instrumental in acquainting producers and packers
with the market--both its advantages and disadvantages.

It should be noted that neither of these sources will help to sig-
nificantly reduce the total cost of organizing and promoting the con-
tract market as far as the total economy is concerned. The economists
and Extension personnel will still have to be paid and the Extension per-

sonnel will have to be adequately informed. The above methods will,

173
however, reduce the "out—of—pocket" costs to the market agency. This
may encourage some group to assume the role of the market agency if the
organization and promotion costs otherwise impose a significant barrier.

Private Assistance. Introducing the forward contract market to
producers will be a major expense because Of their large numbers and
geographic dispersion. The market agency could lower the cost by en-
couraging the assistance Of private firms. Brokerage houses, feed com—
panies, and other firms serving hog producers could extend forward con-
tracts as an added service to producers. These firms could either act
as brokers between a producer and the contract market, or they could en—
ter a contract themselves and make arrangements with a producer to ful-
fill the contract.

For example, a feed company could promise to buy hogs at a guaranteed
price from producers who buy feed. The firm could sell on the forward
contract market and in turn agree to take the hogs from the producers,
probably at a slightly lower price so as to cover the company's ex-
penses. The feed company would bear part of the cost of introducing the
market to the producers. Since the firm could include forward trading
as part Of its "product mix", there might be certain economies which
would actually reduce the tOtal cost Of introducing the contract market.

Another form of private assistance for introducing the contract
market would be to encourage several producer and packer publications to
print feature articles about the market. Since new methods Of marketing
hogs are likely to be popular with their readers, it may not be difficult

to get coverage in these trade publications.

174

Ammortizingithe Cost

 

The out—Of-pocket expenses of the market agency will have to be
collected from the producers and packers that use the forward contract
market. Assuming that all Of the organization costs ($150,000) and
promotion costs ($3,540,000) are borne by the agency and that it wishes
to ammortize the cost at 8 percent over 20 years, it will have to re-
ceive $375,000 per year in addition to its Operating costs. Depending
on the availability Of private and public assistance, the cost could be

reduced.

Operating the Forward Contract Market

 

In Operating the contract market, the market agency will have to
perform a number of important tasks, as well as continue to meet the

requirements of the Commodity Exchange Act outlined above.

Tele—Comppter Market

 

The market agency will have to keep the telephone—computer system
functioning so that traders can always gain access to the market during
the trading hours and so bids and Offers will always be processed as
specified. It will probably be necessary to monitor the market almost
continuously. The New York Stock Exchange, the Chicago Mercantile Ex-
change, and other exchanges currently employ some type of specialist to
continuously monitor, as well as to record, the trading at each "trad-
ing post" or "trading pit". When the New York Stock Exchange converts
to a computerized trading system in the mid-1970's, it will still main-

tain these specialist positions.l

 

1Wall Street Journal, May 13, 1969, p. 36.

 

175

Contract Fulfillment

 

The confidence that producers and packers have in the contract mar-
ket will depend on how accurately and promptly hogs are delivered, eval-
uated, and paid for as specified by the contract. Only by careful super-
vision can the market agency enforce the contract and maintain trader
confidence.

Delivery. Whenever a producer enters a contract, he will agree to
deliver hogs within a specified delivery interval. As the interval is
approached, he will have to call the computer market to specify the exact
delivery day (within the agreed upon interval). This process will give
the market agency some assurance that a producer intends to deliver.
Those producers that fail to specify a day of delivery by the deadline
for doing so could be called by the market agency. Later, if a packer
does not receive the hogs he expects on any given day, he could call the
market agency. The market agency could make some specified monetary ad-
justments which could come from a penalty levied against the producer at
fault. Such a penalty would encourage producers to deliver on time.

Hog Evaluation. The packers will have the responsibility Of eval-

 

uating each hog carcass according to the specifications Of the contract.
The market agency will use a spot—checking team to ensure producers that
their hogs are fairly evaluated.

Payment. In the forward contract market the packer will continue
to pay the producer directly. All the packers interviewed said they
would slaughter and evaluate the hogs on the day they arrived and would
mail the checks on the next day. The producers would get their checks
about three days after the delivery. This was acceptable to almost all

the producers (47 out Of 48 responding). The majority felt they could

176
plan ahead enough to wait even longer, as 33 Of the 48 said they were
willing to wait at least five days.

In order for the market agency to ensure each producer that he will
be paid according to the price and the premium-discount schedule to which
he agrees, each packer could be required to send a complete report to
the market agency, showing the carcass characteristics of each hog and
the amount paid to each producer. Many Of the producers said they would
also like a copy and it could be included with the payment to the pro-
ducer. The market agency could use its copy to check that the producer
was accurately paid. But some kind of sample would undoubtably be used
instead of verifying every payment.

The packer could deduct the producer's trading fees from the pro—
ducer's check and include a check for the combined producer's and packer's

fees when the slaughter reports were sent to the market agency.

Market Revisions

 

Another important function Of the market agency is to keep abreast
of changing economic conditions in the hog-pork industry, including
changing technologies in the production, slaughter, and evaluation of hogs.
It is also important to be aware Of new develOpments in the tele-communi-
cation and computer industries. The market agency should not only be a-
ware Of these changes but also be able to implement desired changes in

the forward contract market.

Cost Of Operating

 

The costs computed below are for a forward contract market designed
to handle 50 million, 25 million, and 5 million head per year. The 50-

million-head level assumes the contract market will handle most Of the

177
barrows and gilts produced annually in the twelve Cornbelt states. The
25—million level assumes half that many. The S-million level is includ-
ed tO demonstrate what the Operating costs might be in the first years
of Operation as the market is being introduced, or if the market never
attracts more than a small proportion Of the barrows and gilts sold for
slaughter.

It is assumed that the variable size contract will result in pro-
ducer contracts that average 50 head and packer contracts that average
300 head. The computer will, therefore, pair six producer contracts
with each packer contract on the average. To trade 50 million head
there will be 1,000,000 producer contracts and about 170,000 packer con-
tracts. For 25 million head there will be 500,000 and 85,000, respect-

ively; for 5 million head there will be 100,000 and 17,000.

Personnel

The market agency will need to hire a general manager, an assistant
manager, and two computer programmers. The programmers could probably
serve as part Of the management team as well as be responsible for their
special technical roles in maintaining and improving the data processing
system.1 Together, these four men will make sure all contracts are ful-

filled; will keep abreast Of changing economic conditions affecting the

 

1The two programmers are an "application programmer" (who would be
responsible for translating the market's activities into a common com-
puter language such as Fortran or Cobol) and a "system programmer" (who
would make sure the computer language was being correctly interpreted
by the computer and that all auxiliary components such as the audio res-
ponse units and the storage units, were being activated as planned).
Both of these programmers would be needed on a full-time basis to "debug'
as well as improve the computer programming. When not solving computer
problems, they could perform lower level management tasks.

178

coordination Of producers and packers, and implement changes where de-
sirable; and will perform other functions generally expected of a manage-
ment team. All four of these men will be needed whether the market handles
25 million or 50 million hogs per year. However, one full-time manager

and one full-time application programmer will probably be sufficient if
only 5 million hogs were traded.

The number of men needed to spot check the grading in the packing
plants will depend on the number Of participating plants and the rate at
which the spot checks can be made. It is assumed that approximately the
same number of packers will use the market whether 50 million or 25 mil-
lion head are handled per year. That is a total of 300 to 400 plants.

It is also assumed that each plant will be inspected 40 times a year (3

to 4 times per month) for a total Of 12,000 to 16,000 spot checks per

year. If a single inspector can spot check an average Of 1 to 1 1/2

plants per day (250 days a year), 32 to 64 men will be needed. For es-
timating purposes 50 men will be used. If only 5 million head are trad-
ed, it is assumed that 200 plants will participate and that 22 to 32 in-
spectors will be needed. For estimating purposes 30 men will be used.

The average cost per man will be $18,000.1

Depending on the volume of hogs traded and the proportion Of pay-
ments that will be verified, the market agency will have to hire a number
of keypunch Operators. For a market trading SO, 25, or 5 million hogs
per year, it is assumed that 13, 7, or 2 keypunch Operators will be suf-

ficient. Each keypunch Operator could verify 1,000,000 hogs per year.

 

1$13,000 salary, $5,500 travel and per diem expenses, $500 miscel-
laneous expenses and administrative costs.

179

Since many packers would compute the value of all their hogs by computer,
only a sample would have to be checked to be sure the packer's computer
program was accurate. Overall, it is assumed that a 25 percent sample
will have to be verified. It is also assumed that there will be a need
for 5, 3, or 2 secretaries to perform various Office tasks. Keypunch
Operators and secretaries will receive an average of $6,500 per year.

The total annual personnel expense for Operating for the forward
contract market would be $1,081,000 for 50 million head, $1,021,000 and -
$595,000 for 25 million and 5 million head. See Table 5.4 for details.

TABLE 5.4 Total annual personnel expenses for a telephone-computer mar-
ket trading 5, 25, and 50 million hogs per year.

 

 

 

 

Total annual cost8
Personnel 5 million 25 million 50 million
head head head

Manager $20,000 $20,000 $25,000

Assistant manager - - - 15,000 18,000

Systems programmer - — - 12,000 12,000

Application programmer 9,000 9,000 9,000
Secretaries and keypunch

Operators (4) 26,000 (10) 65,000 (18) 117,000

Spot-checking team (30) 540,000 (50) 900,000 (50) 900,000

Total $595,000 $1,021,000 $1,081,000

 

 

 

 

8Numbers in parentheses indicate the number of personnel involved
if greater than one.
About 90 percent Of the personnel cost is due to the need to inspect pack-
ing plants for adherence to the carcass evaluating standards.' If produc-
ers were willing to accept fewer inspections per year, fewer manhours
would be needed and personnel expenses could be effectively reduced. Per-
haps only half as many inspections would be needed if the penalties for

violations were stiff enough yet acceptable to packers.

180

Office

The general office expenses for space, equipment and supplies are
assumed to be fairly typical for offices of the size required by the
market agency.1

Included in Office expenses is the postage required to send written
(printed) confirmations to producers and packers completing contracts in
the computer market. These were requested by the producers and packers
interviewed. It is assumed that the packer only needs a written notice
when his larger contracts--averaging 300 head each as compared with an
average of 50 head for producer contracts--are completely subscribed
since he will be notified Of the progress on each one by telephone. For
50 million head there will be 170,000 written confirmations to packers
and 1,000,000 to producers. The cost of mailing these 1,170,000 confir-
mations will be $93,600.2 For 25 million and 5 million head the cost
will be $46,800 and $9,360.

The total annual office expenses for 50, 25, and 5 million head are

$106,650, $55,150, and $12,960 as shown in Table 5.5.

Telephone-Computer System3

It is assumed that each contract for 50 head will require four tele-
phone calls: (1) when a producer or a packer places a bid or Offer on

the Open file; (2) when someone accepts the bid or offer (and receives

 

1Cost estimates derived from telephone interviews with four Lansing,
Michigan firms Operating offices and/or renting Office space.

2Includes $0.06 postage and $0.02 other costs per confirmation.
3The telephone and computer facts appearing in their section (and

elsewhere in the thesis) were contributed by personnel of the Internation-
al Business Machines Corporation and the Michigan Bell Telephone Company.

181

TABLE 5.5 Total annual office expenses for a telephone-computer market
trading 5, 25, and 50 million hogs per year.

 

 

 

 

Total annual cost for a market trading
Item 5 million 25 million 50 million
head head head
Office space $ 3,000 $ 7,000 $ 11,000
(including utilities)
Office equipment 300 550 850
Supplies 300 800 1,200
Postage 9,360 46,800 93,600
Total $12,960 $55,150 $106,650

 

 

 

 

confirmation during the same call); (3) when the market agency calls the
first trader to confirm the acceptance of his bid or Offer; (4) when the
producer later calls to specify the day (within the delivery interval) on
which he will deliver the hogs. Actually only 3.17 calls will be requir-
ed for each 50-hog contract since packers will trade in much larger units.
For example, packers would make their bids on 50 million hogs with only
170,000 calls instead of the 1,000,000 calls made by producers. The
transactions would be completed and confirmed with only 3,170,000 calls.
The other 830,000 calls are assumed to account for information calls that
do not result in transactions and calls to change previously made but un-
accepted bids and offers.

Since barrows and gilts are not slaughtered at an even rate through-
out the year,1 it is not likely that they will be traded at an even rate.

Therefore, 20 percent extra capacity (above average capacity) is allowed

 

11m 1965, 1966, 1967, and 1968, the month for slaughtering the most
barrows and gilts was 26.2, 18.7, 16.3, and 18.7 percent above the aver-
age monthly slaughter rate for the year. Derived from U.S. Department
Of Agriculture, Economic Research Service, Livestock and Meat Statistics,
Supplement for 1968, p. 79.

182

in the telephone-computer system to handle the peak periods.

With four telephone calls per producer transaction and 20 percent
extra capacity to handle seasonal peaks, the telephone-computer market
will require sufficient capacity to handle 19,200 calls per day to trade
50 million head; 9,600 and 1,920 calls for 25 and 5 million head (Table
5.6).

TABLE 5.6 Required daily capacity (number Of calls per day) for a tele-
phone-computer system handling 5, 25, and 50 million hogs

 

 

 

per year.

Required

capacity:
No. of trans- Average no. no. of

No. Of head actionsa NO. of calls of calls Plus calls per
_per year pergyear per year per day 20% day
5,000,000 100,000 400,000 1,600 320 1,920
25,000,000 500,000 2,000,000 8,000 1,600 9,600
50,000,000 1,000,000 4,000,000 16,000 3,200 19,200

 

 

 

 

 

 

8Number of producer transactions of 50 head each. Each Of these
transactions requires four calls.

b250 days per year.

The capacity of the system must not only be large enough to meet the
maximum number of calls expected on any one day but also the maximum num-
ber of calls expected in any single hour of the day. The latter will de-
pend on how many hours per day the market will be Open and what proportion
of the calls will come in the "busiest hour" of the day. The alternatives
in Table 5.7 are included in the cost analysis.

Given the daily requirements and the percentage of calls expected in

the busiest hour, the hourly capacities in Table 5.8 will be needed.- If

183

TABLE 5.7 Proportion of calls coming in the "busiest hour" of the
trading day.

 

 

 

No. of hours the market is Percentage of transactions
operated per day in the "busiest hour"
2 60
4 35
6 25
8 20

 

 

TABLE 5.8 Required hourly capacity (number of calls per hour) for a
telephone-computer system handling 5, 25, and 50 million
hogs per year.

 

 

 

 

No. of calls per hour depending
No. of No. of calls on the length of the trading day?
head per ’
_per year day 2 Hrs. 4 Hrs. 6 Hrs. 8 Hrs.
5,000,000 1,920 1,152 672 480 384
25,000,000 9,600 5,760 3,360 2,400 1,920
50,000,000 19,200 11,520 6,720 4,800 3,840

 

 

 

 

 

 

8Must have capacity to handle the percentage expected in the "bus-
iest hour".
each telephone call lasts for three minutes, one telephone line will han-
dle 20 calls per hour. The minimum number of telephone lines to the com-
puter is shown in Table 5.9. A computer processor capable of handling

more than 200 lines simultaneously would probably not be readily available

184

TABLE 5.9 Required number of telephone lines to trade 5, 25, and 50
million hogs in a system that Operates 2, 4, 6, and 8 hours

 

 

 

 

per day.
No. of telephone lines needed depending
No. of on the length of the trading day
head

_pergyear 2 Hrs. 4 Hrs. 6 Hrs. 8 Hrs.
a

5,000,000 I 58 34 24 19

25,000,000 288 L_____lp8 ________ 120___ _ 96

a
50,000,000 576 336 240 i 192

 

 

aComputer processors capable of handling more than 200 lines at
one time are not readily available. Systems with requirements below
and to the left of the dotted line are not feasible at this time.
to the market agency.1 Therefore, systems requiring more than 200 lines
are excluded from the analysis.

The cost of operating a telephone computer system will depend on the
cost of its components: telephone lines and audio response units,2 which
together form the input-output equipment, and a computer processor. The
number and cost of the components needed depends on the amount of cap-
acity per hour that has to be provided. If, for example, the market were
Operated for eight hours a day, a smaller (less expensive) computer and
fewer telephone lines would be needed than if the same volume of trans-

actions were handled in fewer hours a day. In addition, the rate on the

 

1The market agency will only operate the computer for eight hours per
day for 250 days. Under those circumstances it would be less eXpensive
to buy computer time by the hour instead of leasing full use of a com-
puter. Firms employing computers with capacity for more than 200 lines
generally are not likely to have enough free time to sublease the come
puter to the market agency.

2The audio response unit is a device which verbalizes electrical im-
pulses from the computer into audible words for conventional telephone
transmission and receiving.

185

telephone lines will be lower if they are used for more than six hours
a day and "inward WATS" ("collect" Wide Area Telephone Service) is used
instead of conventional long distance service.1 On the other hand, the
cost of operating a computer of any given size will increase as it is
used for more hours per day.

A simple programming procedure has been used to find the least—cost
telephone-computer system capable of trading 5, 25, and 50 million hogs
per year during 2-, 4-, 6-, and 8—hour trading days. The complete list
of possible solutions is shown in Appendix C. The least-cost solution
for each of the three volumes is shown in Table 5.10.

TABLE 5.10 Minimum cost of telephone-computer systems trading 5, 25,
and 50 million hogs per year.

 

 

 

 

No. of Type of Annual opgrating costs
head No. of trading telephone
_per year hours per day service Telephone Computer Total
5,000,000 2 Long $ 504,600 $ 98,000 $ 602,600
distance
25,000,000 8 WATS 2,428,800 348,000 2,776,800
50,000,000 8 WATS 4,857,600 496,000 5,353,600

 

 

 

 

 

 

Source: Appendix C.

The cost of the computer service will only be 10 to 20 percent of
the cost of the telephone service. The percentage will tend to decline
as volume increases because a larger, more efficient computer can be us-
ed, thereby reducing the cost per head. 0n the other hand, telephone
costs per head will remain about constant at $.10. As more hogs are trad-

ed the number of calls (and the number of telephone lines) will increase

 

1See Table C.2 for details.

186

in almost direct prOportion with the number of hogs traded. The $.10
per head for telephone service is for an average of four calls per con-

tract. If five calls per contract are needed, the cost will increase

to $.125 per hog.

Total Operating Cost
The total cost of operating the forward contract market for 5, 25,
and 50 million head will be $1,210,560, $3,852,950, and $6,541,250, res-

pectively, as shown in Table 5.11. On a per head basis the cost will be

$.24, $.15, and $.13.

TABLE 5.11 Total annual cost of operating the forward contract for 5,
25, and 50 million hogs per year.

 

 

 

 

 

Operating costs

Item 5 million 25 million 50 million

head head head
Personnel 3 595,000 $1,021,000 $1,081,000
Office 12,960 55,150 106,650
Tele-Computer system 602,600 2,776,800 5,353,600
Total cost $1,210,560 $3,852,950 $6,541,250

Cost per head $.242 $.154 $.131

 

 

 

 

Although the cost per head of most inputs will tend to decline as

more head are handled by the market, the telephone cost is assumed to

vary in almost direct prOportion with volume.

Since the telephone cost

for both 25 million head and 50 million head will account for a high

proportion of the total cost (63 and 73 percent), the total cost per head
will be quite similar at both these levels. The cost per head at the 5-
million—head level will be much higher because of the lower proportion of

telephone cost (42 percent) and the higher prOportion of personnel cost.

187
The cost per head of the latter will increase quickly as volume decreases.
This is largely a result of the assumption concerning the number Of pack—
ing plant inspectors needed. If a low volume contract market serves a
large number of low volume buyers, the personnel costs per head for pack-
ing plant inspection will be quite high. If, on the other hand, a low
volume market were restricted to a few high volume packers, the cost
could be substantially reduced. But such a market might be less attrac-
tive to producers as their bids would not be exposed to as many buyers.
The distance between participating packers would be increased as their
number decreased and higher transportation costs between packers would
limit the number of effective buyers participating in the market in any
one area. Such a market could still be a benefit to producers and pack-
ers if it could reduce their coordination costs, but it would have a

smaller role to play in the price determining process.

Summary

Most of the producers and packers interviewed suggested that a joint
producer-packer board be established as the market agency for the for-
ward contract market. Several indicated that the Chicago Mercantile Ex-
change or the Board of Trade would also be acceptable. The agency would
be responsible for (l) organizing the market within the guidelines es-
tablished by the Commodity Exchange Act and the specifications presented
in Chapter IV of this dissertation, (2) promoting the market to potential
producers and packer, and (3) Operating the telephone-computer system
and ensuring the fulfillment of the contracts as specified.

The cost of performing all of these functions will have to be shared

by the producers and packers using the market. If the organization and

188

promotion costs of the market agency are the full $3.69 million esti—
mated earlier in this chapter, the agency will have to earn $376,000 per
year for the next 20 years to pay off the investment with 8 percent in-
terest. When the $376,000 is added to the annual Operating costs, the
trading fees will be $.32, $.17, and $.14 per head1 if the market handles
5, 25, and 50 million head, respectively. The single most important cost
item will be the telephone service cost which is $.10 per head for all
volume levels. At very low volumes, however, personnel cost per head
will also be a major item and will be responsible for a much higher aver—
age total cost per head. This cost could be reduced if the low volume
market were restricted to a few high volume packers, thereby reducing

the spot checking costs which account for 90 percent of the personnel
costs. Alternatively, fewer inspections per plant per year would also
help to reduce the Operating cost of the contract market, especially at

low volume levels.

 

1The ammortized organization and promotion cost will be $.075, $.015,
and $.008 per head plus the Operating cost of $.242, $.154, and $.131
for a market handling 5, 25, and 50 million head per year.

CHAPTER VI
EVALUATION OF THE FORWARD CONTRACT MARKET

The economic feasibility of the forward contract market will de-
pend on the added costs and benefits producers and packers can expect
from using the contract market as compared with current market alter-
natives. The costs will include any added expense or reduced return
from producing, selling, buying, or slaughtering hogs while trading
in the contract market instead of the other alternatives; the benefits
will include any reduced expense or added return from the same functions.
One would expect adoption of the contract market only if the added
benefits exceeded the added costs.

Some of the added costs and benefits or, simply, the "effects" of
using the contract market will be experienced by producers and packers
collectively while other effects will be experienced by only one group
or the other. Consequently, the chapter is divided into joint effects,

effects on producers, effects on packers.

Joint Effects: Producers and Packers

 

MarketinggEfficiency

One way to compare the advantages and disadvantages of two alter-
native marketing systems is to compare their relative efficiencies at
performing basic marketing functions in which both the buyers and the
sellers participate. The two basic functions are (l) determining the
rate of exchange and (2) physically transferring ownership.

Pricing efficiency depends on the accuracy, speed, and cost of
price determination and the effectiveness of prices in guiding economic

activities. Operational efficiency involves the cost (or number of

189

190
resources used) to accomplish the physical transfer of livestock from
producers to packers. In actual practice, however, it is difficult
to consider separately these two kinds of efficiency because pricing
activities cannot always be separated from physical handling activi-
ties.1 Consequently, pricing and operational efficiency will be dis-
cussed concurrently below.

Large numbers of buyers and sellers. Without the need to physi-
cally handle or inspect the live hogs during the exchange process, the
forward contract market could operate on a much larger scale and over
a much broader geographic area than current spot markets. Although
each producer and packer currently participates in such a broad mar-
ket, he can only do so indirectly by trading in one of a number of
small spot markets throughout the country. The contract market would
also consist of several small markets as most hogs in each area would
tend to go to the packers in that area. But the contract market would
interconnect all these areas directly via its computer to facilitate
pricing in local markets consistent with overall supply and demand.

Of the 50 producers interviewed, 22 sell all their hogs to only
one buyer (local dealer, cooperative, or packer market) and 9 others
sell to no more than two buyers. The producers said they sell this
way because of the high cost and low return of establishing trading
relationships with a larger number of buyers and of traveling long
distances to auctions or terminal markets where several buyers compete.
Eighteen other producers do use the terminals, but nine of them sell
less than 50 percent of their hogs there. In contrast, the forward

contract market would allow a seller to consider several bids with one

 

1Williams and Stout, Livestock-Meat, pp. 120—125.

 

191

telephone call to one market, and with the automatic transportation
adjustment mechanism, he would immediately receive the highest effec-
tive bid for his hogs (less transportation and shrinkage costs). In
other words, the forward contract market would expose each producer's
offer to a larger number of potential buyers than is possible in cur—
rent spot markets. The same would be true for each packer's bid.

Unambiguous product description. The forward market would trade
an almost perfectly homogeneous product since all trading would be
based on a hog of standard specifications and on a standard set of ex-
change conditions. The only allowable variations between transactions
would be variations in the time and place of delivery, but these would
be restricted to several standardized alternatives. Consequently, the
contract market would overcome the lack of comparability of price quo—
tations within and between spot markets which is the result of ambi-
guous product descriptions and which inhibits the role of price as an

n 1

effective "coordinator .

Information. The contract market would provide producers and pack-

 

ers with more information than is currently available. As producers and
packers made transactions for future delivery, they would create new
information (in the form of forward prices) which would indicate their
perception of future supply and demand conditions and their willingness
to act on those perceptions. Succeeding traders in the contract market
could use this information when determining the amount of their bids

and offers. Spot markets also form prices based on traders' percep-

tions of supply and demand, but the prices are of less value in suceeding

 

1Wayne D. Purcell, "Improved Communication", pp. 8-12.

192
(spot) transactions. The spot prices relate to a different period in
time with a different set of supply and demand conditions than those
in which the suceeding traders are interested. Of course, neither
spot prices nor forward prices are perfect indicators of future supply
and demand, but the latter would contain more relevant information
about the future.

Freedom of entry and exit. If forward contracting is used ex-

 

tensively for hog marketing in the future, the contract market could
help to maintain the existing freedom of firms to enter and exit.
Without the market, packers may make extensive use of their own for-
ward contracts (or of integration) in order to overcome their problems
of supply control. In that case, the mobility of resources in and out
of hog production would be reduced if many producers had difficulty

in securing a contract for their hogs. Without a contract it might
become impossible to produce hogs as is often the case with broilers,
sugarbeets, peas, and several other crops at the present time.1 The
forward contract market would assure the availability of contracts to
any one who could produce at the prices being bid, and new producers
would be free to enter the market.

Operating costs. A comparison of the dollar costs of operating
the markets will be used as an indicator of the amounts of resources
needed by each as well as the value of those resources. Under imme-
diate consideration in this section is the operational cost of the
facility where buyers and sellers meet and the "entrance" cost paid

by each.

 

 

1Mighell and Jones, Vertical Coordination, p. 34.

193

The operating cost for a terminal market facility is about $.50
per head which is paid by the producers. In addition, they must pay
a commission fee of about $.50. Packers must pay a fee or hire a buy-
er for about $.10 per head. Hence, the total cost of pairing buyers
and sellers is about $1.10 in terminal markets.1

The average cost of Operating an auction market is about $.55 to
$.70 per head which is paid by the producer. The packer must pay an
additional $.10 per head to be represented in the auction. The average
cost of operating local markets is about $.35 to $.55 which is shared
by the producer and the packer. An added entry fee for the packer
might consist of a few cents per head for telephone calls, but the mar—
ket may also call the packer in which case the cost is already included.2

In contrast with these conventional methods of transferring owner-
ship is the forward contract market. In Chapter V it was estimated
that the cost of establishing and Operating the contract market would
be $.32 per head if it handled 5 million head per year and $.17 or $.14
per head for 25 million or 50 million head per year. However, one more
cost item must be added before producers and packers actually have ac-
cess to the market. They must have access to a local telephone in order
to call the market. The cost of the telephone calls has already been
included and will be a part of the trading fee.

If conventional telephones could be used, the added cost would be
zero, but only touchtone (pushbutton) telephones are capable or transmit—

ting messages to the computer. These telephones will cost the traders

 

1See Chapter II, the subsection on the "Costs of Current Market
Institutions."

21bid.

194

an additional $24 per year ($2 per month). On a per head basis, the
cost would be quite high ($.24 or $.12) for a producer using the market
to sell 100 or 200 head per year. It seems reasonable to assume that
these low volume producers would share the cost of the telephone with
a number of other producers. Several neighbors could make arrangements
for sharing a touchtone telephone or perhaps the telephones could be
made available at local telephone Offices, farm supply stores, or other
convenient locations. A small fee would probably have to be charged
to cover the expenses of making the telephones available to producers.
It is impossible to make an accurate estimate of the number of
telephones that would be used by the traders from the information avail-
able at this time. Furthermore, a large unknown prOportion of the cost
could probably be allocated to other uses. For farm families, consump-
tion could probably absorb a large share of the cost. In spite of these
handicaps, the following "guesstimate" is made in order to obtain the
magnitude of the cost involved. It is assumed that the 27,770 Cornbelt
producers selling 500 or more head per year1 would be in the market
often enough to want to install their own touchtone telephones. It is
also assumed that the 199,740 producers selling between 100 and 499
head per year2 would either install the telephone for themselves, share
it with neighbors, or use one publicly available at the rate of ten
producers per telephone. Of the 350 packers assumed to use the market3

330 of them would install the telephone and the 20 largest ones buying

 

1Appendix'B.
21bid.

3See Chapter V, "Number of Packers".

195
in excess of 1,000,000 head per year1 would install a teletypewriter
for quicker more efficient service (for $75 per month). The total cost
would be $1,171,776. This would be the cost for both 50 million head
and 25 million head where the same number of traders are assumed to use
the market. For 5 million head half as many traders are assumed, hence
the cost for telephones (and teletypewriters) would be $585,888. On a
per head basis, this ”guesstimate" would add $.02, $.05, and $.12 for
50, 25, and 5 million head. (If by chance the telephones were shared
by only five producers selling between 100 and 499 head per year, the
cost per head would be $.03, $.07, and $.17).
After adding the telephone costs of producers and packers, a fur-
ther comparison of the operating costs of pairing buyers and sellers
in conventional spot markets and in the forward contract market shows
the following:
Terminal markets average $1.10 per head
Auction markets average .65 to .80 per head
Local markets average .35 to .55 per head
Forward contract markets
would average $.16 per head for 50 million head
.22 per head for 25 million head
.43 per head for 5 million head
As far as Operating expenses are concerned, the forward contract market
would cost about the same as conventional local markets only if the for-
mer operated at a level as low as 5 million head per year. All other
comparisons show that a forward contract market could operate with sig-

nificantly lower costs per head.

One reason for the lower cost of the contract market is that it

 

1National Commission on Food Marketing, Livestock and Meat, p. 135.

 

196

would operate on a larger scale than the other markets. The scale is
different because of the different technologies used by the two types
of markets and the different functions performed. Spot markets may or
may not have an upper size limit beyond which long run average Operat-
ing costs increase. Past studies have not found any evidence of a turn-
ing point within the range of zero to 250,000 head per year. Some ter-
minal markets handle several million head per year.1 A more important
barrier to size is undoubtably the cost of transporting hogs to a few
large, central places for exchange. As markets become larger, they
must draw animals from longer average distances which increases the
cost of using the large markets.

The computerized contract market, on the other hand, will not in-
volve the physical handling of the product, only verbal agreements to
trade a specified product. The volume of the forward contract market
will not be restricted by physical space and transportation costs,
except for the cost of telephone calls. And if WATS telephone service
is used, even the telephone rate will not be a function of distance.
The computerized contract market must Operate over a much larger area
than the spot markets to generate sufficient volume to keep its oper-
ating costs low. If the contract market can achieve a volume of 5
million head or more, it will have lower operating costs (including
entrance costs paid by producers and packers) for pairing buyers and
sellers than most of the conventional spot markets currently in use.

It must be recognized, however, that a major marketing function

 

11a 1968, the Omaha market, for example, sold 2.0 million hogs,
1.5 million cattle, and 0.2 million sheep. U.S. Department of Agri—
culture, Livestock and Meat Statistics,_§upplement for 1968, p. 40.

197
performed by spot markets is omitted by the contract market just des-
cribed. That is the function of assembling hogs from producers for
shipment to packing plants. To the extent that this function is still
needed, the contract market's costs are underestimated. But "central
physical assembly of product is probably unjustified in our day."1
Large, efficient size lots of hogs can be moved directly from many farms
to packing plants. The forward contract market would enable and en-
courage direct shipment with only one loading and unloading, whereas
almost every hog sold through a terminal, auction, or local market does
not take the shortest route from the farm to the packing plant and re-
quires two loadings and unloadings. To the extent that the contract
market can reduce transportation costs, the cost of using the market re-
lative to conventional spot markets will be lower, and the difference in
costs will be greater than that estimated above for Operating and entry
costs.

The forward contract market will also eliminate the process of
visual inspection of hogs prior to purchase. To a certain extent, this
activity has already been eliminated in many spot markets where packers
buy from order buyers and dealers by telephone. Even when a packer
uses his own buyers, he must buy on the basis of description. The pro—
ducers and packers interviewed could not foresee any problem with buy-
ing hogs by description in the contract market since all hogs would be
evaluated on a carcass basis according to their expected cutout value.

In short, the forward contract market can lower exchange costs by
eliminating most of the assembly market function and the visual inspec-

tion function associated with the exchange process. This in turn affects

 

1Breimyer, "Agricultural Organization", p. 39.

198
pricing accuracy by allowing large numbers of producers and packers

to interact directly in the same market.

Barometer Market

 

Whether the contract market achieves a volume of several million
head per year or only a volume of a few million head or less, it would
probably achieve a higher level of pricing efficiency than current spot
markets. Consequently, the contract market would be in a position to
act as a "barometer" market, a function currently performed by terminal
and other markets. As a barometer, the contract market would be used
as an indicator of supply and demand conditions for determining prices
in transactions that occur outside the barometer market. The forward
contract market would be a more accurate barometer than various spot
markets because of its unambiguous product description and standard-

ized exchange conditions.

BargainingrPositions

 

The forward contract market could improve the bargaining position
of either the producer or the packer, depending on the circumstances
surrounding each transaction (or potential transaction). To the ex-
tent that the lack of bargaining power is due to ignorance of market
alternatives, the contract market could increase the number of price
bids and offers for both a producer and a packer to consider. If one
assumes that producers are generally more ignorant of alternatives be-
cause they have fewer contacts in the current market system than do
packers, the producers would gain an advantage relative to packers.
But that assumption may not always be true, especially with regard to

small packers who have few contacts in the market. It also seems

199

possible that a producer and a packer could both gain a bargaining ad-
vantage if, by using the contract market, they avoided a dealer who
currently has the advantage.

The contract market will also increase the number of alternatives
Open to producers and packers in another dimension. Forward contracting
will allow a producer to seek a buyer on a larger number of days than
will spot markets. He could begin to sell his hogs well before they
reached slaughter weight. Consequently, he would be less "desperate"
in trying to find a buyer on any one day. Producers who commonly sell
in terminal or auction markets would very likely gain an advantage since
they are currently "forced" to sell, regardless Of the going price that
day, once their hogs are in the pens. On the other hand, the packers
in the contract market would have more freedom in buying hogs for a given
day's (week's) slaughter since they would be allowed to make transactions

several days or weeks prior to slaughter.

Effects on Producers

 

Production

 

It was hypothesized that contracting with a guaranteed forward
price would reduce uncertainty, improve resource allocation, and there-
by lower production costs. However, most of the producers and packers
interviewed did not wish to make long-term contracts far enough in ad-
vance Of delivery that producers would have sufficient time to make sig-
nificant changes in their production. Only 6 out of 49 producers and
2 of the 10 packers said they would contract as much as ten months in
advance of delivery which would be the minimum amount of time needed

for the contract price to affect breeding decisions. Furthermore, when

200

producers were asked if forward contracting would allow them to change
any of their production techniques and practices, 29 (about 60 percent)
said they would not make any changes, but 13 (about 25 percent) said
they might produce either more hogs or better quality hogs. In response
to another question, 38 producers (about 70 percent) said a forward
contract would not have any effect on their production costs, but 10
producers (about 20 percent) said it could improve their planning and
efficiency which might have some effect on reducing their costs

(Table 6.1).

TABLE 6.1 Producer Opinions concerning the effect of the forward
contract market on their hog production.

 

 

 

Item Number of producers
Change in production
techniques or practices
none 29
increase production 8
improve hog quality 5
improve planning 3
other 3
uncertain 1
Total 49
Lower production costs
none 38
improve efficiency 10
other 1
Total 49

 

 

As another method of weighing the advantages and disadvantages of
forward contracting at a guaranteed price, the producers were asked a
series of questions about the "most-likely" prices they would receive

at local markets and the minimum prices for which they would contract

201

for delivery in one, three, and six months (from the date of the inter-
view). The differences between the producers' most-likely prices and
minimum acceptable contract prices were quite similar for deliveries
in one or three months. For six months, few producers felt they were
able to estimate the spot price and comparisons could not be made. The
results for the three-month contracts are presented below.

As shown in Table 6.2, only 14 producers (35 percent of the res-
pondents) saw some real value in a gualanteed price and were willing
to contract for less than their estimated most—likely spot price.
TABLE 6.2 Number of producers who will contract at prices "less than",

"same as", and "more than" their expected spot prices at

the time of delivery when the contract is offered three
months before delivery.

 

 

Number of producers

 

 

 

 

Lowest price Average difference
at which With Without between expected
a producer contracting contracting Total spot price and
will contract experience experience lowest contract
price
($/cwt-)
Less than expected
spot price 6 8 l4 $-0.75
Same as expected
spot price 7 10 17 0.00
More than expected
spot price 3 6 9 +0.94
Total 16 24 40 $-0.05

Average difference
between expected
spot price and
lowest contract
price ($/cwt.) $-0.13 $ 0.00 $-0.05

 

 

 

 

 

Nine producers (about 22 percent) thought they should be paid more to

make forward contracts. Seventeen producers (43 percent) did not see

202

any net value in a guaranteed price. A slightly higher proportion of
producers with contracting experience than without were willing to con-
tract for less than they expected, and the average dollar response from
all contracting producers showed they were willing to discount more for
a guaranteed price than were non-contracting producers.

The average dollar response of all 40 producers was that they would
accept $.05 per cwt. less than the most-likely spot price if given a
guaranteed price three months in advance Of delivery. There are a
number of reasons or conditions which explain why the discount was not
larger. One of them is of a temporary nature because it involves a par-
ticular market situation at the time of the interviewing. The others
are more permanent because they relate to on-going production relation-
ships.

On the temporary side is the fact that several producers who made
contracts for delivery in the summer of 1969 delivered their hogs for
several dollars below the spot market prices. The forward prices were
based on the live hog futures market which two to four months prior to
delivery was several dollars below the spot price at delivery. For
example, producers who contracted in mid—April for early July delivery
contracted at about $23.50 per cwt. In early July the spot price was
about $26.00 which meant that producers who forward contracted received
$2.50 per cwt. less than those that did not forward contract. Conse-
quently, many producers, whether they had contracted or had simply Ob-
served, were somewhat discouraged with forward contracting and forward
pricing at the time of the interviews. If, instead, forward prices
were higher than the spot prices at the time of delivery, more producers

would have undoubtably been willing to contract for a larger discount

203
or a smaller premium than was recorded in the interviews.

The more permanent reasons for the small net value of forward con-
tracting are as follows. First, it has already been mentioned that
forward contracting will have only minor influence on production costs.
Second, the hogs of the forward contracting producers will still be
subject to the effects of weather and diseases. These effects may keep
the producer from fulfilling his contract and make him liable for cer-
tain penalties. Until a producer is confident that he can fulfill a
contract on time, forward contracting will add new price uncertainties
while removing old ones. Third, the risk of going bankrupt because of
unexpected low prices is not very high for most hog producers.1 Hence,
the net benefit of a guaranteed price is small. Young or expanding
farm firms with heavy debts would be more likely to place a high value

on a guaranteed price than well established firms.

Marketing

The forward contract market in contrast with spot markets will
increase the number of alternatives Open to a producer when selling his
hogs. As previously mentioned, it will (1) put him in contact with a
larger number of buyers and do it more rapidly by means of a single call
to the computer market; (2) allow the producer to seek a buyer for a
given lot of hogs on a larger number of days; and (3) provide more inf
formation about the most profitable delivery time because of the array
Of forward prices generated in the market.

These added benefits of forward contracting are not without added

costs. First, a producer will have to spend more time keeping informed

 

1Futrell in Live Hog Futures, pp. 24-25.

 

204
of market conditions if he is going to offer a lot of hogs for sale
over a longer period of time. A producer might also spend more time
searching for the highest bidder, but that is not likely if he places
his Offer on the Open file of the computer market. Second, the pro-
ducer might have to study his hogs more carefully to become more accu-
rate at predicting when they will be at their most profitable slaughter
weight. Third, some producers may pay a higher "psychological cost"
when trading in the contract market because of the guaranteed price
because they do not have a need for a guaranteed price, such as the
65 percent of the producers that wanted a contract price at least as
high as their expected spot price in Table 6.2. For these producers
there will be a larger number Of days on which they could have traded
and a larger number of days for which they will not be sure whether
they should have traded at the going price or waited for a possibly
higher one. This kind of uncertainty does not last as long in spot
market trading where there are only a few weeks for selling a lot of
hogs. For other traders, such as those with a small ratio of assets
to liabilities, there will probably be a net psychological benefit to

forward trading.

PricingpAccuracy

 

Trading hogs on the basis of their carcass characteristics will
improve the accuracy of payments to producers so that each is paid
according to the wholesale value of his hogs. If the dollar cost of
trading in the contract market is the same as that of other markets,
producers of relatively good quality hogs, who are presently receiving
less than actual value for their hogs, will receive higher dollar in-

comes. Producers of relatively poor quality hogs, who are presently

205

receiving more than actual value, will receive lower dollar incomes.
If the dollar cost of trading in the contract market is less than in
other markets, as it seems to be, the dollar incomes of producers of
both kinds of hogs will increase, but the incomes of producers with
better hogs will increase more than the incomes of other producers.

Of course, the above analysis assumes that the forward contract
market will not cause the average price level to change. If it does,
the average level of producers' incomes will rise or fall with it.
Nevertheless, the differences between producers' incomes will be more
dependent on the quality Of hogs produced than it is today without

much carcass trading.

Effects on Packers

 

To analyze the effect of the forward contract market on slaughter-
ing firms, it will be useful to look at the different functions that
packers must perform and to see how these functions would be affected

by trading in the market.

Procurement

 

Purchasing. Packers must plan to purchase a number of hogs for
each day's slaughter and plan to have the correct amount of labor avail-
able to handle them. The forward prices would provide the packer with
additional information not provided by spot markets. The information
could improve the ability of the packer in deciding the number of hogs
to buy and the prices to pay for hogs to be slaughtered within a couple
of days or a month or longer. As the bids were made and the contracts
completed, the packer would always know how many hogs he had committed
for a given week and how many more he would like to have. By communi-

cating directly with the computer market instead of with buyers in the

206

field (either his own buyers or order buyers), he could make more time-
ly decisions and execute them more rapidly. The contract market would
further simplify the buying process because the packer would only plan
to buy the number of hogs desired for an entire week. The computer
market would arrange appointments with producers to deliver the desired
proportion of hogs on each day of the week. At the present time, the
packer must arrange to have the desired number of hogs delivered each
day. Although the present system gives the packer greater freedom in
arranging the deliveries, he might be willing to forego that freedom if
it would make the volume of his supply more uniform. Packers' "last
minute" adjustments in volume are probably the cause of some of the
sharp daily price changes in spot markets. If so, they could be re-
duced if packers used the forward contract market.

Although forward contracting will improve the price information
available to packers, the contracting will also make new demands on
packers for estimating the future prices at which to bid. The packers
will be accepting new price risks when they make forward contracts with
producers. Since a packer's margin does not leave much room for pricing
mistakes, a packer may make a forward agreement to buy hogs for more
than he will be able to sell the pork after allowing for his operating
margin. Some packers will wish to hedge their price risks in the live
hog, pork belly, or skinned ham futures markets which will be consider-
ed in a separate section below.

If a packer bought all his hogs through the contract market, he
would execute all his transactions from an Office by means of a touch-
tone telephone Or teletypewriter. During the preliminary interviews,

two packers were asked how total procurement via the forward contract

207
market would affect their manpower requirements. Both said they would
operate with no more and probably less than their present Office staff.
This means that they would be able to eliminate all their field staff
as well as the use of order buyers. If a packer received less than all
his hogs from the forward contract market, he would have to maintain
some working relationships with people in the field.

Hedging. The price risks imposed on packers by forward contracting
could be hedged by selling contracts in the live hog, pork belly, and
skinned ham futures markets. When the hogs are delivered or the pork
products are sold, the futures contracts would be bought back to remove
the hedge.

Nine of the ten packers said they would hedge their forward price
risks at least some of the time. (One packer said he did not know any-
thing about hedging and could not answer the question). The packers
generally said they would not hedge short-term contracts of two to
possibly four weeks, as the size of the risk would not warrant the
expense of making the hedge. Furthermore, two packers said they would
hedge selectively rather than routinely. That is, they would not hedge
when they were quite confident that spot prices would be at least as
high as their forward contracted prices in the delivery month.

Packers planning to make forward contracts more than two to four
weeks prior to delivery would have to have personnel trained at making
hedging decisions. For several packers this will be an added expense
when adopting the forward contract market as a means of procurement.

In addition, there will be the cost of the brokerage fees when
making the hedges in the futures markets. Table 6.3 shows that the

brokerage fee per head will be significantly higher if the live hog

208

TABLE 6.3 Brokerage fees for hedging hogs in the live hog, pork belly,
and skinned ham futures markets.

 

 

 

Brokerage Brokerage fee
Futures fee per Size of Equivalent No. per
contract contract contract of head3 ~ head
Live hog $20.00 20,000 lbs. 91 $.220
Pork belly $36.00 30,000 lbs. 1181 $.030
Skinned ham $36.00 30,000 lbs. 977 $.037

 

 

 

 

 

aAssumes a 220 pound hog yielding a 165-pound carcass (75%); the
carcass yields 30.7 pounds of hams and 25.4 of bellies. Engelman,
Dowell, Ferrin, and Anderson, Marketing Slaughter Hogs by Carcass
Weight and Grade (University of Minnesota Ag. Exp. Sta. Tech. Bul. No.
187, April, 1950), pp. 14, 37.

 

Source: Chicagngercantile Exchapge Year BookL 1968—1969 (Chicago:
Chicago Mercantile Exchange, 1969), pp. 88—91, 143-147,
264-267.
futures contract is used instead of the bellies or ham futures. It
should be noted, however, that few hedges are perfect. In other words,
it is unlikely that the change in the futures market prices will ex-
actly offset the difference between the forward contract price and the
spot price at delivery. The live hog futures might provide a more
accurate hedge than either of the two pork futures since the former
includes a larger prOportion of the product and the value of the pro-
duct bought in the forward contract market. If the two pork futures
cannot provide as accurate a hedge as the live hog futures, the effec-
tive cost differences between the pork futures and the hog futures will
not be as large as the differences in Table 6.3. As the cost of making
hedges to reduce price risks to an acceptable level increases, packers
will be more likely to make short—term forward contracts instead of

long-term contracts in order to reduce the need for hedging.

209

Unloading and holding. Unloading and holding costs are likely to
be unaffected by changing from spot market trading to forward contract-
ing. Approximately the same number of hogs will be received by each
packer and he will have to operate holding facilities to be sure to
have a continuous flow of hogs once the plant begins to operate each
day. It is possible, however, that contracting will allow better plan-
ning of the arrival of hogs for slaughter so that fewer hogs will have

to be held over from one day to the next.

Production

 

Slaughter. The cost of slaughtering hogs depends on the efficiency
with which labor and other resources are used. With labor accounting
for 55 percent of total slaughtering, cutting, and packaging costs,
labor must be planned for and used efficiently if a packer wants to keep
slaughtering costs at a minimum. Estimates of a week's kill have to
be made, and the work gangs for the week have to be notified by Friday
of the previous week that they should report for work. Once a man is
notified, he is guaranteed his wage for at least 36 hours of work and
may be used for up to 40 hours at the same rate. Beyond 40 hours over-
time wages must be paid. It was shown in Table 2.2 that unplanned
changes in hog volume could have significant effects on slaughter labor
costs because of the relatively fixed cost of labor within weeks. A
i;5 percent unexpected change in hog volume would have no effect on
slaughter labor costs per head if a packer were planning to kill for 38
hours. A 15 percent unplanned increase in volume could increase labor '
cost per head by 3 percent for the week; and aIlS percent unplanned de-

crease in volume could increase labor cost by 11 percent.

210

Forward contracting would increase the level of knowledge packers
had for planning and coordinating their procurement and slaughter
activities. Packers could thereby reduce the magnitude of unplanned
volume changes. Depending on how far in advance the packers completed
their contracts for any given week and on the proportion of hogs bought
by contract, they would have a higher degree of certainty about how
many hogs would arrive on a given day and in a given week. Complete
procurement by forward contracting could give a packer a high degree
of certainty except for the i;5 percent delivery allowance in the con-
tract and some chance that a producer might fail to deliver.

If a packer knew with relative certainty the number of hogs he
would have arriving for a given week (or longer period), he could plan
to take a constant number of hogs each day. This is probably the most
expected approach. However, experience with forward contracting may
reveal that slaughtering hogs at a constant rate is not the most profit-
able approach. Certain indivisibilities may make it more profitable to
slaughter at a faster rate on some days (or weeks) and at a slower rate
on others. With forward contracting either a constant or a changing
rate could be planned so that available slaughtering resources (labor
and plant) could be used efficiently to slaughter the hogs available.

The seasonality of supply and demand is likely to continue with
heavier supplies in the winter months and lighter supplies in the sum-
mer months inspite Of the contract market. The main advantage to for-
ward contracting will be to allocate hogs among days in the short-term
and to increase the certainty of supply on any given day (or week).

Value determination. The forward contract market will require all

of its hogs to be traded on the basis of their carcass value. Each hog

211
will have to be identified according to its seller as it arrives at the
packing plant (or collection station) and each carcass will have to be
graded after the slaughtering process.

Several packers are currently tatooing, grading, and calculating
the carcass value of the hogs they slaughter. A few hogs are actually
being bought directly on the basis of such an evaluation,1 but most of
them are evaluated in this manner so that the packer can control the
size of his margin between the price paid for the live hog and the
wholesale selling price.

The cost of performing the three stages of identification, grading,
and computing the carcass value is estimated to be about $.05 to $.10
per head,2 but the packers who have adopted the measure for control
purposes must believe the added cost is less than the added value of
the information obtained for managing their firms. If these packers
adopted the forward contract market for all or part of their procurement,
they would incur little added cost so far as determining the value of
a producer's lot of hogs was concerned. There would be some added cost
if the hogs could not be graded as quickly because the accuracy stan—
dards and the penalties for mistakes were higher under the contract mar-
ket than under the packer's own system. There would also be some added
cost in preparing and sending a check and an invoice to each producer
and periodically to the market center. But to the extent'that con—
tracted hogs replaced hogs procured in spot markets, forward contract—

ing would replace the functions of determining value and writing checks

 

13.2 percent of hog slaughter in 1967. U. S. Department of Agri-
culture, Packers and Stockyards Resume, November 8, 1968.

2See explanatory footnote 2 on p. 52.

212
in the field and eliminate the associated cost.

Packers who currently do not evaluate every hog carcass will incur
higher added costs when buying hogs via the contract market. If it is
assumed that valuable management information will be Obtained at the
same time, only some of the added cost would need to be allocated to
forward contracting.

A final note on value determination concerns the use of the stan-
dardized premium-discount schedule for determining the price of all car-
casses that deviate from the base specification in the forward contract.
HOpefully, by changing the schedule at least once a month and by leav-
ing it undecided until a few weeks before delivery, hogs will be pric-
ed from the base hog with a level of accuracy that is acceptable to
both the producers and the packers. Nevertheless, a premium-discount
schedule will always be an approximation of actual price differences and
with any given schedule some hogs will be priced more accurately than
others. Over several delivery periods and thousands of hogs one would
expect the result of the errors to "average out" for each packer, but
it cannot be guaranteed. It is possible that some packers will have to
pay more or less than the wholesale value (minus operating and profit
margin) Of hogs slaughtered. The amount of risk created by this situa-
tion is unknown but it will add to the packers' cost of using the con-

tract market.

Distribution
The forward contract market will not only affect hog procurement
and slaughter but will also affect pork distribution. As contracting is

used to increase the certainty of a packer's hog supply, it will also

213
increase the certainty of his pork supply for distribution. To the
extent that this increased certainty of supply allows improvements in
distribution planning, a new level of distribution efficiency will
be achievable. For example, a packer who is more sure of his supply
over a longer period of time might make fewer but longer-term orders
with his customers, thereby increasing the supply certainty of his
customers as well.

On the other hand use of the forward contract market may create
some new distribution problems and raise costs for some packers, such
as those killing a Specific kind (size and grade) of hog for a speci-
fic market. The generalized forward contract, which allows a wide var-
iety of hogs to be delivered, will not provide the pork products that
the packer needs for his customers. He will be unable to use the con-

tract market unless or until he finds some new customers.

Other Effects

 

Current Hog Markets

 

Since the contract market will be a substitute for the spot mar-
kets, any volume achieved by the former will have to come from the lat—
ter (except for increases in annual production). If the contract mar—
ket achieves a substantial share of the total hog market, local markets
and auctions which only handle hogs will be directly replaced or forced
to close because of low volume and high costs. There do not seem to be
many viable alternatives for these resources, except that a limited num-
ber of them might be operated as packer collection stations in the con—
tract market system and others might begin to handle other species. Most
spot markets currently handling a variety of livestock species in the

Cornbelt will only suffer only partial reductions in volume because of

214

reduced hog volume. Some markets may be able to maintain their volume
by absorbing parts of other markets which are forced to close, but
transportation to fewer, more-dispersed markets will increase.

Many of the markets that remain may suffer external diseconomies
created by the forward contract market. From the point of view of the
entire livestock industry this would be an added cost to adopting the
contract market for hogs. However, it seems reasonable to assume that
similar contract markets could be established for other species with
similar results on their market coordination.

The futures markets for h(gs and pork products would likely be
strengthened by thw parallel farward contract market for hogs. Al-
though forward contracting wouil be a substitute for producers who
wish to hedge in the futures ma“kct, very few producers are currently
hedging.1 On the other hand, xlckers accepting new price risks by for-
ward con: acting would likely increase their use of the futures markets

(live hog, pork belly and/or a.inned hams) for hedging purposes.

Consumers
The final question to be answered is: How will implementation of
the forward contract market affect consumer welfare?

Better quality. Since the contract market will substitute a car-

 

cass evaluation for the live evaluation currently used for most hogs,
pricing accuracy will be increased. As a result, the producers will
receive more accurate signals and incentives to produce the kinds of
hogs that consumers want. Meat-type hogs will receive higher prices re-

lative to lard-type hogs and the proportion of meat—type to lard-type

 

1See Chapter II, pp. 33—35.

215
hogs should increase.

Lower price. If the forward contract market can help to reduce
production and marketing costs at the farm level, the packing level, and
between, it will increase the returns to producers and packers. But
with competitive markets, as exist in the hog-pork subsector from the
farm market to the retail store, at least some of the gains are likely

to be passed on to the consumer in the form of lower prices.

CHAPTER VII

SUMMARY AND CONCLUSIONS

The coordination of some 800,000 individual hog producers and 2,200
hog packers for the production and slaughter of 80,000,000 hogs per year
is accomplished by means of a bargained exchange system where prices
guide the activities of the producers and packers. Personal interviews
with several packers and producers and a review of previous studies
have indicated that this system has two basic coordination problems. (1)
Hogs are not allocated in a way that minimizes the combined cost of trans-
porting hogs and pork products and the cost of slaughtering because of
inadequate information about supply and demand. As a result, there is
a more irregular flow of hogs to slaughter than necessary to meet season-
al and cyclical changes in supply and demand, and there is a misalloca-
tion of hogs among packers at any given point in time. (2) Producers
of relatively high quality hogs receive less than their hogs are worth
while producers of relatively low quality hogs receive more than their
hogs are worth because of pricing inaccuracies. As a result, producers
receive inequitable rewards for current production and cannot allocate
resources efficiently for future production according to the desires of
consumers.

In order to alleviate these problems and to improve producer-packer
coordination, forward contracting and vertical integration have been
receiving increased attention. Vertical integration has not been used
very much because of the large investment required. According to one

estimate, $25 million would be needed to acquire the breeding stock and

216

217
facilities to supply a single packing plant.1 Forward contracting, on
the other hand, appears to be a more workable alternative. A few pack—
ers are currently experimenting with forward contracts which they offer
to producers; a few hog marketing firms are offering contracts to pack—
ers and producers.

The currently conceived methods of forward contracting and vertical
integration seek to diminish the role of the open market as a coordinat-
ing mechanism and as a procedure for establishing prices. In contrast
with these approaches, some observers2 have proposed a market for trad-
ing deliverable forward contracts. The market would consist of a cen-
tral electronic computer to which producers and packers would gain di-
rect access by means of conventional touchtone (push button) telephone.
The purpose of this dissertation has been to examine the economic feas-
ibility of such a market for slaughter hogs.

The study had three specific objectives: (1) to identify the market
coordination problems of hog producers and packers, (2) to design a com-
puterized forward contract market capable of alleviating the coordina-
tion problems identified and (3) to evaluate the economic feasibility of
such a market by comparing it with the marketing alternatives currently
in use.

In a preliminary analysis, a telephone-computer market developed

3

for shell eggs was studied to see how its principles and mechanics could

 

1Clifton B. Cox, Armour and Company, speech to the National Insti-
tute of Animal Agriculture, Purdue University, April 8, 1969.

2Breimyer, "Agricultural Organization", p. 39; Shaffer, "Institu-
tional Obsolescence", p. 257.

3Schrader, Heifner, and Larzelere, Electronic Egg Exchang .

 

218
be adapted to a contract market for slaughter hogs. In addition, coor-
dination problems were identified and alternative specifications of a
contract market were develOped. The problems were more clearly identi-
fied and the alternative market specifications were tested during for—
mal interviews with 50 producers and 10 packers in Illinois, Iowa, and
Missouri. Also during the interviews, the producers and packers were
asked to identify the anticipated effects of such a market on their pro-
duction and marketing activities. The cost of operating the contract
market was developed after interviews with representatives of the Inter-
national Business Machines Corporation and the Michigan Bell Telephone
Company.

The coordination problems identified in the literature and during
the interviews seem to fall into the three basic categories noted at the
beginning of this chapter. The following list highlights the forward
contract specifications that appear to be capable of alleviating those
problems and at the same time appear to be capable of being traded in a

telephone-computer market.

Product description

 

(1) That all contracts be negotiated in terms of
a base price for a standard hog and that a
standardized premium-discount schedule be used
to price all hogs deviating from the standard
hog.

(2) That the actual price for each hog be estab-
lished after slaughter and be based on the
measurable characteristics of the carcass.

(3) That the hogs acceptable for fulfilling the
contract include all those producing car-
casses of 135 to 195 pounds (180 to 260 live
pounds) and grading USDA NO. 1, 2, and 3.

219

Size of contract

 

(4) That the number of hogs in a contract be allow—
ed to vary from a minimum of 30 head to a max-
imum of 500 head.

(5) That a number of smaller contracts offered by

producers be used to fill a larger contract
offered by a packer at the same price.

Length of contract period
(6) That contracts be available for one day to 12

months in advance of del very.

Day of delivery

 

(7) That one-, two-, and four-week pricing and de-
livery intervals be established and their use
depend on the length of the contract period.

(8) That each producer make an appointment to de-

liver on a specific day by the Wednesday be-
fore his delivery interval begins.

Trading zones and transportation

 

(9) That trading zones be square and "tilted" 45
degrees and be 50 to 100 miles wide.

(10) That the computer market automatically adjust
the price bids and offers so as to account for
the distance between zones when a potential
buyer and seller are located in different zones.

Contract renegotiation

 

(11) That a producer and/or packer be permitted
' to find a third party to complete the de-
livery or acceptance of a contract.
The forward contract market should be able to improve the alloca-
tion of hogs among packers and overtime for two reasons. (1) Because
the contract market eliminates physical handling and visual inspection

of the hogs prior to the sale, a single market could be used to inte-

grate hog buying and selling over a broad geographic area. (2) Because

220
the market facilitates forward transactions and generates forward price
information, it could reduce uncertainty for producers and packers and
reduce fluctuations in slaughter volume over time.

The contract market should also improve pricing accuracy since the
contract requires a carcass pricing of all the hogs traded in the market.
The price differences for different types of hogs should more accurate-
ly reflect the differences in wholesale value. As a result, producers
should receive more equitable payments for present production than they
currently receive in most spot markets. They should also receive more
accurate incentives to allocate resources efficiently for future pro-
duction. Consumers should, therefore, see an improvement in pork qual—
ity and perhaps lower pork prices.

The economic feasibility of the forward contract market will depend
in part on whether it can provide a net economic advantage to producers
and packers when compared with their current market alternatives. The
combined cost to producers and packers when trading in terminal markets
is presently about $1.10 per head. In auction markets and local markets
the costs currently average about $.65 to $.80 and $.35 to $.55 per head,
respectively. In contrast, if most producers and packers decided to
adopt the contract market, it would handle 50 million head per year (most
of the Cornbelt barrows and gilts grading USDA No. l, 2, and 3) and the
average cost would be only $.16 per head. If the market handled 25 mil-
lion head, the cost would be $.22, and for a fairly low volume of 5
million head, the cost would be $.43 per head. If the cost of transpor-
tation is also included, there would be an even greater difference be-
tween Spot market and contract market costs per head because many hogs

would probably be moved directly from the farm to the packing plant under

221

the contract market, whereas most hogs would make an intermediate stop
for the exchange process in a spot market.

However, the relatively low operating cost of the contract market
will not be sufficient reason for its adoption. Producers and packers
must consider the changes they will have to make in their production
and marketing activities and the cost and benefits Of making those
changes when using the contract market instead of a spot market.

The forward contract market will have a different effect on differ-
ent kinds of producers. The market's high level of pricing accuracy
will tend to increase the prices received by producers of relatively
high quality hogs and tend to lower the prices received by producers of
relatively low quality hogs. The opportunity to make advanced sales
will help some producers lower production costs through improved plan-
ning, but generally the contracts will not be made far enough in advance
to have a major effect on a producer's allocation of resources. Like-
wise, the guaranteed forward price will be an advantage to some pro—
ducers, such as those with large debts, but a guaranteed price may be a
disadvantage to those who have the ability to sell hogs on market days
with relatively high prices.

For packers, the contract market will probably simplify their pro-
curement planning and purchasing process, and enable them to reduce the
size of their procurement staffs. Forward contracting will also pro-
vide increased supply certainty which will allow a more efficient allo-
cation of labor and other resources in processing activities. For pack-
ing plants that do not over or under estimate their supply by more than
;t 5 percent, increased supply certainty is likely to be of little bene-

fit unless considerable amounts of resources are expended to maintain that

222

kind of volume control. On the other hand, plants that often have i_10
percent unplanned volume in any given week may be able to reduce their
slaughter costs by one to five percent in that week. Additional savings
in cutting and distributing activities may also be possible.

Packers will also face added expenses when using the contract mar-
ket. They will assume additional price risks associated with (1) using
the standard premium—discount schedule to calculate carcass values, and
(2) guaranteeing producers a forward price. The latter can be hedged
in the futures markets; the former will have to be hedged by less for-
mal means. In addition packers will have added expenses associated with
using carcass characteristics to determine hog value instead Of using
live weight or live weight and grade. However, packers who currently
evaluate every carcass will have little added expense when compared
with packers who do not evaluate carcasses at the present time.

For existing spot markets, a contract market handling several
million head will impose external diseconomies. Both those markets
handling all hogs as well as those handling a mixture of species are
likely to face increased operating costs per head as volume slackens.

With regard to choosing a market agency that would organize and op-
erate the forward contract market, the producers and packers suggested
that a joint producer-packer board be established. Their second choice
was an organization like the Chicago Mercantile Exchange or the Board of
Trade. The market agency would be responsible for (l) organizing the
contract market within the guidelines of the Commodity Exchange Act, (2)
promoting the market to potential producers and packers, and (3) operat—
ing the telephone-computer market in a way that contracts would be ful-

filled as specified.

223

Additional Research

 

The foregoing evaluation shows that the operating costs for the
forward contract market would be considerably less than the cost of
most current market alternatives. It also shows that the net effect of
short-term forward contracting on the hog production and selling costs
of producers is quite small. Further investigation of the effect on
producer's costs would improve the accuracy of the estimates but would
probably be of little added benefit in evaluating the overall effect of
the contract market.

On the other hand, high priority should be given to estimating
the magnitude of the effect on the planning, procurement, slaughtering
and cutting, and distribution costs of packers. Although there are
several indications that the advantages of the contract market would out-
weigh the disadvantages, there is still considerable uncertainty about
the net effect. If the market agency is going to be able to promote
the contract market successfully to packers, it will need some more facts
to show the expected net effect on packers.

Some detailed case studies of four to six packers of various sizes
and with varying degrees of supply fluctuation would be helpful in syn-
thesizing the effect of the contract market on packers. The studies
could involve an analysis of the several activities performed by each
packer to see how these activities would be altered or discontinued, and
where new ones would be added, if the packer were to use the contract
market instead of available spot markets.

Additional research is also needed to study the effect of the con-
tract market on the transportation costs of producers and packers. Since

producers and packers are concerned with the cost of moving hogs to packing

224
plants and since packers are concerned with the cost of moving pork to
their customers, it is necessary to study the transportation of hogs
and pork concomitantly. Otherwise, an apparent saving in the trans—
portation of hogs might be the result of an increased expenditure for

the transportation of pork, or vice versa.

Concluding Remarks

 

There seems to be little question that it is technically feasible
to trade hogs by description with a standardized contract and a central
computer with direct telephone access. The more important question at
this time concerns the economic feasibility of such a system. That is,
will the cost of achieving the technical feasibility be less than the
benefit of the market to producers, packers, and consumers.

A forward contract market could increase the amount of market in-
formation available to producers and packers and thereby improve the ef-
ficiency by which hogs are allocated among packers and over time. It
could also improve the equity of payments to hog producers for current
production and improve the allocation of resources for future production.
As a result, consumers could expect to receive better quality pork at
lower prices than they currently pay for such quality.

In the final analysis, however, the question of whether producers
and packers will adopt the contract market will depend on how individual
producers and packers weigh all the added costs and benefits of chang-
ing from current spot markets to the contract market. The producers must
consider the changes in their production and selling activities; the pack-
ers must consider the changes in their buying, slaughtering, and distri-
bution activities.

The foregoing analysis shows that adOption of the contract market

225
would tend to reduce hog production costs; at least it is unlikely that
they would be increased. Adoption would also tend to reduce slaughter-
ing costs. Further, if the contract market would achieve an annual vol-
ume of 5 million head or more, its Operating costs would be substantially
less than the operating cost of current spot markets, thereby reducing
some of the selling costs for producers and buying costs for packers.
Expected savings in transportation costs would further reduce selling
and buying costs but additional research is needed in this area. The net
effect of the contract market on a packer's procurement, slaughtering,
and distribution costs is largely unknown and additional research is
needed in this area also.

In conclusion, this study has accomplished the following: (1) it
has explained how a telephone-computer market could be established and
Operated for slaughter hogs in order to reduce coordination problems
of producers and packers; (2) it has made a number of recommendations
for specifying the contract to be traded in such a market; and (3) it
has made a preliminary analysis of the economic implications of the mar-

ket for hog producers and packers.

BIBL IOGRAPHY

BIBLIOGRAPHY

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National Independent Meat Packers Association, Jacksonville, Florida,

October 20, 1965.

”Heat Packers' Costs for Fresh Beef and Pork", Reprinted from
Marketing and Transportation Situation, USDA, ERS. Washington:
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"Agricultural Organization in the Modern Industrial

Breimyer, Harold F.
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Broadbent, Emer E., Madsen, A. G., and West, V.I. Pricing Butcher Hogs at
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Chicago Mercantile Exchange. "Futures Trading in Live Hogs (New Rules)"

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. "Rules and Regulations for Trading in Beef Cattle (Live)
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November 4, 1964.
Year Book, 1967-68. Chicago: Chicago Mercantile Exchange, 1968.

 

Year Book, 1968—69. Chicago: Chicago Mercantile Exchange, 1969.

 

Cox, Clifton B. and Blum, Martin A. Cost Of Operating Selected Indiana
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February, 1955.

Daellenbach, Lawrence A. "Effects of Short-Run Variation in Input
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227

Dowell, James I, Wold, Dennis L. and Anderson, Emory E. Cost—Volume
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Engleman, G., Dowell A., Ferrin, E. and Anderson, P. Marketing Slaughter
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Erlandson, Gordon W. "Geographic Changes in Livestock Production."
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Fox, Karl A. and Kumar, T. K. "The Functional Economic Area: Delineation
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French, Ben C. "Some Considerations in Estimating Assembly and Cost
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Futrell, Gene A. In Live Hog Futures Study Conference. Sponsored by
the Chicago Mercantile Exchange, Chicago, November 16, 1967.
(Mimeographed).

 

Gibb, Richard Dean. "An Economic Analysis of the Efficiency of Michigan
Livestock Auctions". Unpublished Ph.D. dissertation, Michigan
State University, 1958.

Gray, Roger W. "Fundamental Price Behavior Characteristics in Commodity
Futures." Futures Trading Seminar, Vol. III. Edited by Erwin A.
Gaumnitz. 3 vols. Madison: Mirmir Publishers, 1966.

 

. In Live Hpg Futures Study_Conference, sponsored by the Chicago
Mercantile Exchange, Chicago, November 16, 1967. (Mimeographed.)

 

. "Why Does Futures Trading Succeed or Fail." Futures Trading
Seminar, Vol. III. Edited by Erwin A. Gaumnitz, 3 vols. Madison:
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Hayenga, Marvin L. and Heifner, Richard G. "The Accuracy of Hog
Pricing Systems." (Manuscript in preparation at Michigan State
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Henning, George F. and Evans, Merrill B. Market Hogs Can Be Accurately
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Hieronymous, T. A. "The Desirability of a Cattle Futures Market." [A
paper with no date or reference to the place given.]

Hog Farm Management. 5:7,10—13, October 1968.

 

228

Ikred, John E. and Cramer, Charles L. "Price Signal Refraction in Pork
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May, 1968.

 

Kohls, Richard L. Marketing Agricultural Products. 3rd edition, New
York: Macmillan, 1967.

 

Lindberg, R. C. and Judge, G. G. Estimated Cost Functions for Oklahoma
Livestock Auctions. Oklahoma Ag. Exp. Sta. Bul. NO. B-502, January,
1958.

 

 

Logan, Samuel H. "Labor Cost of Slaughtering Hogs." Supplemental Study
No. 4 to Technical Study No. 1, Organization and Competition in the
Livestock and Meat Industry, National Commission on Food Marketing.
Washington: U.S. Government Printing Office, June, 1966.

 

 

Marshall, Alfred. Principles of Economics. 8th edition; London: Macmillan,
1925.

 

Mighell, Ronald L. and Jones, Lawrence A. Vertical Coordination in
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National Commission on Food Marketing. Organization and Competition in
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North Central Livestock Marketing Research Committee. Objective Carcass
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Purcell, Wayne D. "An Appraisal of the Information System in Beef
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. "Improved Communication--the Key to Increased Efficiency and
Coordination in Beef Marketing." Paper presented at the NCR—61
Seminar, Chicago, November 6—7, 1968.

Rand McNally New Cosmopolitan World Atlas. 1967 Edition.

 

Reynolds, James W. and Kiehl, Elmer R. A Determination of Objective
Carcass Grade Standards for Slaughter Hogs. University of Missouri
Ag. Exp. Sta. Res. Bul. No. 507, August, 1952.

 

Rizek, R. L., Judge, G. G., and Havlicek, J. Joint Spatial Analysis of
Regional Slaughter and the Flows and Pricing of Livestock and Meat.
Part III of Spatial Structure of the Livestock Economy. 3 parts.
North Central Regional Research Bul. No. 163. South Dakota Ag. Exp.
Sta. Bul. No. 552, October, 1965.

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Schrader, Lee F., Heifner, Richard G., and Larzelere, Henry E. Th3
Electronic Egg Exchange: An Alternative System for Trading_Shell
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December, 1968.

 

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Smith, Vernon L. "Effect of Market Organization on Competitive
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Snell, James G. "A Comparative Cost Analysis of Alternative Marketing
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Stanton, B. F. "Seasonal Demand for Beef, Pork, and Broilers."
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Thomas Register. New York: Thomas Publishing CO., December, 1968.

 

U.S. Department of Agriculture, Agricultural Marketing Service. Livestock
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Williams, Willard F. and Stout, Thomas T. Economics of the Livestock-
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APPENDICES

APPENDIX A

THE EFFECT OF VOLUME CHANGES ON A
PACKER'S SLAUGHTER LABOR COST
The results below were not actually observed, but were calculated
on the basis of parameters and relationships known to exist in the
packing industry. The basic data was obtained from some research done

by Samuel H. Logan1 in which the following data were presented:

 

Annual
Hourly kill Annual No. of labor
rate rate workers cost
75 141,750 25 $ 171,947
150 283,500 43 299,604
300 567,000 75 515,049
600 1,134,000 131 909,978

From this data, an average hourly wage of $3.30 to $3.36 was calculated.
Since Logan's data were for 1965, the wage was inflated to $3.50. From
interviews with packers it was learned that the current labor contract
specifies a minimum of 36 hours if called for the week and a maximum of
40 hours at the regular wage rate. Overtime, is at 1.5 times the regu—
lar rate. In addition, a worker is given 0.5 hours per day for changing
clothes, washing, and preparing equipment. Hence, total slaughtering
time is 2.5 hours per week less than the total work time. It was assum-
ed the packer planned for 38 hours of work (35.5 hours of slaughtering
time) which would allow him to kill 5.6 percent more or fewer hogs with-

out paying overtime or having idle labor.

 

1Samuel H. Logan, "Labor Cost of Slaughtering Hogs", Supplementary
Study No. 4 to Technical Study No. 1, Organization and Competition in
the Livestock and Meat Industry, National Commission of Food Marketing
(Washington: U.S. Government Printing Office, June, 1966), pp. 6-9.

 

231

232

For a plant operating at 300 head per hour and 600 head per hour,

the following standards were established:

300 Head Per Hour

600 Head Per Hour

 

Labor cost

75 workers x 38 hours x

131 workers x 38 hours x

 

per week $3.50/hr. = $9,975 $3.50/hr. = $17,423
No. of hogs 300/hr. x 35.5 hrs.= 10,650 600/hr. x 35.5 hrs.= 21,300
per week

 

Labor cost
per hog

 

$9,975/10,650 = $0.937

 

$17,423/21,300 = $0.818

 

For a plant expecting to Operate at 300 or 600 head per hour, the

following results occur if 10

percent more hogs than planned arrive:

300 Head Per Hour

600 Head Per Hour

 

 

 

 

Added no. of head ly065 2,130
No. of head without over-

time (increase from 35.5

59 37.5 slaughter hours,

38 to 40 working hours) 600 1,200
NO. of head on overtime 465 930
Amount of overtime 1.55 hours 1.55 hours

 

Labor cost per week

(75 x 40 x $3.50)

(131 x 40 x $3.50)

 

 

+ +
(75 x 1.55 x $5.25) (131 x 1.55 x $5.25)
= $11,110 = $19,406
No. of hugs per week 11,715 23,430
Labor cost/hog $.948 $.828

 

 

 

For a plant expecting to operate at 300 or 600 head per hour, the

following results occur if 10 percent fewer hogs than planned arrive:

233

300 Head Per Hour 600 Head Per Hour

 

Fewer no. of head 1,065 2,130

 

Minimum labor cost 75 x 36 x $3.50= $9,450 131 x 36 x $3.50= $16,506
__per week

 

No. of hogs/week 9,585 19,170

 

 

 

Labor cost/hog $9,450/9,585 = $0.986 $16,506/19y170 = $0.861

 

When the above steps were repeated for 5%, 15%, and 20% volume
changes the results in Table A.1 were Obtained.
TABLE A.1 The effect of unplanned volume changes on slaughter labor

costs for hog packing plants planning to Operate at 300
and 600 head per hour.

 

 

 

 

 

No. of head slaughtered per Labor cost per head
week

No. of head Actual as Actual as
per hour a percent a percent
Planned Actual of planned Planned Actual of planned

8,520 80 $1.109 118

9,050 85 1.044 111

9,585 90 0.986 105

10,120 95 0.937 100

300 10,650 fl 10,650 100 $0.937 A 0.937 100

11,185 105 0.937 100

11,715 110 0.948 101

12,250 115 0.964 103

c12,780 120 . ._0.979 104

17,040 80 $0.969 118

18,105 85 0.912 111

19,170 90 0.861 105

20,235 95 0.818 100

600 21,300 a 21,300 100 $0.818 ‘d 0.818 100

22,365 - 105 0.818 ‘ 100

23,400 110 0.828 101

24.495 115 0.842 103

L25.560 120 L0.855 105

 

 

 

 

 

APPENDIX B

SIZES OF HOG FARMS IN 1969

TABLE B.l Projected number of hog farms and number of hogs sold by
farms of different sizes for 1969.

 

 

I No. of producers

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

No. of ho 3 sold
No. of hogs Average no.
sold per farm 1959 1964 19693 per farm, Tota
per_year w 1964 1969
North Central Region

1-9 78,909 33,593 14,301 4.9 70,075
10-49 268,545 147,262 80,754 28.5 2,301,489
50-99 158,019 121,001 92,655 , 70.9 6,569,240

100-199 141,067 120,166 102,482 138.2 14,163,012

200-499 74,174 85,716 97,258 290.5 28,253,449

500-999 8,858 15,612 22,366 647.8 14,488,695

1000 or more 1,096 3,250 5,404 1500.3 8,107,621

Total 730,668 526,600 415,220 XXX 73,953,581
United States (All Re ions)

1-9 227,182 107,930 41,985 4.5 188,933
10-49 538,513 280,937 146,649 26.9 3,944,858
50-99 202,962 158,342 123,507 70.0 8,645,490

100-199 161,611 139,237 120,022 137.4 16,491,023
ZOO-499 81,572 94,680 107,788 289.7 31,226,184
500-999 9,983 17,394 24,805 648.0 16,073,640
1000 or more 1,542 4,100 6,658 1608.0 10,706,064
Total 1,273,365 802,620 571,414 XXX 87,276,192
aProjected: farms selling less than 200 hogs per year are declin-

ing in number; the percent of decline from 1959 to 1964 is used to pro-
ject the number of farms in 1969; farms selling 200 or more hogs per
year are increasing in number; the absolute increase from 1959 to 1964
is added to 1964 to project 1969.

bProjected: the average number of sales per farm in each size
category in 1964 is assumed to be the same in 1969.

(1959 and 1964 data) Derived from U.S. Department of Commerce
Bureau of the Census, Census of Agriculture, 1964, Vol. 11,
Chapter 2, "Livestock, Poultry, and Livestock and Poultry Pro-
ducts" (Washington: U.S. Government Printing Office, 1967),
pp. 155-161.' '

Source:

 

234

APPENDIX C

COST OF TELEPHONE-COMPUTER SYSTEMS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

TABLE C.1 Annual costs of telephone-computer systems for the forward
contract market handling 5, 25, and 50 million hogs per year.
No. of No. of No. of Com- Annual costs (thousands of dollars)
trading tele— tele- puter Telephone
hours phone phone model Com- Audio service
calls linesc puterd response Conne - Callsg Total
Per Per per unite tions
day yeara hourb
i1) _ (2L (3) (A) (5) (6) f7) (8) (9) (10)
5,000,000 Head Per Year
2 500 1152 58 A 50.0 48.0 40.6 464.0 602.6*
4 1000 672 34 A 100.0 24.0 23.8 544.0 691.8
6 1500 480 24 A 150.0 24.0 16.8 576.0 766.8
8 2000 384 19 A 200.0 24.0 13.3 '467.0 704.7
2 500 1152 58 B 75.0 48.0 40.6 464.0 627.6
4 1000 672 34 B 150.0 24.0 23.8 544.0 741.8
6 1500 480 24 B 225.0 24.0 16.8 576.0 841.8
8 2000 384 19 B 300.0 24.0 13.3 467.0 804.7
2 500 1152 58 C 100.0 48.0 40.6 464.0 652.6
4 1000 672 34 C 200.0 24.0 23.8 544.0 791.8
6 1500 480 24 C 300.0 24.0 16.8 576.0 916.8
8 2000 384 19 C 400.0 24.0 13.3 467.0 904.7
25,000,000 Head Per Year
All A h
2 500 5760 288 B h
4 1000 3360 168 B h
6 1500 2400 120 B h
8 2000 1920 96 B 300.0 48.0 67.2 2361.6 2776.8*
2 500 5760 288 C h
4 1000 3360 168 C 200.0 96.0 117.6 3360.0 3773.6
6 1500 2400 120 C 300.0 72.0 84.0 2952.0 3408.0
8 2000 1920 96 C 400.0 48.0 67.2 2361.6 3876.8

 

235

236
TABLE C.1 (cont'd.)

50,000,000 Head Per Year
TV All A
All B

 

500 11520 576
1000 6720 336
1500 4800 240
2000 3840 192

CDC‘J-‘N
COCO
D‘D‘D‘D‘D"

400.0 96.0 134.4 4723.2 5353.6*

 

 

 

 

 

 

 

 

 

 

*Indicates least—cost combination.

8250 days per year. Col. (2) = Col. (1) x 250

bTable 5.8.
CTable 5.9

dModel A is an IBM 30 at $100 per hour; B is an IBM 40 at $150 per
hour; C is an IBM 50 at $200 per hour. Col. (6) = Col. (2) x (the
computer cost per hour).

eAudio response units (IBM 77-70) are capable of handling 48 tele-
phone lines each and cost $2,000 per month or $24,000 per year. Since
it is unlikely that a firm renting computer time to the market would
have audio response units, it is assumed that they will have to be
leased directly from IBM. Col. (7) = Col. (4) e 48 [and rounded to
next whole number] x $24,000.

fTelephone connections include $12 per month for local phone
service plus $45 per month for a "data set" (to translate telephone
signals into computer signals). The annual cost is estimated to be
$700 per telephone line. Col. (8) = Col. (4) x $700.

3For cost of telephone calls, see Table C.2. The lowest cost
service is used above.

hIndicates the computer has insufficient capacity to handle the
required number of calls per hour. Model A has a maximum capacity of
60 telephone lines; B, 100 lines; C, 200 lines. At the rate of 20
3-minute calls per hour, they can handle 1200, 2000, and 4000 calls
per hour, respectively. According to Table 5.9, several combinations
of trading hours and computer models exceed the maximum capacity.

237

TABLE C.2 Annual cost of telephone service: conventional long dis-
tance and inward WATS.

 

 

 

 

 

Cost per line for 250 daysa'
Conventional long
No. of hours distance at
used per $16 per $20 per Inward
day hour hour WATS
2 $ 8,000 $10,000 $24,600
4 16,000 20,000 24,600
6 24,000 30,000 24,600
8 32,000 40,000 24,600

 

 

 

 

3Long distance calls would average $.80 (for 3 minutes) for a mar-
ket handling 5 million head and operating within a 350 mile radius of
the market center; $1.00 for a market handling 25 to 50 million head
within a 700 mile radius. With 20 3-minute calls per line per hour, a
single line will cost $16 and $20 per hour, respectively. Inward WATS
("collect" Wide Area Telephone Service) can be obtained for $2,050 per
month, or $24,600 per year.

HICH

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