A theoretical and financial analysis of pork production contracts

Chris Lynn Hillburn

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: A theoretical model of pork production contracts using the principal-agent framework is used to investigate optimal compensation schedules for both feeders and owners. The optimal compensation schedules derived may take on a variety of forms, but all payment schedules should contain an inverse relationship between the quality and quantity of inputs provided by the owner and the compensation provided to the feeder;A simulation analysis is used to investigate the risk and returns to both the feeder and the owner for feeder pig finishing and feeder pig production contracts. For the owner the returns from a contract are similar (though somewhat smaller) to that of a sole proprietor, and the owner is able to reduce risk. The contract feeder's risk and returns are substantially reduced as compared to a sole proprietor. For both the feeder and the owner some contracts are found to dominate other contracts (as measured by stochastic dominance). Pork production contracts may or may not be equitable arrangements for a feeder, depending upon the specific compensation schedule, the investment in facilities required, and the actions of the owner. Owners, like sole proprietors, are subject to wide variations in returns due to their acceptance of price risk and some production risk, but avoid the risk of large investments in facilities through a contractual arrangement with a feeder;Feeders' risks in a contractual arrangement are largely due to biological factors such as feed efficiency and death loss. Thus there exists a large difference in expected returns between feeders with good production efficiency versus feeders with poor production efficiency;Feeders face additional risk if investment in facilities is financed with a term loan that does not match the term or length of the contractual arrangement. The possibility of termination of the contract or an alteration of terms by the owner places additional financial risk upon the feeder and the feeder's lender;Contracts alter the feeder's cost structure in that fixed costs represent a large percentage of total costs. This implies an increase in operating leverage and an increased sensitivity to changes in total revenue as compared to a sole proprietor.

Date: 1993-01-01
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