Ebook Adjustment Costs of Quality Price and the Value of Long-Term Contracts: the US Pork Industry Case
The use of long-term contracts has been explained by their function as a safeguard against rent-dissipating activities in the context of relationship specific investments (Williamson, 1975, 1996; Klein, et al., 1978). This transaction cost economics (TCE) explanation on the choice of long-term or formal contracts in procurement practices has also been supported by empirical evidences (Joskow, 1987, for coal industry; Gallick, 1984, for tuna industry; Lyons, 1994, for U.K. engineering subcontracting).
In contrast, Masten’s recent studies of contracting in the U.S. trucking industry reveal that the value of long-term contracts may originate from saving the costs to negotiate a price for each transaction in a series by intertemporal bundling’ of heterogeneous freight transactions (Masten, 2006; Lafontaine and Masten, 2002). Masten claims that the formal contracts’ function of economizing on the cost of pricing heterogeneous transactions may explain a class of contracts that involve little in the way of relationship specific investments, including franchise contracts, equipment lease, distribution and advertising agreements, and software licenses.
Along the lines of Masten’s analysis of the use of long-term contracts, we examine economizing benefits of long-term contracts other than the TCE explanation of safeguarding against opportunistic hold-up. However, while Masten emphasizes savings on measurement costs arising from non-contractible attributes of a task in a transaction, we examine savings on price adjustment costs for measurable quality attributes of intermediate goods by the use of long-term contracts in the U.S. pork industry. Specifically, we argue that long-term contracts may be explained by the ‘concerted’ coordination function of the contracts as compared to the ‘spontaneous’ coordination function of spot markets.
In order to procure hogs of consistent size across multiple suppliers and through time, for example, a pork processing firm provides an incentive payment to induce hog suppliers to make an optimal decision (from the pork packer’s perspective) on timing to market, which affects the mean and variance outcomes of the sizes of hogs procured. When hog suppliers’ decision on timing to market is primarily influenced by the exogenously-determined prices of a “base hog” and feed within a certain marketing time horizon, hog suppliers’ decision may result in suboptimal quality outcomes for a hog processor. Given the volatility in these market prices, the processor’s incentive payments for quality attributes must adjust to changes in these two exogenously determined prices to preserve the hog supplies’ incentive to deliver the desired level of quality. However, the information costs originating fundamentally from human being’s bounded rationality (Simon, 1947) hinder the timely adjustment of the quality price.
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