identity preservation in the organic wheat supply chain shon
TRANSCRIPT
IDENTITY PRESERVATION IN THE ORGANIC WHEAT
SUPPLY CHAIN
Shon Martin Ferguson
Dept. of Agricultural Economics University of Saskatchewan Saskatoon, Saskatchewan
S7N 5A8 Canada
Tel: (306) 966-4043 Fax: (306) 966-8413
E-mail: [email protected]
July 1, 2003
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Table of Contents
INTRODUCTION............................................................................................................. 1 PURPOSE OF THE PAPER ................................................................................................... 2
THE ORGANIC WHEAT SUPPLY CHAIN................................................................. 2 BACKGROUND.................................................................................................................. 2
ORGANIC WHEAT TRANSACTION TYPES ............................................................ 5
IDENTITY PRESERVATION........................................................................................ 7 TESTING........................................................................................................................... 7 IP AT THE PRODUCER LEVEL ........................................................................................... 9 IP AT INTERMEDIARY AND END-USER LEVELS .............................................................. 10 THE DEGREE OF IP AND PRODUCTION COSTS ................................................................ 11
CHARACTERISTICS OF TRANSACTIONS IN THE ORGANIC WHEAT SUPPLY CHAIN............................................................................................................. 12
TRANSACTION COSTS IN THE ORGANIC WHEAT SUPPLY CHAIN ............ 16 PRODUCER/BUYER TRANSACTION COSTS...................................................................... 16 ANALYSIS OF PRODUCER/BUYER TRANSACTION COSTS ................................................ 17 INTERMEDIARY/BUYER TRANSACTION COSTS............................................................... 19 ANALYSIS OF INTERMEDIARY/BUYER TRANSACTION COSTS ......................................... 20 SUMMARY OF TRANSACTION COST ANALYSIS............................................................... 20
SUCCESS FACTORS FOR ORGANIC WHEAT IP ................................................. 22
EXISTENCE OF SUCCESS FACTORS IN NON-GM WHEAT AND OTHER GRAINS........................................................................................................................... 23
CONCLUSION ............................................................................................................... 25
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REFERENCES................................................................................................................ 26
Introduction
Identity preservation (IP) of grains in Western Canada is becoming an
increasingly important issue for the industry. Changing consumer preferences,
technological advances, international trade and increased regulation of food quality have
created a need for IP systems (Hobbs et. al. 2001). The call for increased IP has been
recently amplified by the potential for genetically modified (GM) wheat varieties to enter
the supply chain. There are considerable worries that consumers may discount the value
of GM wheat, resulting in substantial value losses to the wheat supply chain.
Many new grain products exhibit credence1 attributes, involving production traits
that entail public interest or output traits that have value only if its identity is preserved
(Hobbs et. al. 2001). The value derived from such a credible quality signal can allow for
the supply chain to enter new markets, or maintain current markets when a new quality
trait enters the product, such as the GM wheat case.
Identity preservation of grain is one technique that can give consumers a credible
quality signal for grain products. The most prominent example of IP in the grain industry
is in organic grains. IP is a central marketing concept of organic grains, and has been
practiced since the birth of the industry. There may be lessons that can be learned by the
broader grain industry about IP potential for non-GM wheat and other grains by
examining its functioning in the organic industry.
1 A credence attribute is an attribute that cannot be detected by the senses, even after the good is consumed.
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Purpose of the Paper
The purpose of this paper is to examine the IP system used in the organic wheat
supply chain. The main objective of the paper is to describe how IP functions in the
organic wheat supply chain. This main objective will be met by first describing and
analyzing the supply chain members and relationships that exist in the industry. A
Transaction Cost Economics (TCE) approach will be used to analyze these relationships.
IP systems as they pertain to the organic wheat supply chain will also be explained.
Given the relevant transaction costs and the IP system, the effect of IP on transaction cost
efficiency in organic wheat will then be analyzed. The product of this analysis will be a
set of success factors that allow the IP system to function in the organic wheat supply
chain. The presence or potential for such success factors to exist in any non-organic
grain supply chain will be evaluated to conclude the paper.
The Organic Wheat Supply Chain
Background
The organic wheat industry in western Canada is small compared to the non-organic
wheat industry, but it is a fast growing segment of the wheat industry. Organic wheat
acreage increased by 126 percent from 1998 to 2001 (AAFC 2002). There were 7899
acres of registered organic wheat in Canada in 2001, making it the second largest crop in
terms of area. There were approximately 1200 organic and transitional producers in
Alberta, Saskatchewan, and Manitoba in 2001. The number of producers and acres of
wheat grown have grown since 2001.
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There are several members of the organic wheat supply chain, consisting of
primary producers, grain companies, brokers, export buyers, and processors (AAFC
2002). There are further upstream and downstream components of the supply chain
beyond these five members, such as upstream seed providers, and downstream
distributors and retailers of the processed wheat. This analysis will limit itself to these
five members of the organic wheat supply chain and will examine the IP system as it
pertains to wheat prior to processing.
There are several supply chain combinations between the five members. In the
case of domestic or foreign organic wheat sales, the supply chain begins with primary
producers selling to grain companies, brokers, export buyers, and/or foreign distributors,
who sell to end-users (processors), or it can consist of primary producers selling directly
to end-users. Producers can also sell to foreign end-users through a grain broker. To
generalize, wheat transactions are therefore performed directly from producer to end-
user, or through an intermediary. Horizontal transactions can also take place between
intermediaries.
Given these possible supply chains, there are five main options for organic
farmers to market their wheat. The first option is to sell to a Canadian processor, such as
a mill. The second option is to sell through a broker or to an export buyer, which is
common in the export case. The third option is to make a sale directly to an end-user.
The fourth option is to sell to a grain company. The fifth option is to sell to an organic
livestock producer.
The Canadian Wheat Board (CWB) is legislated to market all wheat and barley
that is destined for export or domestic human consumption in the prairie region of
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Canada. The presence of the CWB creates a unique situation for organic wheat
producers, since the CWB does not market on behalf of organic wheat farmers, but
permits agents to market organic wheat with their permission. Within all the first four
aforementioned options, some grain companies and Canadian processors act as agents of
the CWB. In this case, the farmer makes the transaction with the CWB, and negotiates
for an organic premium over and above the CWB price. Some Canadian grain companies
and processors, as well as all foreign companies and brokers/export buyers are not agents
of the CWB. In these cases, wheat must be sold at the pooled wheat price and bought
back at the cash price from the CWB in order to maintain the integrity of price pooling,
then the primary producer can sell his or her wheat directly to the buyer. In the fifth
option, producers can sell organic wheat for livestock feed without interacting at all with
the CWB. When wheat is sold through a CWB agent and a pooled price is received, the
producer must still negotiate for the organic premium with the buyer. This contrasts to a
non-organic sale of wheat through the CWB, where the total price is negotiated
collectively.
Price discovery for organic wheat is very different than price discovery in non-
organic wheat. For non-organic wheat, the CWB collects extensive surveillance of the
supply and demand situation in all parts of the world. The CWB disseminates and
distributes this information for their use as well as for producers’ use. There are also
future’s markets for wheat in Canada and the U.S, providing price discovery information.
There is much less market information available to the organic wheat industry
compared to the non-organic wheat industry, as there does not exist any institution that
gathers and distributes wheat price information, nor is there a futures exchange for
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organic wheat. This results in significantly less information flows in the organic wheat
case, especially for farmers. Despite these institutional limitations to price discovery,
producers, intermediaries, and end-users communicate prices regularly through person-
to-person communication.
Organic Wheat Transaction Types
The transactional relationship between the producer and buyer for organic wheat
is either a spot market or a production contract. The “buyer” in this case can be one of
the five options discussed earlier, and include either intermediary grain buyers and grain
end-users. In the spot market case, producers grow their wheat and then communicate
their available quantities and qualities to potential buyers. Producers and buyers must
communicate individually with each other through telephone or internet. A producer
may be in a situation where buyers tender bids to the producers if demand exceeds
supply, but the producer may become a price taker at the mercy of buyers if supply
exceeds demand.
Under the spot market or production contract scenario, contracts are written that
specify the given quantity and quality to be transacted. These contracts specify the date
on which the wheat is delivered, how many days in after the transaction in which the
buyer must pay the producer, and which party is responsible for any transportation costs
incurred. The buyer is given a sample of the wheat before the contract is signed, and the
buyer usually specifies in the contract that he/she has the right to reject the wheat if the
quality of the wheat is lower than that of the sample. These quality attributes can include
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physical appearance characteristics similar to those evaluated in non-organic wheat
(appearance, protein content, dockage, etc.), as well as the organic nature of the wheat.
Production contracts between the producer and buyer are agreed to before the
producer has planted his or her wheat crop. The contract specifies the same things as a
purchase contract on the spot market, but may be more vague regarding the date upon
which the wheat is transported to the buyer. A production contract can also include
specifications on the type of seed used by the producer. Many production contracts allow
for the buyer to monitor the wheat as it grows and as it is stored.
The incidence of monitoring by the buyer and more stringent production
specifications implies that production contract transactional relationships entail a higher
degree of vertical coordination between the parties than spot market transactions. This is
not to say that vertical coordination is absent in the case of spot market transactions for
organic wheat. Coordination exists in the organic wheat supply chain relationship
between producers and buyers in the form of logistical coordination through IP protocols.
Spot market contracts are used exclusively by intermediaries and their buyers in
organic wheat transactions. “Buyers” in this case refers to other intermediaries or end-
users. These contracts specify the time, place, quantity, and quality aspects of the
transaction. Some contracts are arranged after harvest, but some are arranged prior to
seeding. The intermediary’s decision on when to contract with buyers depends on their
perception of the risk of not being able to fulfil a contract. It is perceived as less risky to
contract before harvest with organic wheat, as it is a very large crop with plenty of
supply. Intermediaries must contract simultaneously upstream with producers and
downstream with their buyers in order to minimize their risks. Quality inadequacy is the
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greatest uncertainty for intermediaries, because upstream producers may not deliver
enough of the necessary quality required by the downstream contract (Neufeld 2003).
Identity Preservation
An IP system as defined by Dobson (2002) as a “closed loop” marketing channel
that allows traceability of the commodity, beginning with the propagation of the parent
seed through to the processed product on the retail shelf. IP systems use a series of
protocols that require specific sampling and documenting procedures. The IP system is a
tightly coordinated supply chain that documents the transfer of ownership and the quality
attributes of the commodity as it is exchanged from seller to buyer. IP provides
information to the consumer on the origin of a product and how the product was
produced and handled.
In the organic wheat supply chain, IP gives consumers the necessary quality
signal credibility that the wheat contains organic credence attributes. IP in organic wheat
does not add credibility to other important quality characteristics, such as physical
appearance, baking quality, and others attributes that determine wheat quality. Weather
is the greatest cause of wheat quality variability (Wilson and Dahl 1999), and an IP
system cannot negate this factor.
Testing
IP works best with the combination of solid record-keeping and testing results
(Sparks Companies Inc. 2001). While strict documenting procedures are integral to the
functioning of an IP system, an IP system is most effective with the ability to test whether
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or not a high degree of purity has been maintained. In the organic wheat supply chain,
testing can check for “leaks” of non-organic wheat into the supply chain.
Organic wheat is a credence good, meaning that the quality attributes of organic
wheat are impossible to discern, even after consuming it. There is not a convincing body
of scientific evidence that purports that organic wheat is better for consumers than non-
organic wheat. Despite this lack of evidence, many consumers believe that organic wheat
is superior to non-organic wheat in its composition and production, and gain utility from
its consumption in holding that belief. The main credence attribute that is “contained” in
the wheat is the absence of pesticide residue in the wheat. Very small amounts of
pesticide residue are allowed in non-organic wheat. Other credence attributes relate to
the use of “sustainable” production practices, such as an absence of inorganic fertilizer.
It is impossible to scientifically test for all of the credence good qualities of
organic wheat. Pesticide residues can be tested for, but this does not entirely rule out the
chance that pesticides were applied to the wheat, since the residues of some pesticides
may break down quickly enough to disappear before it is tested. Testing for pesticide
residues is performed by some buyers of organic wheat (Pletz 2003), but it is
prohibitively expensive. Thus, testing for organic purity cannot be an integral part of the
IP system for organic wheat.
Given the credence nature of organic wheat and the inability to adequately
scientifically test for organic quality attributes, an information asymmetry problem
results (McCluskey 2000). Information on the quality of organic wheat is asymmetric
because only food producers know if their products contain organic quality attributes.
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The IP system must rely entirely on documentation protocols in order to maintain purity
along the supply chain.
Given the inability to adequately test for the attributes of organic wheat, many
protocols are in required in the supply chain. Producers must be certified by an
accredited organic certification agency in order to sell their wheat as an organically
produced product. Intermediaries and end-users must also be certified by a quality
assurance agency.
Producer certification agencies require the farmers to do many things that both
ensure that their wheat is grown in an organic manner, and that its identity is preserved
on the farm. The most significant and restrictive protocol required by producers is that
their farm is entirely organic. “Parallel production” (producing both organic and non-
organic outputs) is not allowed. This restriction aids to ensure that organic wheat cannot
be mixed with non-organic wheat. Producers are also required to maintain strict
documentation on their production techniques and on the location of their wheat once it is
harvested. Buyers require that organic producers follow these procedures and require the
documentation as evidence that the wheat is in fact organic.
IP at the Producer Level
IP at the farm level can take several forms, depending on the degree to which IP is
requested by the buyer. The level of IP that is required by the certification agency is to
identify the field or fields upon which the product was grown. Certification agencies do
not require that wheat from different fields be kept separate, but buyers can request for
this to be performed. This “field to plate” IP is the highest degree of IP that can be
performed at the farm level.
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IP at Intermediary and End-User Levels
IP must be stringently maintained beyond the farm gate in order for the final
organic wheat product to be labeled as “organic” at the retail counter. Organic wheat IP
continues as the wheat is transported from the farm. Affidavits must be signed and
witnessed each time that the wheat changes hands. Information on the wheat’s “history”
is passed along on a paper trail until a label is stamped on the final product.
Transportation and handling containers must be thoroughly cleaned before use.
In the case of wheat purchased by grain companies or export buyers, wheat is
transported to facilities where further cleaning and redirection can occur. IP is important
in these facilities as well, but IP is practiced to varying degrees. The most important
element preserved at these facilities is the organic attribute of the wheat. Elevators are
often dedicated solely to organic grain in order to achieve this level of segregation.
Individual producers’ deliveries can be segregated at these facilities, which allows for the
highest level of IP to occur, but several producers’ organic wheat is often combined into
one storage bin. There are also opportunities for blending wheat of different physical
qualities in an effort to provide downstream buyers with a more homogenous quality.
End-users of wheat must continue to maintain IP. Most organic wheat products
do not require “field to plate” traceability at this time, so it is often unnecessary for IP to
go beyond segregating organic and non-organic wheat. The demands of end-users define
the degree to which grain companies and export buyers need to preserve the identity of
their wheat.
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The Degree of IP and Production Costs
IP systems increase production costs at each level of the supply chain. The extent
to which costs are increased depends on the degree of IP, whether it is identified from the
specific field, specific producer, or from any organic producer. IP at the field level is the
most costly IP system for all levels of the production chain.
The severity of differences in production costs between levels of IP is different
for each supply chain stage. At the farm stage, identity is naturally preserved at the farm
level. There are some costs for farmers to preserve the identity of wheat from separate
fields, as more storage bins may be necessary.
Transportation costs are increased as the degree of IP increases. At farm level IP,
separating fields may not allow for semi trucks to utilize their capacity, resulting in
higher costs. This circumstance can also occur if rail cars cannot be filled to capacity in
the case of rail transportation. In the case of offshore exports, the most efficient method
of transportation is by bulk boatload. Using containers to ship wheat overseas to
maintain field or farm IP is much more costly than by bulk.
At intermediary and end-user stages, field-level and farmer-level IP can be much
more expensive than organic-level IP, as it can significantly disrupt the large economies
of scale at handling facilities. As mentioned earlier, blending economies are also an
important production cost consideration. To summarize, IP can significantly increase
production and transportation costs, depending on the level of IP required in the supply
chain.
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Characteristics of Transactions in the Organic Wheat Supply Chain
Transaction Cost Economics (TCE) is a field of economics that examines the
efficiency of transactions between members of the supply chain. The main idea behind
TCE is that there is a cost not only to produce goods, but also to transact them between
stages of production (Coase 1937). These transactions entail a cost whether they are
performed in the market or organized within a single firm. The efficiency goal of firms
from a TCE perspective is to minimize the sum of transaction costs and production costs.
This analysis will examine the significance of transaction costs related to the organic IP
system.
As stated by TCE theory, the key characteristics of transactions are the degree of
uncertainty surrounding the transaction, the degree of asset specificity, and the frequency
of the transactions (Williamson 1979). By defining these characteristics in the organic
wheat supply chain, one can better understand the types of transaction costs that arise.
There are three main potential uncertainties regarding transactions between
producers and buyers, defined as quality uncertainty, price uncertainty and payment
uncertainty (Hobbs and Young 2000). While all three uncertainties are important, this
analysis will focus on the aspect of quality uncertainty, since it is the only uncertainty
that can potentially relate to the use of IP systems.
Quality inadequacy risk can be a concern to producers and their buyers in the spot
market or production contract scenario if the buyer rejects the load due to quality
inadequacies. In this situation the producer can pay the added cost of taking his/her grain
elsewhere, or can negotiate a lower price with the buyer. The expectation is that
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discounts would be larger for quality inadequacies in organic wheat than non-organic
wheat, as most organic wheat end-users demand only high quality wheat.
A clause to guard against inadequate quality may be necessary from the
perspective of the buyer since their own downstream buyers may have very specific and
high quality specifications. The IP protocols may prohibit, or the frequency of
transactions may be too low, for blending or substitution with other producers’ wheat in
order to compensate for the lower quality. Quality specifications are very important as
wheat continues along the supply chain, from the intermediary grain companies and
export buyers to the end-users.
There is a possibility of wheat buyers using a quality inadequacy clause in an
opportunistic manner, since producers may have incurred costs specific to the transaction
before quality is assessed by the buyer. When the wheat has been delivered to the
buyer’s location, the next best price available to the producer is another buyer’s price less
the cost to transport the wheat to the new buyer’s location, less the added logistical costs
to the farmer. If the buyer knows this “salvage value” of the wheat, he or she may act
opportunistically by saying that the quality is inadequate and attempt to renegotiate a
price for the wheat.
Despite the apparent risk for opportunism by the buyer, the risk of quality
inadequacy is perceived by producers to be small (Pletz 2003), as sampling procedures
ensure that the buyer has adequate information on the wheat’s quality before delivery
occurs. Although the Canadian Grain Commission (CGC) can be called upon as a third
party to assess quality if there is a disagreement, this is not very common. The desire of
buyers to maintain a good reputation among sellers is the major method through which
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opportunistic behaviour is negated. Reputation is a very powerful motivator for parties to
act sincerely because the organic wheat supply chain is composed of relatively few
domestic members, and these few members are efficacious in transmitting reputation
information throughout the supply chain (Pletz 2003).
The problem of quality inadequacy is greater when transacting with wheat end-
users in the organic wheat supply chain (Neufeld 2003) than with intermediaries. It is not
unusual for shipments to be rejected by end-users. Quality inadequacy risk is higher
because end-user specifications tend to be more stringent than those used by the grain
company. While intermediate customers are accustomed to variable quality due to
weather variability, end-users expect quality to be much more consistent. The grain
company or export company acting as a middleman between producers and end-users has
the challenge of buying heterogeneous qualities of wheat and providing homogeneous
quality to end-users.
Of the several wheat quality factors, attributes such as dockage and physical
characteristics are at a far greater risk to be called into question by a buyer than the
organic nature of the wheat. This is true in both producer-intermediary transactions and
intermediary-end-user transactions (Pletz 2003 and Neufeld 2003). It is perceived that
the protocols used by producers and intermediaries are deemed as sufficient by end-users
in guaranteeing proper IP of the organic trait, given that the producer is certified organic.
Problems with the integrity of IP at the farm level are generally thought to be dealt with
by the certification agency.
Payment uncertainty can be defined as the chance that a buyer will not make
payments within the time period specified by the contract. Payment uncertainty is
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perceived as a very small problem for both producers and intermediaries (Pletz 2003 and
Neufeld 2003). Payment uncertainty used to be a more significant problem a few years
ago when organic grain had begun to be transacted, but it is no longer a concern.
Payment uncertainty for producers and intermediaries is strongly negated through the
importance of the buyer’s reputation in domestic transactions. The importance of the
buyer maintaining a good reputation is not quite as strong an incentive for foreign
transactions. Failure of a buyer in another country to pay can have much less severe
reputation consequences, as it is difficult to communicate reputation information to the
various sellers transacting with that buyer.
Price uncertainty can be defined as the uncertainty of the seller receiving a “fair”
price for a given quality. Producer and intermediaries believe that price discovery
systems are adequate (Pletz 2003 and Neufeld 2003). Information asymmetries may exist
for producers, resulting in uncertainty over current and future price. It is difficult to
gauge the amount of price uncertainty that exists, and further research is necessary in this
area.
Transactions between producers and buyers do not include specific assets, as there
are several buyers and sellers of organic wheat, and the organic standards required by the
buyers are very similar. Transactions between grain companies and export buyers and
end-users do not include specific assets, for similar reasons to those described above.
Transactions occur infrequently between levels in the organic wheat supply chain.
Producers may sell wheat through a few transactions, or even one transaction, on an
annual basis. Individual grain companies and export buyers and end-users also tend to
make larger, fewer transactions in a year.
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The combination of low uncertainty, low asset specificity, and low frequency of
transactions leads to the view that a low level of vertical coordination is necessary in
order to minimize transaction costs. The use of spot markets and some production
contracting illustrates an agreement between this theoretical prediction and the reality of
organic wheat marketing.
Transaction Costs in the Organic Wheat Supply Chain
Transaction costs experienced by the producer can be categorized as search costs,
negotiation costs, and monitoring costs (Hobbs 1997). The previous analysis has
discussed the issues of quality uncertainty, price uncertainty and informational
asymmetry resulting from the credence nature of organic wheat, as well as payment
uncertainty. Given these properties of organic wheat supply chain relationships,
transaction costs between producers and their buyers, as well as between intermediaries
and their buyers can be defined and discussed.
Producer/Buyer Transaction Costs
The Saskatchewan Organic Directorate (2000) and an Agriculture and Agri-Food
Canada (2002) have published reports in which they give producers advice on how to
minimize problems between producers and buyers when making organic product
transactions. These tips illustrate the relatively important transaction costs for producers
and buyers in the organic wheat supply chain.
Search costs include initially finding a buyer for the organic product. This is
performed by communicating directly with the various buyers. The producer can check if
the buyer is licensed by the CGC, which is performed by contacting the CGC. The buyer
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should also check the reputation of the buyer by calling previous clients of the buyer and
asking about their experiences with the buyer.
The main negotiation cost for producers and buyers is the writing and agreement
to a contract. Contracts should include the quality, quantity, price, timing and method of
payment, details of shipping (such as who pays freight and the shipping date), who pays
for cleaning and grading, and what procedures are to be used for testing and grading.
Producers and buyers should meet in person and discuss the specifics of the contract.
The producer’s wheat quality must be determined by the buyer, which can include visual
examination by the buyer, as well as protein tests and possibly pesticide residue tests.
There are several monitoring costs that result mainly from ensuring that the
contract is upheld, including quality uncertainty monitoring costs. There may be a need
to use a third party such as the CGC if there is a quality dispute, such as quality
inadequacy problems perceived by the buyer upon delivery. Producers should arrange to
receive weight information at a second scale and upon unloading the product at the
buyer’s location. Late payment problems can be handled by contacting the GCG or by
hiring a lawyer.
Analysis of Producer/Buyer Transaction Costs
Given the transaction costs between producers and buyers in the organic wheat
supply chain, it is desirable to know the magnitude of these transaction costs. It is
difficult to quantify transaction costs, even when qualitative survey data or quantitative
proxy data is available. Transaction cost data is not available for the organic wheat
supply chain, which further amplifies the difficulty of interpreting the size of these
transaction costs.
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Given the difficulties of quantifying transaction costs in the organic wheat supply
chain, it is more fruitful to compare the transaction costs of the organic wheat supply
chain to the non-organic wheat supply chain. The non-organic wheat supply chain can be
used as a benchmark from which the organic wheat supply chain can be compared. Any
transaction costs in the organic market that are expected to be significantly larger than its
counterpart in the non-organic market can be used as an indicator that the particular
transaction cost is large.
The majority of search, negotiation, and monitoring costs are expected to be fairly
similar between the organic and non-organic supply chains. Three particular transaction
costs in the organic supply chain are expected to be relatively larger, those of price search
costs, reputation search costs, and quality inadequacy costs.
Price search costs are expected to relatively larger for organic wheat because of
the inefficient methods of price information distribution that are currently employed,
namely person-to-person communications. This transaction cost is high for producers,
but low for buyers that may have economies of scale in price discovery.
Reputation costs are expected to be relatively high for producers because it may
take significant time resources in order to properly determine the reputation of a buyer.
Several phone calls may be made to check a buyer’s reputation for only one transaction.
Reputation costs become lower over time, after a buyer establishes a good reputation with
a producer or within the general industry. If producers maintain the same buyer over
time, this cost is low, but if producers are constantly switching, then reputation must be
checked more often and this cost rises. Reputation search costs are low for buyers
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because the organic certification agencies monitor producer reputations, which can be
checked by a buyer.
Quality inadequacy costs are expected to be large for producers, since discounts
for quality inadequacy can be larger and more unpredictable than in the non-organic
wheat market. The ability to use the CGC as a third party to settle quality disputes can
minimize these costs. Some buyers of organic wheat are not licensed by the GCG and
thus disputes must be settled by some other means, resulting in higher costs. Quality
inadequacy cost is expected to be larger for the buyers as well, since it can be more
difficult to find organic wheat of a suitable quality if the initial producer has poor quality
wheat. The cost to the buyer of sourcing wheat from another producer is relatively lower
for organic wheat than for other organic grains with lower total acreage. It is more
difficult to find substitutes sources when very little total product is grown.
Intermediary/Buyer Transaction Costs
An interview with an intermediary in the organic wheat supply chain provided
some knowledge on the nature of transaction costs between intermediaries and their
buyers (Neufeld 2003). The transaction costs in this relationship are similar to those
between producers and their buyers. There are search costs associated with finding the
buyer and seller finding one another, as well as reputation search costs. Negotiation costs
include the specification of a contract that specifies all of the characteristics of the
transaction. Monitoring costs include the costs required to ensure that payment is
completed. Payment can become more complicated in foreign transactions, where banks
in each country need to become involved. There can be a cost of inadequate quality upon
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delivery, resulting from discounts or rejections of shipments. Quality dispute resolution
is difficult in foreign transactions, as the CGC cannot be used as a third party.
Analysis of Intermediary/Buyer Transaction Costs
Using the non-organic wheat supply chain as a benchmark illustrates that quality
inadequacy costs are relatively high. Quality inadequacy problems occur more often in
organic wheat than with non-organic wheat, and the cost of subsequent discounts by the
buyer, or complete rejection by the buyer are likely to be significant. Price search costs
for organic wheat are expected to be similar to non-organic wheat transactions, where
intense personal communication is the backbone of price discovery as well. Reputation
search costs are not expected to be high, as the same reputation searches must be made in
the non-organic wheat market.
Summary of Transaction Cost Analysis
Quality inadequacy is a significant transaction cost in the relationship between
producers and their buyers, as well as between intermediaries and their buyers. It is
important to note that the present quality inadequacies are unrelated to the organic IP
system. Most quality inadequacy problems relate to physical traits such as appearance,
weight, and protein content. Quality-related transaction costs do not relate to the IP
system used in the organic industry, but rather to inadequate quality communication
between the levels of the production chain on other terms. Sampling procedures do not
always predict quality well, and different quality standards between countries can result
in misunderstandings over desired quality levels. It appears that the IP system for
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organic wheat, as well as other grains, is doing its job very well, despite the inability to
test for the organic trait.
The use of an IP system in organic wheat coordinated by a third party does not act
to significantly change the relationship between members of the supply chain. Despite
the fact that quality uncertainty necessitates increased vertical coordination in order to
lower transaction costs (Kennett 1998), the use of an IP system to negate organic quality
uncertainty has not led to highly coordinated forms of vertical coordination. The
complicity of transactions increases due to the need for organic certification papers to
accompany the wheat as it moves through the supply chain, but spot markets can still
perform well in the organic wheat supply chain. The most important characteristic that
allows low degrees of vertical coordination to succeed within organic wheat IP is that the
specific identity of the partners is not critical to the transaction (Williamson 1979). The
organic IP system allows the buyer to be confident that the organic wheat contains the
same organic quality traits, regardless of the certified producer from which it was
purchased.
The results of the transaction cost analysis mention IP very little directly, but they
do highlight the vital importance of using an IP system in the organic wheat supply chain.
If an IP system was not present, there would be a propensity for quality uncertainty to
occur for the organic trait in addition to the physical trait uncertainty already occurring,
and transaction costs would increase. IP is integral to maintaining efficiency in the
organic wheat supply chain, as it substantially lowers transaction costs necessary to
credibly signal organic quality.
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The current IP system for organic grains must also be evaluated in terms of
efficiency compared to the next best alternative. Kennett et al. (1998) state that two
conditions must exist in order for an initiative in supply chain management to continue.
The first condition is that the economic rents created for the whole system must be
greater than the economic rents generated from alternative systems. The second
condition is that each party’s share of the economic rent must exceed their costs.
The first condition can be evaluated by looking at the next alternative to a third
party certification IP system, which is the internalization of IP within a firm in the supply
chain, meaning vertical integration of production, intermediaries, and end use. The
coordinating costs of a vertically integrated system would likely be much higher than the
cost of funding the current third party certification agencies, so it is very easy to believe
that the first condition is satisfied with the present IP system. The second condition is
also likely met, as the decreased transaction costs from quality inadequacy far outweigh
the cost of maintaining a certification agency.
Producers and intermediaries’ opinions correspond with these ideas, believing that
sustaining the IP system in the organic industry is very important for the ability of
producers and intermediaries to satisfy end-users that grain contains the organic trait.
Success Factors for Organic Wheat IP
From the previous analysis of IP in the organic wheat supply chain, one can define
some success factors for IP in organic wheat:
1) The use of a third party in order to monitor and coordinate the IP system at all levels
of the supply chain.
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2) Stringent documentation and protocols within the IP system (especially important if
the quality trait is a credence quality that cannot be tested for).
3) Trust and reputation are important to the members of the supply chain
4) The quality trait that the IP system is credibly signaling must be desired by end-users
enough for the premiums from using an IP system exceed the costs.
Existence of Success Factors in Non-GM Wheat and Other Grains
Some of the IP success factors mentioned above could exist in a non-GM wheat
or other grain supply chains, while some success factors do not. It is likely that a third
party could be instituted into any grain supply chain to coordinate an IP system, as
several agencies already provide a regulatory function in grain supply chains.
The use of stringent protocols and documentation may be more difficult outside of
organic supply chains, especially when IP for credence qualities could require that an
entire farm grow only crops with that credence attribute. In the case of organic
production, an entire farm must grow only organic products, which helps to limit
contamination with non-organic products. The ability to restrict “parallel production” for
other IP crops may not be attainable. Producers may not want to completely stop
growing GM crops on their land in order to comply with protocols allowing them to sell
non-GM wheat and other products with beneficial credence qualities
Trust and reputation are as important to the non-organic supply chain as is to the
organic supply chain, so this success factors can likely be met for non-organic IP
systems.
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Finally, the need for end-users to be willing to pay enough for the IP system in
order to exceed the system’s costs may be lacking in many potential applications of IP to
non-organic grains. In the case of using IP for non-GM wheat or other grains, there are
significant production and transportation costs involved with creating such a system. It is
difficult to know if end-users would be willing to pay enough to cover such a system’s
large costs. There is likely more opportunity for the supply chain to extract a premium
for IP use in niche markets, such as nutraceuticals and specialty grains. Consumers are
willing to pay more for some credence attributes than others, and an IP system must only
preserve the identity of a quality when consumers are willing to pay enough to cover its
cost.
There are success stories of IP systems functioning in non-organic grains. An
excellent example is Warburtons Ltd., a British baking firm purchasing IP Western
Canadian wheat. This arrangement has been tremendously successful, and premiums
paid by Warburtons exceed the cost of the IP system (Kennett et al. 1998). The quality
attributes protected by the IP system in this case are not credence attributes, but rather
specific varieties of wheat, and therefore can be easily tested to ensure purity. This
allows the protocols for Warburton wheat IP to be much more relaxed than in the organic
supply chain. A high premium paid by Warburtons and the low restrictiveness of the IP
system due to testability make this arrangement successful. It is unlikely that the entire
volume of Western Canadian grain production could ever benefit from such an IP system,
as many grain customers are not interested in grain quality attributes that necessitate a
costly IP system.
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Conclusion
IP is one technique that has the propensity to credibly signal certain quality traits
in grain supply chains, and is successfully used in the organic supply chain. The organic
wheat IP system has proven that credence traits can be successfully protected with IP,
with minimum quality inadequacy transaction costs. IP systems can have various degrees
of restrictiveness for production and handling of the product, resulting in various levels of
production and transportation costs. IP can have a future in the non-organic supply chain,
but the increased costs of the system must not exceed the premium derived from using an
IP system, and members of the supply chain must be willing to incur production and
transportation costs as well as decreased flexibility in order for the system to succeed.
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References
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Wilson, W.W. and B.L. Dahl. 1999. “Quality Uncertainty in International Grain Markets: Analytical and Competitive Issues.” Review of Agricultural Economics. 21(1):209-24.
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