Economics and Management of the Food Industry

Jeffrey Dorfman, Jeffrey H. Dorfman

• Publisher: Routledge
• Year: 2014
• Print ISBN: 9780415539920
• eBook ISBN: 9781134456567
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book analyzes the economics of the food industry at every stage between the farm gate and the kitchen counter.

Central to the text are agricultural marketing problems such as the allocation of production between competing products (such as fresh and frozen markets), spatial competition, interregional trade, optimal storage, and price discrimination.

Topics covered will be useful to students who expect to have careers such as food processing management, food sector buying or selling, restaurant management, supermarket management, marketing/advertising, risk management, and product development. The focus is on real world-relevant skills and examples and on intuition and economic understanding above mathematical sophistication, although the text does draw on the nuances of modern economic theory.

1 The basics of the food industry

 

The food industry is an incredibly diverse sector of the world economy, ranging from farming to food processing, wholesaling, retailing, and food service. Some parts of it are very local, but international trade is a large component. Some parts of the food industry are very well documented, such as food processing and the major commodity markets in developed countries; other parts lack comprehensive data, such as sales of farm production and small-scale food processing in less developed countries. Certainly, the world food industry represents at least $4 trillion in value.

In this book, the focus will be on the food industry from the farm gate to the dinner table. Discussion will cover the economics and management of food processing firms, wholesalers (including exporters and importers), and retailers. The book will specifically cover grocery retailers (supermarkets) and also restaurants. Many of the topics covered apply to firms at all three of those stages, and interregional trade, risk management, and game theory will be covered in the chapters to come. Some topics apply to just two of the three stages: optimal storage, for example, really applies mostly to food processors and wholesalers.

Size, scope, and value of the industry

The food and fiber sector consists of farms, input suppliers, food processors, wholesalers, retailers, restaurants, natural fiber textiles, paper products, wood manufacturing, tobacco product manufacturing, small and large food markets, restaurants, caterers, and food service facilities. This is an enormous economic sector. In the United States, the food and fiber sector represents about 16 percent of the economy, or about $2.5 trillion per year, and supports roughly 20 million jobs.¹ Actual farm-level production of agricultural commodities represents only 14 percent of the food and fiber sector, totaling around $350 billion or a little over 2 percent of the total gross domestic product (GDP). The next stage, food processing, adds $750 billion in value or about 5 percent of the total GDP. Tobacco and wood manufacturing add an additional $120 billion. Restaurants, bars, and other food service establishments produce approximately $575 billion of the United State's total gross domestic product, or almost 4 percent of the total economy. The remaining $700 billion of the food and fiber sector comprises the food wholesaling and food retailing (supermarkets, etc.) industries.

The food industry is based on the transformation of raw products into food products. The food industry takes farm commodities and prepares them for retail according to consumers' tastes and preferences. Sometimes, the transformation is trivial: a peach on the farm turned into a peach in the grocery store by basically washing it and transporting it to the grocery store; while other times the transformation is significant: rice fermented into saké (a Japanese rice wine), bottled, labeled, and shipped to a foreign country for sale. The food industry gets basic ingredients to markets for people to purchase such as meat, fish, fruits, and vegetables. The food industry also produces highly processed, complex foods with many ingredients for the convenience of the consumer who does not want to cook (or cook from scratch); examples here include items such as frozen dinners, canned soups, instant pasta bowls, and to-go dishes now widely available in developed-country markets. At the other extreme, restaurants and caterers take the food all the way to the plate and only require that the consumer do the eating. All these activities take place for one simple reason: the companies involved hope to make a profit through their efforts and by selling their products. What guides all the companies that populate the food industry in this profit-seeking quest is opportunities for arbitrage.

Arbitrage—a central concept for our analysis

Arbitrage is the most important concept in economics. The most popular definition in this era of advanced financial engineering is that arbitrage is the process of profiting from price differentials in different markets for the same product. For example, a gold trader might buy gold in London and sell it in New York after spotting that gold is $0.01 per ounce less expensive in London. While making one cent per ounce may not seem exciting, if the trader buys and sells 10,000 ounces, the profit is $100. Even $100 may not seem exciting, but since the transaction takes only seconds the hourly profit (or annualized return on investment) can be very high.

In a more general, economic sense, arbitrage is the taking advantage of price differences in linked markets to earn profits. Within the context of the food industry, arbitrage is why a company decides to store a product for later sale rather than selling it now; it expects to profit from a higher price later. When a juice processor sees higher prices for juice than the price of the fresh fruit plus processing cost, it arbitrages between those two markets by buying fruit and making juice. Companies that buy a product in one country in order to resell it in another country at a price that is higher by more than the transportation cost are arbitraging between the product markets in the two different countries. Essentially, this broader view of arbitrage includes all profits earned from recognizing differences in a product's potential net value between markets that can be linked by some physical, spatial, or temporal transformation.

Arbitrage defined in this broader manner is an extremely valuable process. When a price difference (adjusted for transformation costs) exists between markets that can be linked, the arbitrager is helping the consumer by moving resources from markets where their value is lower to higher-valued uses. The persons or companies doing the arbitrage are rewarded with profits, but they also serve society by allocating resources efficiently among markets according to the relative strength of demand in those markets. In the food industry, markets can be linked by

 

● physical transformation: tomatoes into spaghetti sauce,

● spatial transformation: Georgia shrimp shipped to New York City, or

● temporal transformation: apples harvested in the fall, stored, and sold months later.

 

In terms of the economics and the mathematics, all of these transformations function in an identical manner. The transformation is the link between two otherwise unrelated markets. The opportunity to arbitrage and earn the resulting profits is the incentive that causes firms in the food industry to transform products and link the markets together. This transformation of products and the subsequent linking of markets leads to increased consumer and producer surplus, economic-speak for a world that is better off.

A trip through the food industry

In the chapters to follow, I will attempt to lay out for the reader the economic principles that apply to the proper management of companies in all facets of the food industry after food leaves the farm. In the realm of food processing, you will learn how to manage a food processing factory, how to be a buyer or a salesperson for a food processing company, and how to determine which products are the most profitable to make. In the marketing (or wholesaling) sector, you will learn the economic rules that govern decisions about storage, trade between regions or countries, and price discrimination. Price markup rules and the economics that help a person derive them will be covered for food processors, wholesalers, and retailers. Most of the book covers the economic principles underlying profit-maximizing management of food industry companies; however, some parts focus more on management, such as how companies use risk management tools and common rules of restaurant management.

While this book is focused on the food industry, the economic principles that apply to the management of a food company apply to virtually all other industries. The things you will learn from this book could be used to run a department store, a jewelry store, any manufacturing facility, and almost any company that sells a product or service. The lessons of running a company in the food industry easily can be applied to the management of businesses in all sorts of industries. Hopefully, whatever career you end up in, you will find the lessons and principles contained here useful for success in that career.

2 Cost economics for processing plants

Standard microeconomic theory tends to present cost analysis using nice smooth curves so that students can find where tangencies occur and the optimal point at which to operate. Unfortunately, in the real world, not all inputs are infinitely divisible. You cannot use one half of an assembly line; it is all or nothing. As we will see in this chapter, the fact that inputs such as workers and assembly lines come in discrete (not continuous) amounts mean that the familiar cost curves transform from their normal, smooth shapes into new shapes that resemble shoddy staircases.

Economists like to call such discretely adjustable inputs lumpy inputs. Working with lumpy inputs also means that rather than being able to use calculus to solve mathematical problems, we need to resort to more basic math and some careful thinking. So, at least for the remainder of this chapter, solving economic problems will rely on the ability to determine the minimum of a set of numbers and the basic operations of addition, subtraction, multiplication, and division. If you can temporarily forget all that you learned about taking deriva-tives and setting them equal to zero, let's do some real-world economics the old-fashioned way.

Fixed versus variable costs in the real world

In our introductory microeconomics class, the concepts of fixed and variable costs are quite straightforward: fixed costs are costs that don't change when the quantity produced changes, whereas variable costs are costs that do change as the quantity of output changes. This dichotomy is simple and neat. However, in the real world it gets a little bit more complicated. First, you must define the time period to be able to identify which costs are fixed and which are variable. Are you analyzing costs for a day, a week, a month, a year, or a decade? A lot of costs are fixed when you look at production over short periods of time, but become variable costs when you are analyzing a longer time period. Second, some costs vary only when the quantity produced changes from 0 to 1. An example is the costs to start up (or shutdown) a plant or an assembly line. If we are thinking about a peach packing plant, these start-up and shutdown costs are variable costs when looking at the costs for a season, but would be fixed costs if we are looking at a week in the middle of July. Another example is depreciation. The depreciation for a building is a fixed cost in virtually all circumstances, but depreciation on a piece of equipment might be a variable cost if the depreciation schedule is based on hours of use.

Variable costs can also be more confusing or subtle than they are made out to be in the standard micro class. Some costs vary with the quantity produced; that fits our traditional definition of a variable cost. But there are also costs that vary with hours of operation (say heating and cooling costs) or the rate of production (running an assembly line faster may use more electricity) that do not strictly vary with output, but are somewhat tied to the level of production. In general, we will consider all such costs to be variable costs but we will need to be careful that we handle such costs properly when choosing the optimal manner in which to operate a plant.

Building a cost function through economic engineering

To build a cost function for the sort of real-world situation that one typically encounters in food processing plants as well as almost any other factory or assembly-line-style operation, the best way is what I call the economic engineering approach. I learned this method from a classic book by Bressler and King (1978).¹ Much of what is presented here follows or is modified from their presentation on this topic.

To begin your analysis of the firm's costs, draw a picture of their operation, representing the process as a line and showing each step in the process from start to finish. Figure 2.1 below provides an example for a simple fruit packing operation. In the diagram, you can see where the fruit enters the packing shed (called the receiving/dumping station), moves through a washing operation, and then gets labeled. The next stop is the sorting station, where fruit are separated by grade as necessary and removed if damaged. The fruit is then packed into boxes, and the final station on our ...

Table of contents

• Cover
• Half Title
• Routledge textbooks in environmental and agricultural economics
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of figures and tables
• Preface
• Acknowledgements
• 1 The basics of the food industry
• 2 Cost economics for processing plants
• 3 Pricing economics for food processors
• 4 Trade among regions
• 5 The economics of storage
• 6 Plant location and size decisions
• 7 Risk management
• 8 The economics of the marketing sector
• 9 Price discrimination
• 10 Imperfect competition and game theory
• 11 Spatial competition
• 12 The food service industry
• 13 Food retailers
• 14 Launching a new product
• 15 Special organizational features in the food industry
• Notes
• Index