The Political Economy of Differentiating Markets: Facing Reality inside the U.S. Department of Agriculture

Grade standards are dead! Long live grade standards! Although an exaggeration, elements of the analogy aptly relate to the role of the U.S. Department of Agriculture (USDA) in the realm of commodity standards and grading. For many years, commodity grade standards have been declared obsolete or irrelevant due to long-standing trends in agricultural and food production and marketing.

Economic trends within the food system mirror changes taking place throughout the economy—growing consolidation at all levels, increasing use of supply chains in lieu of arms-length spot market transactions, and ever-increasing product offerings tailored to specific market niches. If the food system is no longer characterized by atomistic competitors producing and marketing relatively few basic commodities with limited variation in product attributes, what economic role is served by USDA involvement in commodity standards and grading?

Commodity standards serve multiple and often overlapping functions. Product identity standards serve to protect market participants from fraudulent or deceptive practices as products move through the production and marketing chain. Grade standards serve to facilitate markets by categorizing commodities according to economically important attributes. It is also possible that under certain circumstances standards may play a less benevolent role if they are used as a tool to extract economic rents for particular segments of the industry.

In this paper, we focus on commodity standards and grading services primarily as mechanisms that facilitate the operation of the agricultural and food production and marketing system.¹ In this vein, Giovannucci and Reardon identify two important developments relating to the role of grades and standards in an increasingly globalized agricultural and food economy. First, there is a shift from commodity-oriented “mass markets” toward markets characterized by highly differentiated products and niches. As a result, grades and standards are shifting from a traditional role of reducing transaction costs in broad commodity markets toward an emerging role as strategic tools for product differentiation and market segmentation. Second, there is a shift in the role of grades and standards from emphasis on outcomes (i.e., measurable product attributes) toward processes (e.g., how the product is produced, processed, handled, etc.).

Changes in the role of the USDA in the arena of grades and standards mirror the worldwide developments noted by Giovannucci and Reardon. Our premise is that USDA involvement in commodity standards and grading continues to provide benefits in traditionally important ways, but that the functions performed by the USDA are changing and thus maintaining relevance, as the agricultural and food system itself evolves.

An Economic Perspective

The USDA has long been involved in setting commodity standards and providing grading services. Setting commodity standards refers to the development and establishment of specific criteria for categorizing a commodity into classes or grades. Standards are applied during the process of providing grading services. Bockstael categorizes commodity grades according to two basic functions: facilitating handling and long-distance trade and differentiating products through labeling at the consumer level. Both of these functions continue to be important and continue to evolve as industries change.

A common neoclassical economic argument is that market failure must predicate government involvement in commodity standards and grading. A classic example of one of those market failures is Akerlof's “lemons” argument, in which there is asymmetric information between buyers and sellers. If quality is unobservable to buyers or costly for buyers to ascertain, then sellers have an incentive to offer inferior quality products in the market. The result is that product quality deteriorates to less than optimal levels, reducing social welfare. Beef grading is an example of a USDA program that conforms to this rationale. USDA beef grades such as Prime, Choice, and Select are designed to convey information about product quality and palatability to marketing chain participants, and ultimately, consumers. Grading is conducted on observable characteristics of beef carcasses prior to disassembly of the carcass into individual cuts of meat. Grading criteria that are no longer observable after fabrication of the carcass are applied, addressing the “lemons” argument condition that quality be unobservable or costly to buyers. By reducing uncertainty about product quality, food system performance should be enhanced.

Another rationale for government involvement in commodity standards and grading does not fit as neatly into neoclassical economic theory. Considerations of fairness and equitable distribution of economic power help to explain historical USDA involvement in establishing commodity standards and providing grading services. Privately led standards development does not necessarily require or involve all segments of the industry. For instance, smaller producers may not have a voice in privately driven standards development. With government involvement, the process is open to comment by the entire public. Thus, there are opportunities for all potentially affected parties to express their views and weigh in on the development of standards. A vivid example is the development of the National Organic Program, where over 275,000 comments were received. Those comments led to substantive changes in the direction of the program. A privately led effort would not necessarily have allowed for such extensive input by producers, processors, handlers, distributors, retailers, and consumers nationwide.

Transactions cost theory goes a long way in providing an underpinning for traditional USDA standards and grades. With factors such as widely dispersed production, heterogeneous products, and geographic and temporal separation between buyers and sellers, establishment of grade standards provides a common language with which market participants can describe economically important attributes of commodities. The USDA's provision of grading service provides a uniform, nationwide mechanism through which the established standards are applied. By establishing and applying grade standards, the USDA can reduce transaction costs throughout the agricultural and food marketing system. Such transaction costs include direct costs, such as inspecting and classifying or grading the commodity, as well as indirect costs, such as contract monitoring and enforcement.

Commodity grade standards also play a role in supporting other federal programs. Accordingly, the economic effects of standards as applied in these contexts must be judged by the impacts of those programs. For instance, grade standards arguably enhance market information and intelligence reported by the USDA, improving the transmission of meaningful price signals to coordinate production and consumption decisions.Various federal regulatory and price support schemes require the use of USDA standards and grading services with their attendant effects. Contract acceptance in support of $1 billion in USDA commodity purchases for distribution through federal feeding programs is based on commodity standards and other factors.

Commodity Standards: The Traditional Perspective

USDA commodity standards continue to provide a common language for commerce. In this traditional role, identity standards provide a common nomenclature for products and grade standards provide a mechanism for sorting those products according to characteristics of economic importance. For some commodities, these standards continue to resonate with consumers (e.g., Prime, Choice, and Select for beef products), whereas in other cases, they operate principally at the production, processing, and wholesale levels (e.g., live cattle, cotton, and most fruits and vegetables).

The USDA's Agricultural Marketing Service (AMS) maintains standards for a multitude of commodities, including cotton, dairy products, eggs, fresh and processed fruits and vegetables, nuts, livestock, meats, poultry, and tobacco. AMS also provides grading services for these commodities with full cost recovery through the payment of fees by program users. In fiscal year 2002, for example, 96% of federally inspected steer and heifer slaughter was USDA-graded, and 88% of federally inspected lamb slaughter was USDA-graded. Practically all cotton grown in the United States is classed (graded by AMS). AMS grades about 80% of the turkeys, 60% of the chickens and other poultry, and 40% of the shell eggs that go to U.S. consumers.

While many of the USDA's grading services are delivered in very traditional ways—that is, end product examination relative to commodity standards—innovations in the provision of these services have been important. The use of digital cameras has become popular in fruit and vegetable quality inspection to provide real-time display of product condition in situations where geographically distant buyers and sellers dispute compliance with contract terms. Cotton classing is performed using High-Volume Instrument (HVI) systems that provide for instrument measurement of most cotton fiber properties (i.e., fiber length, length uniformity, strength, micronaire, color, and trash), so that objective, repeatable, and nationally (actually, internationally) consistent results can be obtained. In addition, a central electronic database is maintained for international as well as domestic telecommunication of cotton classing data to relevant industry agents.

Interestingly, as the structure of the food retail sector has consolidated, a trend has emerged where corporate entities choose to have the USDA perform a quality control function for products being procured from a variety of sources and marketed through large numbers of retail outlets. These firms seem to place value in the uniformity, consistency, and national coverage that the USDA grading service can provide. Perhaps the best example is Wal-Mart, which decided that USDA shell egg grading would be a contract prerequisite for those wishing to supply its stores.

The USDA also works outside its traditional standards development process by joining in the development of industry-led consensus commodity standards. For example, the USDA participates in standards development activities through private organizations such as the American National Standards Institute (ANSI). Government participation in such privately led standards development lends a degree of expertise while also ensuring appropriate consistency across standards where that may be important.

The USDA is an active participant in several international commodity standards organizations, both governmental and industry consensus-based. Included are the Codex Alimentarius Commission, the United Nations/Economic Commission for Europe, and the International Standards Organization. The USDA is uniquely positioned to speak with one voice in these international organizations, representing the interests of U.S. producers, industry, and the public. This is important because standards developed by these organizations are, in some cases, codified as minimum import requirements by countries. Also, by playing a role in their development, the USDA can guard against their use as nontariff barriers to trade and shape them for possible application in World Trade Organization adjudications of technical barriers to trade complaints.

As private-party commerce moves increasingly into the digital age, there is a newfound need to develop standards and protocols to facilitate the efficient exchange of information and products. The USDA has worked with industry to develop digital standards for commodities. The Meat and Poultry B2B Data Standards Organization—mpXML—is a private, nonprofit organization founded by the USDA and meat and poultry businesses to develop and promote the use of open standards for exchanging business information among all segments and entities in the meat and poultry supply and marketing chain. The membership of mpXML is open to all sectors of the meat and poultry industry, including producers, packers, processors, wholesale distributors, brokers, retailers, associations, government agencies, and technology and services providers. This broad representation helps guarantee that mpXML's work meets the needs of the entire industry and not just particular segments. Additionally, the USDA has been able to introduce the concept of open standards for exchanging business information into the work of the international standards-setting organizations.

Commodity Standards: An Evolving Role

Economic arguments in support of traditional commodity standards generally consider unbranded, undifferentiated commodity products. When consumer markets are increasingly fragmented and characterized by branded products seeking to fill every possible demand niche, is there a continuing role for commodity standards? Perhaps counterintuitively, the answer appears to be yes.

It is certainly true that private standards and branded programs have made gains in retailing, but many of these programs benchmark from USDA commodity standards. For example, reduced-fat marketing claims for cheddar cheese benchmark against the commodity identity standard. The existence of the identity standard provides a basis for differentiating the product while reducing opportunities for fraud and abuse.

The USDA itself oversees forty certified, process verified, and brand name programs for beef, which private firms utilize to make branded-type claims. The oldest and perhaps best known of these is Certified Angus Beef, which was initiated in 1978. All of these programs are predicated in some fashion on USDA standards and grades. The USDA quality grade (e.g., Prime or Choice) may or may not appear on the consumer package, and it typically does not because companies use these programs to differentiate their products from their competitors' offerings, especially unbranded “commodity” beef. As with USDA beef grading, these programs operate on a voluntary, user-fee-funded basis. In fiscal year 2002, 11.9 million head of cattle and 4.1 million beef carcasses were certified under live animal and carcass certification programs used by the industry for commercial marketing.

In the case of beef, certification programs operate in much the same way as grading services. Individual animals or carcasses are assessed by USDA personnel against written criteria maintained by the USDA. In the case of certification programs, however, individual companies or organizations may develop their own particular specifications appropriate to the product and marketing claims to be made. Industry participants benefit from these programs by being able to differentiate their products, but typically with reduced development costs since key elements of the programs are tied to established USDA commodity standards. In addition, the trained, nation-wide USDA workforce allows certification services to be delivered at relatively low cost.

From a social welfare standpoint, arguably there are economic efficiency gains to USDA involvement in these types of certification programs. First, the availability of uniform standards in the public domain may reduce overall cumulative development costs by industry participants seeking to implement certification programs aimed at differentiating their products. With publicly available uniform standards as a “starting point,” industry participants need not build branded-type programs from the ground up. In effect, much of the basic development cost is already reflected in the USDA standards. Second, USDA may be a low-cost provider of certification services, contributing to an efficient allocation of labor resources in the economy. Third, equity considerations may argue for USDA involvement in certification activities. Public provision of standardization and certification services likely lowers entry barriers to potential entrants seeking to provide differentiated products. Given concerns about industry structure, concentration, and market power in many segments of the agricultural and food industries, there may be social benefits to facilitating entry in these markets.

Although the typical scenario has been for the USDA to establish standards, with grading services then applied by either the USDA itself or other public or private entities, a converse scenario has emerged in recent years. The USDA is increasingly being asked to provide services that apply standards essentially developed by other entities.

Commodity standards still play a role in some of these systems, but the scope is typically much broader. One of the USDA's more visible process verification programs is the National Organic Program (NOP).² However, while the NOP is driven by statutory and regulatory requirements, a growing number of industry groups and businesses have sought voluntary, user-pays programs. These programs share a common foundation in International Standards Organization (ISO) protocols but are adapted to an industry's or a business's need to support a marketing claim that it wishes to make. Examples include Excel Corporation's Verified Pork for Strategic Export Program, Farmland Industries' America's Best Pork, Premium Standard Farms' pork program, PM Beef Group's beef program, and the Red Angus Association of America's Red Angus Feeder Calf Certification Program.

In a related audit-based certification program, all farms, ranches, and feedlots that raise beef destined for shipment to the European Union (EU) as non-hormone-treated cattle must be audited, approved, and listed by the AMS to be eligible for export certification. Similarly, there is a program to certify production systems that finish hogs destined for slaughter, processing, and subsequent export as meat to the EU. A new Sheep-Protein-Free Feed Certification Program for poultry producers has been initiated to meet export market requirements. And similar audit-based programs are beginning to proliferate for the fruit and vegetable industry.

Importantly, for many of these process verification programs, food production companies first work with private entities to develop verifiable programs that will support whatever marketing claims are of interest. The USDA's role is limited to auditing or verifying that program elements are met. This has the dual advantages of adhering to ISO principles for separation of program design and verification, while also providing the apparently advantageous marketing cachet of a USDA process-verified seal.

A characteristic typical of these process verification programs is that products are differentiated according to credence attributes—attributes that cannot be determined even after consumption. In these cases, a role can be argued for government to supply process verification services to assure the presence or absence of the relevant credence attributes (Young and Hobbs). Or, as in the case of the NOP, the USDA certifies that private or other public entities are qualified to conduct the necessary audits (i.e., certifying the certifiers).

Conclusion

On balance, there appear to be both efficiency and social welfare arguments in support of the USDA's continued involvement in the development of commodity standards and the provision of grading and certification services. The public reservoir of USDA commodity standards continues to find direct application and serves as the basis for many branded marketing programs. The international marketing advantages of a common language of trade and the need to prevent commodity standards from being used as nontariff trade barriers continue to argue for a federal government presence. As has been the case, both commodity standards and the provision of grading and certification services must evolve with industry structure and marketing practices if they are to continue to provide economic benefits. The real test, of course, is whether the private sector continues to believe that the commercial benefits of USDA commodity standards, as well as grading and certification services, outweigh their costs. Thus far, this seems to be the case.