Contracting in Agriculture, Design, and Welfare Considerations
(Tom Vukina, North Carolina State University, presiding)
QUALITY INCENTIVES AND SUPPLY CHAINS:
MANAGING SALMONELLA IN PORK PRODUCTION
PETER BOGETOFT AND HENRIK BALLEBYE OLESEN
Food safety is an important concern in mod-
ern food production. The transmission of
Salmonella from animals to humans via pork
meat exemplifies this (Hald and Wong).
Managing Salmonella in pork production in-
volves quality management in supply chains
with multiple players. The Salmonella preva-
lence in pork meat can be reduced through
measures taken both before slaughtering and
during the slaughtering process. We focus on
the farm-level control measures. Actions can
be taken both in the production of piglets (the
multiplying stage) and in the fattening of the
pigs (the finishing stage) (Hald and Wong).
Salmonella control measures in the finishing
stage have the highest effect if there are severe
Salmonella problems in the multiplying stage,
and vice versa (Dahl). Hence, the control mea-
sures are substitutes. Salmonella rarely causes
noticeable health problems to pigs and has no
direct effect on productivity (Dahl). Hence, the
incentives to implement control measures at
farm level must come from economic incen-
tive schemes.
One can test for Salmonella prevalence us-
ing an inexpensive serological test (approxi-
mately $1.00 per test) at the slaughterhouse.
Also, bacteriological testing of the piglets is
possible, but expensive (approximately $1,000
per test) and, therefore, rarely used (Wegener
et al.; Dahl). In Denmark, testing is done reg-
ularly only at slaughtering. Based on these
tests, the producers are penalized for supply
of Salmonella infected pigs (Nielsen et al.).
Often, multiplying and finishing stages are
Peter Bogetoft and Henrik Ballebye Olesen are professor and as-
sistant professor, respectively, Department of Economics and Nat-
ural Resources, The Royal Veterinary and Agricultural University
Copenhagen, Denmark.
This article was presented at the ASSA winter meetings
(San Diego, CA, January 2004). Articles in these sessions are not
subjected to the journals standard refereeing process.
Amer. J. Agr. Econ. 86(3) (August 2004): 829834
Copyright 2004 American Agricultural Economics Association
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controlled by different producers, and the
setup involves moral hazard (as actions cannot
be precisely monitored), and adverse selection
(as the costs of the actions are private informa-
tion). In this article we analyze how the struc-
ture of the supply chain (i.e., who trades with
whom) affects the possibility to motivate in-
vestments in quality improvement. Pig produc-
tion is predominantly organized in one of the
two ways (see figure 1). In integrated produc-
tion, a single producer handles both the mul-
tiplying and the finishing stages. In separate
production, two producers handle the multi-
plying and the finishing stages, respectively. In
Denmark, separate production is typically gov-
erned by three-month contracts between the
multiplier and the finisher (Graversen). With
the time lag between contracting and the test-
ing, the relationship among producers shall be
analyzed as a priori trading, where prices, pos-
sibly conditional on subsequent test results, are
settled before testing (Bogetoft and Olesen
2003a).
Technically, this article is an extension of
Bogetoft and Olesen (2003a), where we ana-
lyzed the investment incentives in a two-stage
supply chain (standard principal-agent rela-
tionship) with imperfect grading. We showed
that the possibilities to motive investments
depend crucially on the competitive environ-
ment. Consider the case of risk-neutral play-
ers. When a buyer (processor or finisher) faces
no competition (monopsonist), he can (a) han-
dle the moral hazard problem by using a suf-
ficiently high powered incentive scheme and
(b) handle the informational asymmetry con-
cerning costs by rationing the investments to
save information rent. Competition among
buyers prevents this. In this case the expected
payments in an ex ante settled contract will
equal the expected value of the good that re-
sults from the induced investment policy. In
830 August 2004 Amer. J. Agr. Econ.

Integrated ownership Salmonella preva-

lence measured
Possible investment in Possible investment in
Salmonella Control Salmonella Control

Pigs
Multiplying Finishing
payment

Separate ownership
Slaughterhouse
Possible investment in Possible investment in

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Salmonella Control Salmonella Control

piglets Pigs
Multiplying Finishing
payment payment

Figure 1. Supply chain structures

this article, we extend this model to a three-
stage supply chain.
In Denmark, the Salmonella control plan in-
volves a nationwide incentive scheme adopted
by all slaughterhouses (Nielsen et al.). Hence,
there is no competition after grading, and a pri-
ori trading is again the appropriate regime to
consider. More than 95% of the pigs in Den-
mark are delivered to cooperatives owned and
controlled by the producers. Cooperatives will
not exercise market power against the produc-
ers (the owners). Thus, the trading between the
finishers and the cooperatives should be con-
sidered as a priori competition (Bogetoft and
Olesen 2003a).
The article is organized as follows. First, we
develop a simple model. We then analyze the
outcome of different, but given (exogenous)
supply chain structures, i.e., we assume that
the trading partners are fixed. Next, we ana-
lyze the outcome with variable (endogenous)
supply chain structure, i.e., when the produc-
ers choose with whom to trade. Finally, we give
numerical examples and conclude the article.
gets a signal about the quality of the good.
At delivery, the pigs can be graded as either
H (high quality = no Salmonella) or L (low
quality = Salmonella). The probability of re-
ceiving these grades depends on the invest-
ment behavior (table 1).
Here, ,  0 and  +  1. Hence, the
probability of getting a high signal is  if there
is no investment. The  and V values are the
extra chances of a high signal and the extra
value generated by investment. The base value
(V 0 ) of a pig and the base costs (c0M and c0F ) of
multiplying and finishing a pig are normalized
to 0 to simplify the exposition.
For simplicity, we assume that the invest-
ment costs in the multiplying and in the fin-
ishing stages are independent. Also, to sim-
plify notation, we assume that the costs are
identically distributed across producers and
stages. The investment costs are known only to
the individual producer. However, the cumu-
lative distribution of the costs, F(c), is common
knowledge and satisfies F(c) > 0 and F  (c) >
0 for all c > 0.

Exogenous Matching
The Model
We first consider a (static) situation where
We consider a three-stage supply chain, where
the producers cannot decide with whom to
a multiplier delivers piglets to a finisher who
fattens the pigs and ships them to the proces-
sor. Both the processor and the producers are Table 1. Investment Behavior, Signals, and
risk neutral. Each producer produces one unit. Expected Value
The expected value of a pig to the proces- Expected
sor depends on the investments made by the H L Value
producers. The producers investments are per-
fect substitutes. Hence, investing in both stages No investment  1 0
does not give higher expected value than in- Investment in + 1 V
vesting in just one stage. one stage
Investment in + 1 V
The processor cannot directly monitor the both stages
producers behavior. However, the processor
Bogetoft and Olesen Quality Incentives and Supply Chains 831

 
trade. Hence, the supply chain structure is (6) F = F cM [V ( + ) ph
exogenous. Since the processor does not exer-   
cise market power, he chooses prices such that (1  ) pl ] + 1 F cA
the expected payment is V if there has been in- [0 ph (1 ) pl ]
vestment in the chain and 0 otherwise. Hence,    
following Bogetoft and Olesen (2003a), the = F cM V F cM cM .
processor offers prices given by
Solving the first-order condition gives the
(1 )  following cost threshold in the multiplying
(1) PH = V and PL = V. stage
 

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Integrated Ownership F cM
(7) cM = V   .
An integrated producer makes the investment F cM
in the stage with the lowest cost and invests if
The cost threshold, V minus the hazard rate,
(2) min{c M , c F } V. shows that the finisher uses his market power
to ration investments in the multiplying stage
The probability of the producer investing is to save information rent.
1 (1 F(V))2 = 2F(V) F(V)2 , i.e., one We can now derive the cost threshold for the
minus the probability of the investments costs finisher, who will invest [using (7)] if
exceeding V in both stages.    
(8) V c F F cM V F cM cM
Separate Ownership  

  F cM
If a finisher in a supply chain with separate cF = V F cM   .
production does not invest, he will offer the F cM
multiplier prices depending on the signal of
the final good, i.e., the finisher will pay ph to Observe that cF < V because the finisher in-
the multiplier if the signal is H and pl if the vests only if the profit from investing exceeds
signal is L. However, if the finisher decides to the expected profit that he can obtain by mo-
invest, he will not motivate the multiplier to tivating the multiplier to invest. Note also that
invest and offer prices ph = pl = 0. Below, we cF > cM , i.e., investments will be higher in the
define the cost thresholds for the finisher and last stage of the production chain, because of
the multiplier, respectively. The cost thresh- the rationing effect.
olds are the cost levels below which the pro- The probability of investment in the sup-
ducers will invest and above which they will not ply chain is the probability of the finisher in-
invest. vesting plus the probability of the multiplier
We first analyze the investment behavior of investing
the multiplier when the finisher does not in-  2    
vest. The multiplier will invest if (9) F(V F cM F cM
   2    
(3) ( + ) ph + (1  ) pl c M + 1 F V F cM F cM
     
ph + (1 ) pl . F V F cM F cM .

This means that the cost threshold for the Comparing this to the outcome with inte-
multiplier is grated producers gives the following result.

(4) cM = ( ph pl ). PROPOSITION 1. With exogenous trading

The individual rationality constraint for
a noninvesting multiplier will be binding
(Bogetoft and Olesen 2003a). Hence,
(5) ph + (1 ) p1 = 0.
1 F(V
The profit to the finisher when he does not
invest [using (4) and (5)] is
structure, integrated ownership yields more in-
vestments and thus better quality than separate
ownership.
Proof : From F(V F(cM )2 /F  (cM )) <
F(V) and 1 F(V F(cM )2 /F  (cM )) < 2
F(V), we get F(V F(cM )2 /F  (cM ))
F(cM )/F  (cM )) < F(V)[2 F(V)] = 2F(V)
F(V)2 .

832 August 2004
This is a standard result for a model
with two-sided moral hazard (Holmstrom).
Bogetoft and Olesen (2003b) analyze this sit-
uation in further detail.
Endogenous Matching
We now consider a dynamic world where the
trading structure is endogenous. We assume
that the integrated producers will not change
trading partners. This assumption seems plau-
sible. An integrated producer will expose his
herd to new diseases and loose coordination
advantages if he buys piglets from an out-
side source (Dahl and Graversen). On the
other hand, we allow the separate producers
to match up with the most attractive trad-
ing partner. In practice, separate producers
actually change trading partners frequently
(Graversen).
Separate Ownership
The substitution between investments makes
it attractive for an investing producer to be
paired with a noninvesting producer. Figure 2
illustrates the possible trading structures when
investing multipliers trade with noninvesting
finishers and vice versa. The producers will use
separating contracts (e.g., contracts that are
only attractive to investing multipliers) to re-
veal the investment behavior of their trading
partner (Bogetoft and Olesen 2003a).
The incentives to invest depend on the equi-
librium prices for the piglets. We analyze the
three cases from the finishers perspective.
However, the results also hold for multipliers
because the problem is symmetric.
In Case I, we assume that the number of
noninvesting finishers exceeds the number of
investing multipliers, i.e., 1 F(cIF ) > F(cIM ).
In this case, the investing multipliers hold the
market power. A noninvesting finisher will ob-
Case I Case II Case III
M F M F M F
Inv. N.Inv. Inv. N.Inv. Inv.
N.Inv. N.Inv. Inv. Inv. Inv.
N.Inv. N.Inv. Inv. Inv. N.Inv.
N.Inv. Inv. N.Inv. Inv. N.Inv.
Figure 2. Matching multipliers and finishers:
three cases
Amer. J. Agr. Econ.
tain an expected net payment of 0 and an
investing finisher will obtain V due to the sym-
metry. This follows from a Bertrand-like ar-
gument. Suppose that a noninvesting finisher
matched up with an investing multiplier re-
quired a positive expected net payment, he
would then be undercut by another noninvest-
ing finisher trading with a noninvesting multi-
plier and, therefore, earn 0. The equilibrium1
gives cost thresholds of cIM = cIF = V and re-
quires F(V) 1/2 to be feasible.
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In Case II, we assume that the number of
investing finishers exceeds the number of non-
investing multipliers, i.e., F(cIIF ) > 1 F(cM ).
II
An investing finisher matched up with an in-
vesting multiplier gets 1/2 V. If an investing fin-
isher trading with a noninvesting multiplier
requires more than 1/2 V, he will be undercut
by an investing finisher, who trades with an
investing multiplier. Thus, investing finishers
and investing multipliers cannot obtain more
than 1/2 V. This means that, noninvesting finish-
ers will obtain at least 1/2 V since a supply chain
generates a payment of V. It follows that an
investing finisher has incentives to save his in-
vestment costs because this can happen with-
out loosing expected payment. Thus, Case II
cannot be an equilibrium.
In Case III, where F(cIII M ) = F(cF ) = 1/2,
III
all pigs delivered to the processor come from
a supply chain with investment in one stage.
The equilibrium must satisfy two sets of con-
straints: (a) the producers should not gain by
changing trading partner and (b) the producers
should not gain by changing their status (e.g.,
from noninvesting to investing producer). If
an investing finisher obtains expected payment
(EPI ) between 1/2 V and V, V/2 EPI V,
neither he nor his trading partner, a nonin-
vesting multiplier, have incentives to change
trading partner. An investing finisher, how-
ever, will stop investing and thereby change
the equilibrium to Case I if his costs exceeds
EPI . Thus, in Case III, we must have EPI
c, where c is given by F(c) = 1/2. A nonin-
vesting finisher obtains V/2 c by investing
and changing the equilibrium to Case II. This
means that the expected net payment to an in-
vesting finisher2 in Case III must also satisfy
N.Inv.
V EP I V /2 c. In total, we have c
N.Inv.
Inv. 1
This can be achieved if investing finishers offer prices ph =
pl = 0 to multipliers, and noninvesting finishers offer prices ph =

V 1 + + and pl = V  1 , where > 0.
Inv. 1 1
2
The equilibrium can be achieved if investing finishers of-
fer ph = pl = V EPI , and noninvesting finishers offer ph =
EPI 1 1 
 + + and pl = E PI  1 , where > 0 and
1
where max(c, V /2) EPI min(V /2 + c, V ).
Bogetoft and Olesen
EPI V /2 + c and V /2 EP I V. Note
that these constraints are not incompat-
ible since 0 c V. If c > V , Case I
applies.
The analysis shows that only Cases I and III
are relevant. Case I applies if F(V) < 1/2 and,
otherwise, Case III applies. The probability of
investment in a supply chain with separate pro-
ducers is 2F(V) in Case I and 1 in Case III.
The values in case of integrated ownership was
2F(V) F(V)2 . Hence, we have
PROPOSITION 2. With endogenous trading
structures, integrated ownership yields lower in-
vestment and thus lower quality than separate
ownership.
This finding contradicts the standard find-
ing in models with two-sided moral hazard.
The reason is that separate producers have
an advantage in being able to pair multipli-
ers with high costs with finishers with low
costs and vice versa. The integrated pro-
ducers do not have this opportunity, which
creates a matching problem. One integrated
producer may have low costs in both the multi-
plying stage and in the finishing stage while an-
other integrated producer may have high costs
in both stages. These integrated producers will
not pair up and utilize the differences in cost
levels.
Example: Uniform Distribution
We assume that cM and cF are uniformly dis-
tributed in the interval [0, 1], i.e., F(c) = c.
Table 2 illustrates the cost thresholds and the
probability of investment in each of the supply
chain structures.
Figure 3 illustrates the probability of invest-
ment in each of the supply chain types as a
function of V. The figure shows that a supply
chain with separate producers and endogenous
matching dominates a supply chain with an
integrated producer that dominates a supply
chain with separate producers and exogenous
matching.
Table 2. Cost Thresholds and Probability of Investment in Different Supply Chain Structures
Supply Chain Cost Thresholds
Integrated producer min{cF , cM } V
Separate producer, exogenous cM = V2 , cF = 12 + 12 1 + 4V
Separate producer, endogenous c = min(V, 1/2)
Quality Incentives and Supply Chains 833
1,2
1
Probability of investment
0,8
0,6
0,4
Separate producers, endogeneous
Integrated producer
0,2 Separate producers, exogenoeus
0
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0 0,5 1 1,5 2
V
Figure 3. Quality investments in different
supply chain structures
Conclusion
In this article we analyze the incentives for
Salmonella control at farm level in different
supply chain structures.
When the supply chain structures are given,
separate production, where the production
stages are controlled by different producers,
will suffer from rationing and coordination
problems. The finisher will ration the invest-
ments made by the multiplier to reduce the
information rent, and investment will not nec-
essarily be undertaken in the stage with the
lowest costs. Integrated production, where one
producer handles both stages of the produc-
tion, does not suffer from these problems.
Thus, separate production results in lower
quality than integrated production when the
structure of the supply chains is given.
We find the opposite result in a dynamic
world with endogenous trading partners, i.e.,
where the producers can choose with whom
to trade: Separate production results in higher
quality than integrated production. The rea-
son is two fold. First, competition among the
producers removes the rationing problem. Sec-
ond, separate producers will match up so that
low-cost producers trade with high-cost pro-
ducers. This gives the separate producers a
matching advantage since integrated produc-
ers are locked in their own supply chains.
Probability of Investment
2V
3V 2
4
+ 12 1 + 4V (1 V2 )
2V for V 1/2 and 1 for V > 1/2
834 August 2004
These findings can be made subject to em-
pirical testing. Our model predicts a trend to-
ward a structure where high-cost producers
pair up with low-cost producers. Finally, our
model indicates that Salmonella management
increases the gains from specialization in pork
production.
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