UNIVERSITÉ

LAVAL
FACULTÉ DES SCIENCES DE
L'AGRICULTURE ET DE
L'ALIMENTATION
Département d'économie agroalimentaire
et des sciences de la consommation

Research Series SR.01.05 (Part 4)

Developing supply chains for

nutraceuticals and functional foods :
opportunities and challenges

Hobbs, J.E

The author is Assitant Professor in the Department of Agricultural Economics at the University of
Saskatchewan, Saskatoon, Saskatchewan

This paper was presented at the INAF/CRÉA half-day seminar entitled "Les consommateurs et le marché des
nutraceutiques et des aliments fonctionnels: analyses et tendances socioéconomiques" held on November 23, 2001 at
Laval University. We gratefully acknowledge support received from the Centre québécois de valorisation des
biotechnologies (CQVB), via the Nutra-Innovation programme.

The Cahiers du CRÉA, Research Series, aim to disseminate the results of research undertaken by members to the
scientific community, industry decision makers and governments. These research results are generally submitted to
scientific refereed journals for publication. Readers’ comments and suggestions are always greatly appreciated. A
list of CRÉA publications is available upon request.

ISBN 2 -922378-39-X
Legal Deposit - Bibliothèque nationale du Québec, 2002
Legal Deposit - National Library of Canada, 2002

Institute of Nutraceuticals and Functional Foods

Centre for Research in the Economics of Agrifood
Faculté des sciences de l’agriculture et de l’alimentation
Université Laval

December 2001
 1

WHAT IS A SUPPLY CHAIN?

A supply chain consists of the set of relationships between (and within) firms that
governs the flow of products from input supply through production, processing and distribution
to the final consumer. Figure 1 presents a stylized representation of a basic supply chain from
producer to consumer.

Producer Processor Wholesaler Retailer Consumer

Figure 1: Basic Supply Chain

Of course, in reality, supply chain relationships are more complex. A firm may undertake
more than one supply chain function. In Canada, for example, food retailers have integrated
backwards into some wholesaling functions. Supply chain relationships need not be linear, but
may be networks of inter-firm relationships, and multiple input supply or distribution
relationships. This paper discusses key features of nutraceutical and functional food supply
chains, the factors influencing the emergence of different supply chain coordination relatio nships
and the implications for developing sustainable long-term supply chain relationships.

In defining “what is a supply chain” in the context of nutraceuticals and functional foods,
three questions arise: what are the key supply chain functions?; who are the main supply chain
participants?; and, how are the relationships between these participants structured? An important
component of the supply chain for a nutraceutical or a functional food is the research and
development activities that lead to the development of a new product or the enhancement of
existing products. Figure 2 presents a stylized depiction of a supply chain for a nutraceutical or
functional food.

Basic R&D Technology Technology Production/ Distribution Consumer

(Discovery) Development Transfer & Processing /Retail
Commercialization

Figure 2: Stylized Nutraceutical/Functional Food Supply Chain

 2

The R&D functions of basic discovery, technology development, technology transfer and
commercialization are essential precursors to the production and marketing of a functional food
or nutraceutical. Independent firms (or entrepreneurs) may carry out these functions, or several
functions may be subsumed within one firm; alternatively joint venture or alliance partnerships
may be used to facilitate transactions along the supply chain. The governance structure of these
supply chain relationships spans a spectrum of coordination possibilities. At one end of this
spectrum lies spot market transactions between independent buyers and sellers, in which
resources move between stages as a result of price signals alone, and no long term relationship
exists between the parties. At the other end of the spectrum lies vertical integration, in which a
firm owns one or more of the stages of the chain, with resource allocation and production flows
determined by internal managerial decisions. In between lie a myriad of coordination
possibilities, including contracts, strategic alliances, technical and equity joint ventures.

The evolution of a supply chain is influenced by many factors, including the institutional
(economic, political, legal) environment, the extent of uncertainty and information asymmetry,
the characteristics of the product and the structure of downstream industries. Transactions
between (and within) firms do not occur in a vacuum. There are costs to carrying out a
transaction, including the ex ante search costs of identifying suitable trading partners and
determining appropriate product qualities and prices, negotiation costs and the ex post
monitoring and enforcement costs of ensuring that the terms of a transaction are adhered to. The
size and distribution of these transaction costs depends on the nature of the transaction
environment and the characteristics of the product being transacted. If the search, negotiation or
monitoring costs of a spot market transaction become too high, we expect to see an alternative
coordination arrangement emerge, such as a contract. By focusing on the factors that determine
transaction costs, we can shed light on the types of supply chain coordination relationships we
expect to see evolve (Hobbs, 1996).

Supply chain relationships may also be a function of the core competencies or internal
capabilities of a firm. The range of activities a firm undertakes is constrained by individual or
team competencies - the set of skills and tacit knowledge - within the firm (Hodgson, 1998).
Different firms have different “skill sets,” just as individuals differ in their aptitudes for different
 3

tasks—individuals and organizations are necessarily limited in what they know how to do well.
This influences the scope of the supply chain activities that the firm is able to undertake. It
provides motivations for closer supply chain relationships as firms seek to maximize the outputs
of their own capabilities or expand those capabilities through contracts, strategic alliances and
joint ventures with other firms or vertical integration (Hobbs and Young, 2001).

Supply chain relationships involving the transfer of technology and information can be
influenced by the nature of the knowledge around which the relationship is built. This may be
codifiable, tacit or distributed knowledge (Sachwald, 1998). Codifiable knowledge can be
specified in formulas and designs, can be patented and can be transferred between firms by
exchanging ownership rights. Tacit knowledge cannot be described and specified in well-
codified forms, it may be acquired gradually over time in a process of learning-by-doing.
Distributed knowledge is valuable only if used in conjunction with the knowledge of others and
therefore it requires cooperation between firms or managerial direction within a firm for efficient
use of this information (Langlois and Foss 1997). Transferring tacit knowledge between firms is
complex, subject to uncertainty and apt to create high transaction costs. This provides a
motivation for closer vertical relations, strategic alliances, joint ventures or a within- firm transfer
of knowledge in a vertically integrated firm (Sachwald 1998). The technological and managerial
capabilities of the firm set limits on its boundaries in terms of the supply chain functions it is
able to perform, and provide motivations for closer supply chain relationships to reduce the
transaction costs inherent in technology transfer, product development and marketing.

The nutraceutical and functional foods sector spans a wide range of different products,
market segme nts and economic conditions, making it hazardous to draw generalizations about a
‘typical’ supply chain. Nevertheless, a discussion of key factors affecting the economic and
institutional environment in which these transactions occur is useful. These factors include
industry structure, both in downstream processing and retailing and upstream raw material
supply, the nature of research and development, the asset specific nature of investments and an
uncertain transaction environment, as well as the need for credible quality signals given
information asymmetry. Each of these factors is discussed, along with their implications for
supply chain organization.
 4

INDUSTRY STRUCTURE

Although the distinction between the two is increasingly blurred, in general nutraceuticals
and functional foods compete in different (although related) market sectors. Nutraceuticals
compete in the vitamin and pharmaceutical market, and tend to be marketed as such; for example
in terms of product and shelf positioning in stores. Functiona l foods form part of a food
processor's and/or retailer's food product line and must compete on that basis with conventional
foods for market share and shelf- space respectively. While this distinction may be a somewhat
crude generalization, it serves to illustrate that a key similarity of both the pharmaceutical and
food processing and retailing sectors is that they are highly concentrated, with increasingly fewer
and larger firms dominating the industries. In the US, for example, eight firms control 73 percent
of the vitamin raw material market. In Australia, the four largest firms have over 75 percent of
the vitamin market (RIRDC, 2000).

The concentrated nature of the downstream processing and distribution industries has a
number of implications for the formation of new supply chain relationships and for market
access. Typically, firms in concentrated industries are able to maintain their market power
because of the existence of barriers to entry, either natural or created, that restrict the ability of
new firms to enter the industry and compete away economic profits. A 'natural' barrier to entry
may be technological in the form of economies of scale, which dictate large-scale operation to
reduce average fixed costs, thus making it difficult for a new entrant to enter the industry
competitively at a small scale and subsequently build up capacity.

Barriers to entry also can be created by the strategies adopted by incumbent firms. Brand
proliferation reduces the market niches available to a new product and is used to establish brand
loyalty to the products of existing firms. The plethora of branded breakfast cereals available on
retail shelves, for example, are produced by a relatively small number of large food
manufacturers, each of whom carries a wide variety of brands. Similarly, pharmaceutical
companies produce multiple brands and brand variations of vitamins, supported by heavy
advertising to create brand loyalty. In concentrated industries, incumbent firms are aware of their
interdependence and may compete aggressively for market share or, possibly, collude to restrict
competition and raise prices. Overt collusion is illegal in most jurisdictions, including Canada
where the Competition Bureau regulates anti-competitive behaviour. In 2000, the Australian
 5

Competition and Consumer Commission launched an investigation of alleged cartel practices by

four major pharmaceutical companies that dominate the supply of vitamins for animal food
purposes (RIRDC, 2000). Tacit collusion is harder to prove.

Although natural health product stores remain an important outlet for nutraceuticals (and
to some extent, functional foods), sales through mainstream food retailing outlets are expanding
rapidly in most markets (Nutrition Business Journal, 2000). In general, food manufacturers
compete aggressively for shelf-space in retail stores. Typically, there is a high failure rate for
new food products, with retailers requiring that a product 'prove' itself relatively quickly to
continue occupying valuable shelf-space 1 . Retailers typically levy manufacturers a 'slotting' or
'listing' fee for access to retail shelf-space and require that food manufactures demonstrate a
sufficient capacity to conduct the marketing and promotional activities necessary to assist
product sales. It is in this highly competitive retail environment that new functional foods (and,
increasingly, nutraceuticals) must survive.

The industry structure of the downstream pharmaceutical, food manufacturing and food
retailing sectors pose a number of challenges and opportunities for developers of nutraceuticals
and functional foods. The concentrated, highly competitive nature of these downstream sectors
suggests that there is a limit to the supply chain functions (as depicted in Figure 2) that can be
undertaken by a small-scale innovator. The corollary to this is that there exist opportunities for
strategic alliance or joint venture partnerships between an innovator and a downstream
manufacturer. These alliance relationships can allow the manufacturer exclusive access to new
product concepts developed by innovating firms and entrepreneurs, in return for access to the
brand name capital and market position of the established manufacturer. Both firms benefit from
accessing the core competency of the other in the form of skills, codifiable, tacit and distributed
knowledge, and marketing leverage.

Upstream supply relationships are also important, including access to raw material inputs.
Innovators need access to genetic material to identify or enhance functional traits. Processors
need access to a stable, consistent supply of raw materials for commercialization and long-term

1
Even major food manufacturers have been forced to withdraw products due to poor sales performance. Gregory
(2000) reports that The Kellogg Company withdrew its "Ensemble" range of products, intended to reduce
cholesterol, following poor sales performance in a trial product launch in the US. Recently, both Campbell Soup
and the Hain Food Group have withdrawn soup style supplements.
 6

market development. Figure 3 illustrates the potential importance of access to key raw material
inputs to various stages of the nutraceutical and functional foods supply chain.

Raw Material
suppliers

Basic R&D Technology Technology Production/ Distribution Consumer

(Discovery) Development Transfer & Processing /Retail
Commercialization

Figure 3: Relationships with Raw Material Suppliers

Clearly, a wide variety of raw materials are potential inputs to nutraceuticals and
functional foods. Of significance for supply chain relationships, however, are those inputs
derived from botanical raw materials in limited supply and those based on patentable genetic
material. RIRDC (2000) reports estimates of the US market for botanical raw materials at
US$500 million in 1999, equivalent to about 25 percent of the global market. Numerous mergers
have occurred between companies supplying botanical extracts, and it has been estimated that to
survive in the US marketplace a company needs annual sales in excess of US$20 million
(RIRDC, 2000). Complex intellectual property and biodiversity issues surround the supply of
botanical raw materials and extracts. Increased demand and the need for a consistent, reliable
supply of raw materials has led to a shift away from wild-crafted plant materials and towards
cultivated crops grown through contractual and other exclusive supply arrangements (RIRDC,
2000).

The Nature Of R&D

R&D plays a central role in nutraceutical and functional food supply chains. The
development of new nutraceuticals or functional foods is a resource-intensive activity, both in
terms of financial resources and the time required for basic research, technology development
and commercialization, including obtaining product approvals and developing and resourcing a
 7

marketing strategy2 . These become financial barriers to entry. In an econometric analysis of the
US plant biotechnology sector, Brennan et al (2000) found a significant correlation between the
number of patents a company owns and its financial valuation in capital markets. A higher
market valuation puts an inc umbent firm holding existing patents in a better position to leverage
additional financial resources to invest in R&D relative to potential new entrants (Gaisford et al.,
2001). Limited access to equity capital generally means that innovators often are not able to
undertake supply chain activities beyond technology transfer (Figure 3). Instead, strategic
alliances or joint ventures arise with downstream manufacturing companies who have the
financial and human capital resources to support an innovation through commercialization.

Alternatively, vertical integration backwards along the supply chain by the manufacturer
is used to secure access to the intellectual property inherent in the innovation. Institutional
failure, in the form of weak patent protection and incomplete contracts, has been an important
motivation for merger and acquisition activity in the biotechnology, nutraceutical and functional
food sectors. The ability for firms to capture rents from the innovation process depends on the
extent to which they can protect the intellectual property inherent in the innovation. Patents are
used to protect intellectual property. However, in the biotechnology sector, a large number of
patent disputes have arisen between biotechnology firms over the control of patent rights and
contractual rights to use key biotechnologies. These disputes reveal the difficulty of establishing
definitive intellectual property rights to these technologies and in writing complete (enforceable)
contracts to govern the exchange of intellectual property between independent firms (Gaisford et
al., 2001; Kalaitzandonakes and Hayenga, 2000).

2
By comparison, the APMA Facts Book (1999) charts the various stages in the development of medicinal products,
including discovery (2-10 years), preclinical testing (4 years ), clinical trials (7 years), registration (2 years- although
this is jurisdictional-dependent), marketing (indeterminate) and post-marketing monitoring (ongoing). Therefore,
whether nutraceuticals are regulated as a food or as a drug has critical implications for the product development to
marketing lag and the commercial viability of R&D activities.
 8

ASSET SPECIFICITY, UNCERTAINTY AND COMPLEXITY

The characteristics of the transactions along a supply chain influence the governance
structure of supply chain relationships. In the presence of high levels of asset specificity3 ,
uncertainty and complexity, writing fully contingent enforceable contracts becomes difficult and,
ceteris paribus, we expect to see vertical integration emerge (Williamson, 1979). Uncertainty,
complexity and asset specificity characterize many of the transactions along a functional food or
nutraceutical supply chain.

An investment in a novel food trait is usually specific to the germplasm or livestock

genetics through which it is delivered. This creates a hold-up problem if the upstream sector
supplying the raw material is concentrated, with few alternative suppliers available. In case of
plant biotechnology, the investment in a biotechnology innovation may be appropriable by a seed
company. This raises monitoring and enforcement costs for a downstream biotechnology firm,
providing another incentive for acquisition of the seed company by the biotechnology firm
(Gaisford et al., 2001).

Furthermore, the complexity of novel food produc ts means that they often contained
several potentially patentable traits. Given the problems in establishing definitive intellectual
property rights, overlapping patents can become a problem. This has been the case in the
biotechnology-seed sector, with disputes among biotechnology companies and between
biotechnology and seed companies as to who owns the rights to use which technologies. As
innovation progresses, with more traits being patented, a new product might contain several
potentially patentable traits owned by more than one company, adding to the complexity of these
supply chain relationships (Gaisford et al, 2001).

Supply chains for new nutraceuticals and functional foods evolve in an environment of
uncertainty. In large part, this is because the products are based on new and evolving
technologies, selling into new and evolving markets. While this presents an opportunity to target

3
Asset specificity refers to assets that have little or no value in an alternative use. In the presence of a small number
of buyers (sellers), a seller (buyer) who makes an investment in an asset specific to a business relationship with a
corresponding buyer (seller) faces a "small numbers bargaining" problem. She faces the risk that the buyer (seller)
will act opportunistically to try to appropriate some of the rents from the asset specific investment. This is known as
the "hold-up" problem. The transaction is 'held-up' if the seller (buyer) is reluctant to invest in the specific asset for
fear of opportunistic behaviour on the part of the buyer (seller).
 9

new “niché” markets, it brings with it added challenges. Another source of uncertainty is the
lengthy time lag that usually exists between the initial scientific innovation that identifies new
traits or enables existing traits to be modified to enhance the functional properties of the food,
and the commercialization of the technology. This makes it difficult to write fully contingent
contracts between innovating firms, raw material suppliers and/or downstream manufacturing
firms if (as is often the case), these contracts are drawn up years before a product reaches the
market. The problem is compounded if there is also uncertainty over the ownership of
intellectual property rights (Kalaitzandonakes and Hayenga, 2000). In this situation, the
transaction costs of negotiating, monitoring and enforcing these contracts could be prohibitive,
creating a strong incentive for vertical integration along the supply chain to internalize these
transaction costs. Strong intellectual property laws, with an efficacious enforcement mechanism,
reduce these transaction costs and facilitate contractual relationships as an alternative to vertical
integration, although the effects of uncertainty remain.

INFORMATION ASYMMETRY AND THE ROLE

OF LABELLING TO SIGNAL QUALITY

Food products can contain search, experience and credence attributes, each of which
infers a different level of information available to consumers. Search attributes are those that
consumers can detect prior to purchase, such as the extent of intra- muscular marbling visible in a
steak or the colour of broccoli. Experience attributes can only be evaluated after consumption,
such as the tenderness of a steak or the texture of broccoli. Consumers cannot detect credence
attributes even after consumption, for example, whether the steer producing a steak was reared in
an animal welfare- friendly production environment, the anti-oxidant properties of broccoli or the
presence of genetically modified organisms in food. Information asymmetry exists between the
firms producing functional foods and nutraceuticals, who are aware of the health-enhancing
properties of these goods, and consumers for whom these properties are credence attributes.
Therefore, the presence of credence attributes must be signalled to consumers to enable firms to
reap returns from investment in isolating or enhancing the functional trait.
 10

Labelling: Regulatory Uncertainty

Labelling is typically used to signal the presence of specific quality attributes to

consumers. For nutraceutical and functional food industries, two challenges are apparent:
regulatory uncertainty and credibility of labelling claims. Regulatory uncertainty arises both
nationally, given the regulatory quagmire in which the nutraceutical and functional foods
industries have existed recently, and in export markets due to the lack of international agreement
on how to define (let alone regulate and label) nutraceuticals and functional foods.

In Canada, nutraceuticals and functional foods have been regulated under the Food and
Drugs Act. The Act allows only a limited range of health claims to be made for foods, otherwise
they are classed as drugs. For example, a food could be marketed as part of a healthy eating
regime or a specific nutrient could be emphasized as being important to maintaining functions of
the body or necessary for health maintenance. Specific health claims linking the food to control
of a disease have not been permitted. If a manufacturer wished to use these claims, the product
would have to be regulated as a drug. Manufacturers of nutraceuticals and functional foods have
been reluctant to classify their products as drugs. In part this is due to the lengthy and costly
approval and testing procedure required for drugs. The reluctance also stems from a desire to
position these products as foods for health and wellness, rather than as drugs to fight illness
(Health Canada, 1998).

The inadequacy of the existing Canadian regulatory system discouraged the development
and marketing of novel foods with potential health benefits for consumers and provided
insufficient guidance as to the scientific basis on which health claims were evaluated for the
protection of consumers. As a result, Health Canada undertook a review of health claims for food
products, focusing on claims related to alleged therapeutic benefits, risk reduction and
structure/function claims 4 . The review culminated in the publication of a policy document in
November 1998 recommending that structure/function and risk reduction claims for food
products be permitted, while products with all other health claims continue to be regulated as
drugs (Health Canada, 1998). This recommendation required that a new regulatory framework be

4
A therapeutic claim states that a product can cure, treat, mitigate or prevent a disease or condition. A risk
reduction claim states that a product can significantly alter a risk factor recognized to be linked to development of
chronic diseases or physiological conditions. A structure/function claim links use of the product with the structure or
function of the body, such as the role of nutrients in maintaining good health (Health Canada, 1998, Appendix B).
 11

developed to govern allowable claims, including the establishment of appropriate scientific

standards of evidence and a monitoring and enforcement mechanism to ensure compliance.

Health Canada subsequently began the process of regulatory reform, focusing separately
on functional foods and on nutraceuticals and natural health products. Responsibility for
nutraceuticals has been given to the newly created Office of Natural Health Products within
Health Canada. A draft regulatory framework for "Natural Health Products" was released in
September 2001 (Health Canada, 2001) 5 . It is proposed that structure/function, risk reduction and
therapeutic claims for nutraceuticals will be regulated under this framework .The draft regulatory
framework proposes that only licensed firms be allowed to manufacture, package, label or sell a
natural health product. Labelling requirements are specified, as are the Good Manufacturing
Practices (GMP) that must be followed in the manufacture, packaging and labelling of the
product. The proposed GMPs include a requirement that any firm manufacturing, packaging,
labelling, importing or distributing natural health products have a quality assurance person
responsible for monitoring the quality of the product.

Functional foods are being treated as a separate legislative area and are the responsibility
of the Food Directorate. Regulations are being established to facilitate structure/function and risk
reduction claims for functional foods.

The regulatory situation is even more uncertain for firms wishing to export functional
foods or nutraceuticals, with little agreement internationally on the appropriate definition of a
nutraceutical or functional food, and regulations evolving differently in different markets. This is
particularly problematic for countries such as Canada, with relatively small domestic markets,
for whom access to export markets is important. For Canadian firms, the US is an obvious export
market, given relative proximity, cultural similarities, the closer economic relations facilitated by
the North American Free Trade Agreement and the sheer size of the US market. It is estimated
that the US nutrition market is the largest in the world, valued at US$44.5 billion and
representing 34 percent of the global market (Nutrition Business Journal, 2000). However, other
export markets also offer potential, including the European Union, which has seen strong growth

5
Natural Health products are defined as products represented for use in the diagnosis, treatment, mitigation or
prevention of a disease and in maintaining or promoting health. They include homeopathic products, substances
used in traditional Chinese and North American aboriginal medicine (Health Canada, 2001).
 12

in the dietary supplements sector, with the nutrition market as a whole in the EU estimated at
US$42.2 billion in 2000, a close second to the US (Nutrition Business Journal, 2000). Asian
markets also offer potential, for example, until the recent problems with Chronic Wasting
Disease among elk herds in western Canada, Korea was a major importer of Canadian velvet
antler products.

Different regulations in different markets increase transaction costs for firms in

determining how regulations differ. Product development, approval and marketing costs are also
increased if product standards, requirements for scientific evidence and labelling regulations
differ. Efforts to establish international guidelines for the labelling of nutraceuticals and
functional foods would facilitate international trade in these products. The Codex Alimentarius
Commission is the international body through which (non-binding) agreements are reached
internationally on food regulations. Codex standards can become the basis for binding
international agreements on regulatory harmonization or the negotiation of equivalency between
standards to facilitate market access. While the Codex does not have a specific Committee to
examine either nutraceuticals or functional foods, issues that will have a bearing on these
products are on the agendas of existing Codex committees.

Credibility of Labelling Claims

The regulatory uncertainty aside, claims made for nutraceutical and functional food must
be credible to consumers. The credence nature of the functional (nutraceutical) property
precludes consumers from determining the accuracy of the claim. Credibility is further
challenged by disputes over label claims, which damage the reputation of the firm(s) involved.
Externality or spillover effects can also damage the reputation of other firms. High profile
disputes over claimed benefits have led to product withdrawals and/or poor sales in some
markets. In the UK market, the Danish firm MD foods withdrew a number of functional
products, including calcium-enriched orange juice and margarine enhanced with fish oil as a
result of challenged claims. The British advertising standards group criticized SmithKline
Beecham for allegedly misleading advertising regarding anti- tooth decay claims for its beverage
Ribena Toothkind (a blackcurrant juice concentrate targeted at children).
 13

Altus (a joint venture between Novartis and Quaker) withdrew its Aviva line of functional
foods - aimed at heart, bone and digestive health - from the UK market, and was reported as
unlikely to launch the product range in other European countries (Nutrition Business Journal,
2000):

Consumer and retailer skepticism, inconsistent shelf presentation and high pricing
are reportedly to blame for this disappointment. Even a price cut of 20% failed to
simulate sales of Aviva. (Nutrition Business Journal, 2000, p.5).

Partly as a result of these problems, but also stemming from the general lack of trust in the food
industry and the food regulatory system following the BSE6 outbreak in the UK:

…the British functional food market remains undeveloped, and consumers and
retailers even hostile to functional products (Nutrition Business Journal, 2000,
p.11).

These UK examples serve to illustrate the fragility of consumer trust and the need for
firms to develop credible labelling claims based on clear, irrefutable health benefits, as well as
supply chain relationships that assure the integrity and consistency of the product. Often, these
supply chain relationships will include identity preservation systems to capture the value, and
ensure the integrity, of an enhanced trait. There would be little incentive for agricultural
producers to produce crops or livestock products with enhanced functional properties if the
resulting output were blended with conventional produce and sold through traditional commodity
marketing channels. Nutraceutical and functional food processing companies would incur
measurement and sorting costs in identifying products with potentially functional properties, and
the net price they would be willing to pay for the product would decrease. Sellers have an
incentive to reduce measurement costs for buyers, so that buyers avoid costly sorting activities
(Barzel, 1980). Thus, a credible identity preservation system reduces the need for costly sorting
and monitoring by buyers. Sellers are able to capture value from the trait, providing an incentive
to produce products with functional traits.

Identity preserved supply chains emerged during the early stages of commercialization of
output-trait technologies in the biotechnology sector. DuPont and Pioneer Hi-bred originally

6
Bovine Spongiform Encephalopathy or "Mad Cow Disease".
 14

created Optimum Quality Grains through a joint venture (Brennan et al., 2000). Among other
output-trait-enhanced products, Optimum Quality Grains commercialized a low saturated fat
soybean (a functional food marketed under the name LoSatSoy) and high oleic soybean and
sunflower oils (Marks et al., 1999). Farmers grow these crops under contracts co-ordinated by
Optimum Quality Grains.

Opportunities to establish credible labelling claims arise through branding and/or third
party certification of quality assurance initiatives. Investments in brand name capital can be
viewed as a ‘hostage asset’, serving to provide an assurance of the firm’s credible commitment to
the integrity of its product line. The establishment of a brand reputation requires a substantial
commitment of resources, which are at risk if the firm makes misleading or false labelling
claims. New firms entering the industry are at a competitive disadvantage relative to incumbent
firms with an established brand reputation. If innovators are able to enter into supply cha in
relationships with an established firm, effectively they have access to the credibility of the firm’s
brand name as an outlet for their innovation. However, it should be noted that brand name asset
specificity leaves the processor vulnerable to opportunistic appropriation of the quasi- rents
inherent in the product’s brand name. For this reason, the processing firm may prefer joint
ventures, strategic alliances or vertical integration over contractual relationships with innovators
and input suppliers, given the problems of drawing up and enforcing fully contingent contracts
for the exchange of knowledge-based assets.

Third party certification of both labelling claims and quality assurance initiatives offer
another means by which credible quality signals can be communicated to consumers. Third party
monitoring could be used to verify the integrity of the production and processing methods used
to produce the food, together with ensuring that raw material supplies are sourced appropriately,
for example, through an identity preserved system. Figure 4 illustrates these roles of third party
certification in the supply chain. The solid arrows represent likely roles for third party
monitoring and certification in the production/processing and input supply stages of the supply
chain. The dashed arrows indicate possible extensions of third party monitoring to the
distribution and retail functions and to technology transfer and commercialization, depending on
the extent to which these stages affect the quality of the final product and the credibility of
labelling claims.
 15

Third party
certification

Raw Material
suppliers

Basic R&D Technology Technology Production/ Distribution Consumer

(Discovery) Development Transfer & Processing /Retail
Commercialization

Figure 4: Nutraceutical and Functional Food Supply Chain with Third Party Certification

The third party monitoring and certification role may be carried out by an industry
association or by an independent quality assurance firm. The public sector (government) could
be the third party certifying agency if the private market fails to provide credible quality
assurance guarantees to consumers. However, the rapid growth of private sector quality
assurance certifying firms in many sectors of the economy suggests that, in the absence of
market failure, independent firms can perform this role. Instead, the public sector plays an
important role in establishing a transparent, stable regulatory framework go verning labelling
claims and product safety. Without an efficacious, transparent regulatory framework, consumers
may lose confidence in the industry; firms operate in an environment of uncertainty and
investment is deterred.

Building Supply Chain Relations hips

Industry associations, such as the Saskatchewan Nutraceutical Network 7, can play a role
in facilitating the establishment of supply chain relationships (see Figure 5). Membership of the
Saskatchewan Nutraceutical Network consists of firms from across Canada (and in other
countries) and spans the supply chain from scientific research, to production, processing,
distribution and marketing. The network acts as a conduit for disseminating information about
market trends, scientific discovery and regulatory developments. It assists firms seeking alliances
with firms at other points in the supply chain by facilitating business-to-business contacts within
the network, thereby reducing search (transaction) costs for these firms.

7
www.nutranet.org
 16

Third party
certification

Raw Material
suppliers

Basic R&D Technology Technology Production/ Distribution Consumer

(Discovery) Development Transfer & Processing /Retail
Commercialization

Industry
Association(s)

Figure 5: Industry Associations Facilitating Supply Chain Relationships

CONCLUSIONS

The nutraceutical and functional foods industries are dynamic, evolving industries
offering exciting opportunities to marry scientific discovery with the growing consumer interest
in health-enhancing foods. As in any evolving industry, new supply chain relationships must be
forged. This presents challenges given the concentrated nature of downstream food processing
and retailing and some sectors of upstream raw material supply, the asset specificity of
investments in technology or technology delivery mechanisms, and the uncertain market and
regulatory environment. Close supply chain relationships (strategic alliances, joint ventures, and
even vertical integration) emerge to reduce the resulting transaction costs. Supply chain
partnerships also offer opportunities for firms to access the core competencies and tacit know-
how of other firms, while providing credible quality assurance guarantees and labelling
information to consumers. It behoves policymakers to establish (maintain) a stable, transparent
and effective regulatory environment governing labelling claims, product safety and the
protection of intellectual property rights so that the nutraceutical and functional foods sectors can
continue to grow.
 17

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