Competition and prices in USDA commodity procurement.

• Author: MacDonald, James M.

1. Introduction

   The United States Department of Agriculture (USDA) is a major food buyer, spending about $3.4 billion in 1999. Over 70% of those expenditures supported international food distribution programs, whereas about $970 million was spent on products for domestic feeding programs, such as the National School Lunch Program.

   USDA food procurement relies primarily on auction mechanisms designed to induce "hard" manufacturer price competition, in Sutton's sense (Sutton 1991). The Department limits product differentiation by designing precise product specifications and by requiring USDA labels in place of commercial brands. It runs first-price, sealed-bid auctions each month for products to be delivered in the following month. The Department also reserves the right, albeit rarely exercised, to cancel auctions whose winning bids exceed unannounced reservation prices.

   Our report evaluates those auctions. (1) We compare private sector prices to auction bids, and demonstrate that the auctions do obtain products at low prices. But auctions frequently attract only a few bidders, and falling bidder numbers concern policymakers. We therefore assess the effects of changes in the number of bidders on prices in the auctions, and find that bidder numbers matter--prices fall as the number of bidders increases. We also investigate nonlinearity--whether the effect of an additional bidder varies with the number of bidders--and find that bids fall more as bidder numbers increase, when bidder numbers are small (one or two) to begin with.

   The results have some general implications. First, they provide evidence on the effects of competitor numbers on prices in markets with easy entry and no product differentiation, that is, in real-world markets that might arguably be called contestable. Second, nonlinearity is important when one wants to evaluate the likely effects of entry, exit, and merger on prices. In evaluating the likely effects of such events on prices, the focus falls to specific questions about the likely change in price attendant upon a move from three competitors to two or from four to three. Because it relies largely on aggregated data, the existing empirical literature on concentration and pricing is rarely able to consider the effects of incremental changes in competitors in already concentrated markets, but that issue is often a key question in policy evaluations.

   This study therefore follows on the issues in the collection edited by Weiss (1989)- whether and how concentration changes affect price, particularly in highly concentrated markets. Much of the existing literature on the topic focuses, because of data availability, on industries with histories of regulation, such as commercial banking, railroads, and airlines. But a few empirical studies investigate markets that use auctions.

   Auctions are widely used in agriculture and food markets. Examples include import tenders, sales of feeder cattle through video auctions, milk procurement by school districts, and priority rights for rail service for hauling grain. Studies of the role of competition in those markets generally find that bidder numbers matter. Two studies looked at school district milk procurement auctions, in Kentucky (Durham and Babb 1997) and Ohio (Porter and Zona 1999). Each found statistically significant but small effects of competition; Durham and Babb found that prices in Kentucky milk auctions fell by 1.6% with each additional bidder, whereas Porter and Zona found strikingly similar results for Ohio auctions--low bids fell by 1.5% with each additional bidder. Each found only limited evidence of nonlinearity, but nonlinearity may be hard to detect in these markets because bidder numbers are tightly circumscribed; 66% of Kentucky auctions and 97% of Ohio auctions had three or fewer bidders. (2)

   Meyer (1988) investigated 1970s Texas rice auctions, in which mills bid to buy rice from growers. He found effects that were statistically significant and fairly large--each additional buyer in an auction drove bids up by 4.6%. He did not test for nonlinearity, and did not summarize the actual variation in bidder numbers across auctions.

   Wilson and Diersen (1999) studied bidding by firms seeking to win Egyptian import tenders for the sale of three commodities: sunflower oil, cottonseed oil, and palm oil. Bids fell as the number of rival bidders (sellers) increased. The declines were very small, 0.6%, as a second bidder enters, and showed evidence of nonlinearity in that the effect of a fourth or fifth bidder was distinctly less than that of a second.

   Bailey, Brorsen, and Thomsen (1995) reported on the effect of buyer concentration on winning bids for the purchase of feeder cattle in 103 video auctions, covering almost 3 million cattle, in the 1987-1992 period. They used a measure of geographic bidder concentration, the degree to which purchases from a particular county are dominated by buyers from one feeding area, and found that winning bids were lower in those counties facing geographically concentrated buyers. The effects, although statistically significant, appear to be fairly small, with geographic monopsony leading to price reductions of 1.1-1.7%.

   Our analysis is based on extensive interviews with auction participants and empirical analyses of a large data set of USDA auction records for five commodities. These five commodities display substantial temporal and cross-sectional variation in bidder numbers, allowing for closer investigation of the effects of competition on bids.

2. The Design of USDA Procurement Auctions

   The Department's clients include school systems and social service agencies. The clients receive an annual budget allocation and product information from USDA, and then specify products, package sizes, quantities, desired delivery dates, and destinations in delivery orders sent to the auction operator, USDA's Kansas City Commodity Office (KCCO). KCCO assembles delivery orders into contracts, each to be let in a separate auction (a contract often aggregates orders from different clients for a common item and location). Each contract specifies a precise product type (for flour, the type could be bleached or unblenched, all-purpose or bakery), a package size (such as 5-, 10-, 50-, or 100-lb. bags), a delivery location, and a delivery time window (a two-week period). Contracts specify quantities in truckloads, as well as any distinctive transportation or packaging requirements.

   When preparing bids, manufacturers (vendors, in USDA nomenclature) take account of product costs, including labor, energy, packaging, and agricultural inputs, as well as expected competition. Bids also reflect distinctive production requirements, such as USDA labels and required inspections. Because bidders provide transportation to the specified locations, bids take transportation costs into consideration.

   Vendors enter sealed bids by a specific deadline, and KCCO selects the lowest bid, subject to certain qualifications. Winning bids that exceed KCCO reservation (maximum) prices are reviewed. (3) The agency may decide to accept the bid, or it may reject the bid and cancel the contract. Orders in cancelled contracts may be reintroduced in the next month (with late delivery to clients), or KCCO may rebid a supplemental contract for the same month.

   In summary, a USDA auction typically calls for bids for the delivery of a precise volume (40,000 lb., for example) of a specific product (all-purpose flour, with precise product specifications and tests), with specified packaging (10-lb. bags), to a particular destination (a warehouse in Buffalo), within a rather short time window.

   In the lexicon of auction literature, these auctions are more like independent private value (IPV) auctions than common value auctions; any one vendor's valuation of the award is statistically independent of other vendors' valuations, because of vendor-specific differences in material and production costs. Winning bids in IPV procurement auctions should vary inversely with the number of bidders; further, bids should vary nonlinearly with bidder numbers, with bigger effects when bidder numbers are small (McAfee and McMillan 1987).

3. The Data and the Model

   Our data set consists of almost 25,000 records of procurement auctions for five commodities (all-purpose flour, bakery flour, pasta products, vegetable oil, and peanut butter) carried out on a monthly basis between January 1992 and December 1996. (4) Table 1 provides summary statistics by commodity and year. The first row in each panel reports the annual number of auctions, which fell sharply between 1992 and 1996. Because some commodity purchases are linked to federal farm programs, which emphasize the purchase of commodities designated as surplus, the overall farm economy and farm policy affect procurement volumes. Domestic food procurement peaked in 1983, a year of large grain and dairy surpluses, at about $2.2 billion, before falling to $800 million in 1996.

   The second row shows mean low bids (dollars per hundredweight) in each year. Bids rose sharply between 1992 and 1996 for wheat-based products as wheat prices rose (average wheat prices received by U.S. farmers rose from $3.24 per bushel in 1992 to $4.30 in 1996). Soybean and peanut prices fluctuated sharply during the period, just ahead of observed bid fluctuations for cooking oil and peanut butter.

   The...