“Price discovery is a public good. Many formulas use information from efforts of those that negotiate cash prices,” says Stephen Koontz, agricultural economist at Colorado State University. “Likewise, forward contracts often rely on historical information on cash prices to construct basis estimates. However, alternatives to the cash market use cash market information but do not contribute to its provision.”

This is from the executive summary to the multiyear Price Discovery Research Project (PDRP) Koontz conducted for the National Cattlemen’s Beef Association. It aims squarely at determining whether or not the current cash market for fed cattle is still effective in discovering price, but also why cattle feeders choose one marketing method compared with another.

Federal and state governments underwrite some of this public good, in terms of the infrastructure for public price reporting. Federal and state governments also collect historic price and quantity information.

USDA’s total budget for fiscal year 2016 is $156 billion, according to the USDA Budget Summary and Performance Plan. Of that, $1.2 billion (0.78%) is earmarked for the Agricultural Marketing Service (AMS), which is responsible for mandatory price reporting. Throw in the budgets for the Economic Research Service, National Agricultural Statistics Service and the Grain Inspection and Packer and Stockyards Administration, and the budget is about $1.5 billion (0.98%) of the total budget.

“There is a public good component to market information when price discovery is made more effective and more efficient by public market reporting activities. Getting to the ‘true’ prices more quickly, and with less error, smooths the process of reacting to informational shocks in the marketplace,” say Koontz and other livestock economists, in Price Discovery in Concentrated Livestock Markets: Issues and Future Directions. This work was published by the Research Institute on Livestock Pricing in 1997, before mandatory price reporting, just as concerns over feedlot and packer consolidation and concentration were coming to a head.

However effective the infrastructure for gathering, analyzing and distributing public data, though, there’s no guarantee the data will enable effective price discovery. In the case of fed cattle these days, the problem revolves around having too little cash information to collect.

Those who trade fed cattle in the cash market shoulder the economic burden of providing this public good of cash reporting, while foregoing the economic advantages currently encouraging others to trade the majority of fed cattle away from the cash market.

“To protect the commons — the value of the cash market opportunity and its information — the industry must help the remaining cash market work better, offset incentives to not use the cash market, and/or create a market for the price information,” Koontz explains.

Cash trade volume

One way to encourage more cash trade is to pay for it.

For instance, one of the prescriptive policies Koontz offers is developing permits or certificates that would require some participation in the cash market. In effect, those who don’t want to participate in the cash market could fulfill their obligation by paying other producers to take their permits — kind of a carbon credit trading for fed cattle.

“This is a market solution to the public good problem,” Koontz explains. “The critical economic issue with thin markets is that there is no market for price information. For example, if you think there is not enough price information, then there is no way to increase its availability by buying more. Prices are simply reported by AMS, which addresses one aspect of the public good problem in that information is difficult to control once released.”

A certificate system could spawn a market for cash information and remain malleable to change.

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“This market for price information would provide for and communicate its value. This is ‘cap and trade,’ ” Koontz explains. “It works where it has been tried. But it is very innovative and hasn’t been tried before in any agricultural industry to facilitate price discovery.”

Market-makers

Another prescriptive policy that offers direct incentive for cash market participation is the employment of market-makers.

“All financial markets that function well employ market-makers,” Koontz says. “Market-makers are often directly compensated and/or derive some compensation from their trading. This is a proven system. But it requires compensation.”

Think of the concept as one or more organizations with an open order to buy and sell fed cattle on a cash basis. In simple terms, sellers outside the cash market who want or need the cash price information would pay for it. In theory, the market-makers would share enough of that compensation with cash sellers to keep them in the market.

However, Koontz says it’s unclear whether such a system would yield the appropriate volume for effective price discovery.

And don’t confuse the use of market-makers with privatizing price reporting, another potential solution.

“Privatizing the collection and reporting of prices is a traditional method of solving public good problems,” Koontz explains. “Allowing a private entity to own price reporting — changing the public good to a private good — would result in users of price data having to pay subscription fees, and would allow compensation to those providing the information and the price discovery.”

Other potential policy solutions Koontz cites for the challenge of thinning cash fed cattle markets:

“All of these potential solutions come with strengths, weaknesses and different chances for success,” Koontz says. “All require different amounts of work, commitment and change. The thinning cash market problem will not solve itself. Action by the industry is needed.”

The first response suggested by Koontz’s PDRP study is industry communication and leadership.

“The industry, through its associations, needs to meet, discuss the issue and assess what individuals are willing to do,” Koontz says. He explains many public goods are managed through informal institutions — family, community, local government and associations — that agree to actions that support the common benefit.

“The solution to price discovery requires a change in industry mindset,” Koontz explains. “Often, we expect research to generate an answer that solves the problem. This is unlikely with the price discovery problem. The exception is the permit system, market-makers and privatizing price information — these would solve the problem. Short of these choices, we are going to have to discuss it regularly, ensure that what is happening is what the industry wants, and then do something more than talk.”

Next month: Industry responds to the dwindling cash fed cattle market

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