Estimating Bargaining Strengths of Canadian

Chicken Producers and Processors Using

a Bilateral Monopoly Framework
Jean-Philippe Gervais
Canada Research Chair in Agri-industries and International Trade,
CRÉA and Department of Agricultural Economics. Laval University,
Québec, QC G1K 7P4 Canada. E-mail: Jean-Philippe.Gervais@eac.ulaval.ca
Stephen Devadoss
Department of Agricultural Economics, University of Idaho, P.O. Box 442334,
Moscow, ID 83844–2334. E-mail: sdevadoss@uidaho.edu

ABSTRACT
This study develops a dynamic price adjustment mechanism for the Canadian chicken industry
using a bilateral monopoly framework+ The model compares the processors and producers’ bar-
gaining strengths in order to determine the equilibrium price of live chickens in Ontario+ The theo-
retical results show how the equilibrium price of live chickens and each party’s profit depend on the
coefficient of bargaining power+ The stochastic properties of price and cost data call for cointegra-
tion techniques to infer the bargaining weights+ The hypothesis of equal bargaining strengths between
processors and producers in Ontario over the 1997–2002 period is strongly rejected by the data+ It
is shown that chicken processors had greater bargaining power than chicken producers because live
chicken prices were highly correlated to chicken producers’ average costs+ @Econlit citations: C22,
L13 and Q13#+ © 2006 Wiley Periodicals, Inc+

1. INTRODUCTION
A bilateral monopoly situation is said to arise when there is a single seller and a single
buyer of a commodity+ The seller produces an intermediate product and sells it to the
buyer who uses it as an input in producing a final output+ Some real-world examples of
bilateral monopoly are players’ associations vs+ owners in professional sports leagues or
labor unions vs+ firms in major industries ~e+g+, automotive industry!+ Even more salient
examples involve the marketing of some agri-food products that entail negotiations between
a producers’ marketing board and processors+ Hueth and Marcoul ~2003! offer an inter-
esting description of various market and commodity characteristics through which actual
bargaining processes are used to market farm outputs+
The description of a bilateral monopoly fits the Canadian chicken industry rather well+
Canadian chicken production has been controlled through a supply management system

We would like to acknowledge the helpful comments of two anonymous reviewers+ The standard disclaimer
about remaining errors applies+

Agribusiness, Vol. 22 (2) 159–173 (2006) © 2006 Wiley Periodicals, Inc.

Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/agr.20078

159
160 GERVAIS AND DEVADOSS

since 1979+ Chicken producers sell live chickens to processors and transactions occur in
a market in which concentration has increased significantly over the past 25 years ~Fulton
& Tang, 1999!+ Before 1995, the Canadian Chicken Marketing Agency determined the
total volume of chicken production in Canada based on petitions by the producers’ pro-
vincial marketing boards and processors+ The national quota was distributed to provincial
marketing boards according to historical market share criteria+ Since 1995, output in each
province is determined through negotiations between provincial marketing boards and
processors and the agreed production quotas in each province is adjusted to sum to the
production quota at the national level+
From 1992 to 2003, prices to producers were determined at the provincial level through
negotiations between producers and processors+ Negotiated prices in the province of Ontario
are generally used as a basis for the price negotiations in the other provinces+ The Ontario
chicken marketing board and representatives of the processing industry met on a regular
basis to negotiate the price that was to be paid by all processors to all producers over a
given period of time+ If an agreement on live chicken prices could not be reached, the
process to determine prices proceeded to arbitration to select one of the party’s final offers+1
The objectives of this paper are twofold+ The first objective is to provide a dynamic
analysis of pricing decisions using a joint profit maximization framework that accounts
for the institutional features of supply management in the Canadian chicken industry+ The
second objective is to apply the theoretical framework to estimate the relative bargaining
strengths of Ontario chicken producers and processors+
The literature on bilateral monopoly dates as far back as 1928+2 As noted by Henderson
and Quandt ~1980!, four possibilities arise in the determination of equilibrium price and
quantity of the intermediate product in a bilateral monopoly: ~1! the monopoly case in
which the seller may dominate the market and make the buyer accept his0her price and
quantity decisions; ~2! the monopsony case in which the buyer may dominate the market
and force the seller to follow his0her price and quantity decisions; ~3! collusion by the
seller and buyer; and ~4! noncooperation by the seller and buyer can result in the nonex-
istence of both parties+
Truett and Truett ~1993! used a contract curve approach to establish that the equilib-
rium price of the intermediate product is determined through a bargaining process between
the seller and buyer and that the optimal solution calls for a joint profit maximi-
zation by the seller and buyer+ Devadoss and Cooper ~2000! used an optimal control
dynamic optimization model to determine simultaneously the price and quantity of the
intermediate product in a joint profit maximizing bilateral monopoly with equal bargain-
ing power+ Dasgupta and Devadoss ~2002! also applied a game theoretic model to derive
the equilibrium price and quantity of the intermediate product when buyer and seller
have unequal bargaining power+ Their game theoretic model specifies multiperiod con-
tracts with threats and punishments that induce a Nash equilibrium for a jointly negoti-
ated price and quantity+
Although the literature on bilateral monopoly is rich, empirical applications on the
matter are relatively scarce+ Schroeter, Azzam, and Zhang ~2000! developed an econo-
metric model that tests three competing theories to measure market power in a bilateral
oligopoly setting: ~1! seller price taking; ~2! buyer price taking; and ~3! bilateral price

1
Starting in May 2003, the chicken pricing process in Ontario has changed and moved to a formula-based
live price negotiated once a year+
2
Early studies on the bilateral monopoly include Bowley ~1928!, Fellner ~1947!, and Henderson ~1940!+

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 ESTIMATING BARGAINING STRENGTHS 161

taking+ Raper, Love, and Shumway ~2000! estimated market power exertion between sellers
and buyers in the tobacco leaf industry by considering the latter three alternatives in addi-
tion to ~4! noncooperative bilateral monopoly; and ~5! cooperative bilateral monopoly+
More recently, Raper and Noelke ~2004! investigated the power of nonparametric tests in
detecting noncompetitive market outcomes+ While these studies found significant depar-
tures from perfectly competitive behavior, they did not infer bargaining weights of agents
in the industry+ The study that is perhaps the closest to the current analysis was carried out
by Oczkowski ~1991!+ He estimated a time-varying bargaining power coefficient by rely-
ing on a Nash bargaining framework to model the pricing mechanisms in the Australian
tobacco leaf market+ Our contribution to the empirical bargaining literature resides in
how the stochastic properties of the variables are handled+
Supply management programs have been under attack historically because producers
are believed to restrict supply and thus increase retail prices+ As noted in Fulton and Tang
~1999!, this argument is far too simplistic+ In most industries where supply management
was put in place, the processing and retail sectors have become increasingly concentrated
and the resulting market power can influence production and prices at every level of the
market+ Fulton and Tang ~1999! tested the competitiveness of the Canadian chicken indus-
try using an equilibrium displacement model+ Their results suggest a departure from per-
fect competition in the industry, but whether chicken producers, processors and0or retailers
possess market power still remain unsolved+
The current analysis directly infers the bargaining weights of each party in the bilateral
cooperating monopoly solution+ This strategy is appropriate in the context of the Ontario
chicken industry+ As noted previously, the market structure unequivocally suggests that
the price and quantity variables are determined in a market where upstream producers
collectively exercise control over the supply of an input to downstream processors who
are also represented by a single entity at the bargaining table ~Association of Ontario
Chicken Processors!+ Thus, the farm price and production decisions are the direct out-
come of a bargaining process between the producers’ marketing board and the proces-
sors’ association+
The theoretical model also underlines the importance of determining the stochastic
properties of the data because bargaining is inherently dynamic+ Price and cost variables
are found to be random walks that are tied through a stationary linear combination rep-
resenting the bargaining outcome+ These empirical features are not found in other studies
using the new empirical industrial organization techniques introduced by Appelbaum
~1979!+3 Cointegration allows for short-run deviations among variables that exhibit a sta-
ble long-run relationship+ In the context of repeated bargaining situations, this empirical
feature of the model is appealing since short-term market effects may temporarily shift
the bargaining power between producers and processors+
The remainder of the paper is structured as follows+ The next section presents the theo-
retical model of price bargaining in the context of supply management+ The third section
presents the data used in the following section+ The fourth section introduces the empir-
ical model and reports the estimated bargaining power coefficients of producers and pro-
cessors+ The final section concludes the paper+

3
It has been customary in the NEIO literature to first-difference the individual series of a system to account
for the potential nonstationarity of the data+ It is well known, due to the findings of Granger and Engle ~1987!,
that modeling a system of time series in first-difference leads to a misspecification when at least one linear
combination of the individual series is stationary, i+e+, that the individual series are cointegrated+

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162 GERVAIS AND DEVADOSS

2. THE MODEL
Producers act as an upstream monopolist through their marketing board and supply the
intermediate product ~X ! to downstream processors+ We assume a constant-proportion
technology at the processing level such that one unit of live chicken is used to produce d
units of processed chicken meat+ Processing of the primary commodity involves J other
inputs+ The processing technology of a representative processing firm is summarized by
the cost function: C~q, r, w! ⫽ ~r0d!q ⫹ x~w!q; where q is the individual output of a
processing firm, r is the per-unit price of live chicken, and w is a vector of other input
prices+ Note that the functional form of the cost function implies constant returns to scale
in processing ~Sexton & Lavoie, 2001!+
In order for producers to effectively exercise supply controls, mandatory marketing
rights must be conferred to producers and borders must be controlled+ Trade of chicken
products is managed through a tariff-rate quota ~TRQ; Gervais & Surprenant, 2003!+ The
tariffication process following the ratification of the Uruguay Round Agreement on Agri-
culture resulted in high over-quota tariffs that transform the TRQ in a de facto import
quota+
Production in the Canadian chicken industry is planned about three months ahead of
the period when chickens are marketed to processors+ Negotiations about the price paid
by processors to producers occur about a month before live chickens are marketed ~Chicken
Farmers of Ontario, 2002!+ The demand for chicken products in each period is denoted by
Dt + It is assumed that processors face a downward sloping demand function for chicken
meat products+ This assumption is consistent with the results of Fulton and Tang ~1999!,
who found that there are deviations from competitive behavior in the Canadian chicken
market+ We abstract from imperfect competition issues at the retail level and simply state
that prices are not exogenously determined from the processors’ perspective+ From a math-
ematical standpoint, the wholesale price ~ pt ! is a function of the quantity sold; i+e+, pt ~Dt !
with pt' ⬍ 0+ The domestic demand can be interpreted as the residual demand faced by
domestic processors once imports are accounted for+ In what follows, we abstract from
inventory management 4 issues; thus Dt ⫽ Qt ; where Qt is the aggregate production of
chicken meat ~Qt ⫽ dX t !+ Profits of processors in period t are

ptB ⫽ pt ~Qt !Qt ⫺ ~rt 0d!Qt ⫺ xt ~w!Qt ; ~1!

where pt is the per-unit price of processed chicken+

To simplify the mathematical analysis, it is assumed that live chickens are produced
under constant returns to scale+ Producers’ average cost of production is time dependent
and equals ct + The producers’ collective profits ~p S ! are

ptS ⫽ rt X t ⫺ ct X t + ~2!

The standard analysis of bilateral monopoly issues involves examining the domination
of one party versus the other ~the first two outcomes noted in the introduction!+ Standard

4
Stocks have almost doubled between 1990 and 2002; from 15,820 metric tons to 31,066 metric tons ~Sta-
tistics Canada!+ The ratio of inventories over total production has also increased over this period+ It is not clear
how inventories influence prices at the wholesale level+ In the current model, the effects of stocks on the price
of the farm output will be totally captured by its potential impact on the processors price+

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 ESTIMATING BARGAINING STRENGTHS 163

microeconomics textbooks present a clear exposition of equilibrium price and quantity

determination under seller’s dominance ~monopoly case! with buyer as a price taker and
buyer’s dominance ~monopsony case! with seller as a price taker+ If neither the seller nor
the buyer entity is willing to behave as a price taker, the market mechanism may break
down and both may go out of business ~the fourth outcome identified in the introduc-
tion!+5 One possibility for avoiding the nonexistence of an equilibrium is for both the
seller and buyer to recognize their mutual interdependence and act in unison to maximize
their joint profits+ This collusion can be accomplished through a two-step process: ~1! the
seller and buyer determine the quantity that maximizes their joint profits and ~2! they
agree upon a price to distribute the profits between them+6 Joint profit maximization is
appealing in the present context because of the bottom-up approach in the Canadian chicken
industry which implies output is set first through negotiations between the producers’
marketing board and processors+ Prices are subsequently negotiated to divide total profits
in the industry+ Producers and processors have relatively good knowledge of prices and
cost variables as mechanisms exist to share information among the industry’s stakeholders+
The joint profits in the industry are given by

pt ⫽ ptB ⫹ ptS ⫽ pt ~Qt !Qt ⫺ xt Qt ⫺ ~ct 0d!Qt + ~3!

There are other ways to model the behavior of processors based on the bottom-up approach
of the Canadian chicken industry described in the introduction+ For example, processors
could choose their demand for live chickens noncooperatively by maximizing their indi-
vidual profits conditional on a live price for chickens+ The sum of their individual demand
j
would sum to aggregate output: Qt ⫽ (j⫽1 qt +7 Pricing negotiations would subsequently
determine output+ Given that the emphasis of the paper is placed on measuring relative
bargaining weights in the pricing of the farm output, the quantity decision rule is of second-
order importance here+ In what follows, pricing of the farm output will depend on the
average revenues and costs of processors and producers+ The assumption of constant returns
to scale in production and processing implies average costs do not depend on output and
thus the farm price and output decisions are independently determined+
Let the variable Vt⫺3 represent the information set of agents when planning production
decision three months ahead+ Suppose the optimization problem of processors and produc-
ers is to maximize expected joint profits in equation ~3! with respect to output given the infor-
mation available+ The optimal solution will be Qt* 6Vt⫺3 + Hence, output will depend on the
information available to the industry at time t ⫺ 3+ The optimization rule defines the opti-
mal output in the industry and the farm price remains indeterminate+ In a standard bilateral
monopoly model, Henderson and Quandt ~1980! observe that quantities are determined
through joint profit maximization and that the equilibrium price is not unique+ This price
indeterminacy is the result of a static model which does not allow for the bargaining process

5
One would expect this outcome will never occur because the disagreement profit for each party would be
zero and Pareto improvement would be feasible+
6
The analysis of quantity and price determination under independent profit maximization would require the
use of dynamic game theory tools ~Dasgupta & Devadoss, 2002!+ The presence of asymmetric information in
the model would also potentially influence the bargaining outcome+
7
Naylor ~2002! has applied the assumption of oligopolistic behaviour for downstream firms in a model of
wage bargaining+ Downstream firms noncooperatively choose their output conditional on the wages they must
pay workers+ In the second stage, downstream firms collectively bargain with a union over the wage offered to
workers+

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164 GERVAIS AND DEVADOSS

to take place+ In this section, a stylized dynamic price adjustment mechanism is formulated
which allows for continuous bargaining between producers and processors+ Interestingly,
the solution below is equivalent to Rubinstein ~1982!’s model of bargaining in which play-
ers make alternating offers until an agreement is reached ~Muthoo, 1999!+
The price adjustment mechanism, which compares buyer’s and seller’s profits at time
t and includes the bargaining power of each party is based on Devadoss and Cooper ~2000!

Drt ⫽ uE @ptB 6Vt⫺1 # ⫺ fE @ptS 6Vt⫺1 #; u, f ⬎ 0 ~4!

where the parameters u and f capture the bargaining power of the buyer and seller, respec-
tively+ The intuition behind equation ~4! is that changes in the farm product price are
directly linked to changes in market conditions affecting profits of both groups+ Based on
the actual negotiation process in the industry from 1997 to 2002, bargaining occurs using
expectations at time t ⫺ 1 of period t prices and costs+ It is important to note that at time
t ⫺ 1, output at time t is known+
The smaller the value of u~f!, the greater is the bargaining power of the buyer ~seller!+
Because of the close interaction between both parties, it is assumed that each party has
knowledge of the ~expected! profit of the other party+ Equation ~4! implicitly assumes
that both parties compare anticipated profit levels when negotiating prices and try to use
their bargaining powers to influence the price outcome+ For example, if the seller has a
greater bargaining power ~i+e+, smaller f!, it can accelerate the upward movement in price
when uE @p B # ⬎ fE @p S # , and soften the downward movement in price when uE @p B # ⬍
fE @p S # + Similarly, if the buyer has a greater bargaining power ~i+e+, smaller f!, it can
accelerate the downward movement in price when uE @p B # ⬍ fE @p S # , and lessen the
upward movement in price when uE @p B # ⬎ fE @p S # This price adjustment mechanism
implies r will adjust upwards if uE @p B # ⬎ fE @p S # and downwards if uE @p B # ⬍ fE @p S # +
If uE @p B # ⫽ fE @p S # , which implies Drt ⫽ 0, further changes in price will not occur, and
the equilibrium price has been reached+
Suppose that the wholesale price of chicken and both average cost parameters follow
an autoregressive process of the form

pt ⫽ ap ⫹ rp pt⫺1 ⫹ vpt ; xt ⫽ ax ⫹ rx xt⫺1 ⫹ vxt ; ct ⫽ ac ⫹ rc ct⫺1 ⫹ vct ~5!

where vpt , vxt , and vct are all white noise processes with variance sp2 , sx2 and sc2 respec-
tively+ No restrictions are placed on the coefficients in equation ~5!+ The assumptions
about the stochastic process of producers and processors’ average costs are fairly general
in that they admit the possibility that they follow a random walk around a deterministic
trend+ The specification of the processor price is consistent with the assumption that price
depends on output+ Given the institutional feature of the industry, output will depend on
past realizations of industry’s variables ~i+e+, the information set available at time t ⫺ 3!+
However, the demand function could be stochastic and evolve according to an auto-
regressive process as defined in equation~5!+8 From an empirical perspective, the price

8
For illustrative purposes, consider the following example+ Assume a constant-elasticity form for the domes-
tic demand function such that the inverse demand function is pt ⫽ A t qt10« + Output is determined through an
optimization process that takes place approximately three months before output is actually marketed+ If we
substitute out the optimal decision rule for output in the inverse demand, the processor price will be function of
time t ⫺ 3 ~hence predetermined! variables and the constant A t + Hence, assuming a stochastic process of the
form defined in equation ~5! is tantamount to assume a stochastic process of a similar form for the variable A t +

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 ESTIMATING BARGAINING STRENGTHS 165

stochastic process is also consistent with the assumption that the wholesale price is strictly
exogenous from the processors and producers’ perspective+
The information set when time t pricing decision is made includes all the information
available at time t ⫺ 1+ Substituting p B and p S into the price adjustment rule in equation
~4! and distributing out the expectation operator according to the stochastic properties of
the variables defined in equation 5 leads to

Drt ⫽ u~ap ⫹ rp pt⫺1 ⫺ ax ⫺ rx xt⫺1 !Qt*

⫹
f
d
~ac ⫹ rc ct⫺1 !Qt* ⫺ ~u ⫹ f! 冉冊 rt
d
Qt* + ~6!

The equilibrium ~steady-state! farm price of chickens ~r * ! is obtained by setting Drt ⫽ 0

in the above equation and solving for the farm price

ud~~ap ⫹ rp pt⫺1 !Qt* ⫺ ~ax ⫹ rx xt⫺1 !Qt* ! ⫹ f~ac ⫹ rc ct⫺1 !Qt*

rt* [
~u ⫹ f!Qt*

u f
⫽ d~ap ⫹ rp pt⫺1 ⫺ ax ⫺ rx xt⫺1 ! ⫹ ~ac ⫹ rc ct⫺1 !+ ~7!
~u ⫹ f! ~u ⫹ f!

The bargaining solution in equation ~7! relates to the Rubinstein ~1982! model of bar-
gaining in which players take turns making offers to each other until an agreement is
reached+ In this latter case, the bargaining weights correspond to the ratio of the discount-
ing factor of each party ~Muthoo, 1999!+ The equilibrium price is a weighted average of
per unit net revenue of the buyer and per unit cost of the seller+9 The bargaining weights,
as we would expect, depend on the bargaining power coefficients+ The greater the bar-
gaining power of the buyer ~i+e+, the smaller the value of u!, the lower is r *, and the whole
bargaining process is said to work in favor of the buyer+ This can be seen by differenti-
ating r * with respect to u: ]rt* 0]u ⬎ 0+ The intuition is that the smaller is u, the closer the
farm price will be to the producers’ average cost+ Conversely, the larger the value of u, the
closer will be the farm price to the average net revenue of the processors+ To exercise
bargaining power, processors must force producers to accept a farm price that is as close
as possible to their average costs and thus would allow them to earn all the economic
profits generated by the exercise of market power when setting output in the first place+
Using similar arguments, it is relatively easy to show that the greater the bargaining power
of the seller ~i+e+, the smaller the value of f!, the higher is r *, and the bargaining process
works in favor of the seller+ This can be seen by differentiating r * with respect to f:
]rt* 0]f ⬍ 0+

9
If both parties have equal bargaining power l such that l ⫽ f ⫽ u, the analysis is further simplified+ Under
the equal bargaining power, the price adjustment mechanism in equation ~4! is simplified as Drt ⫽ l@ptB ⫺ ptS # ,
where the parameter l, in addition to representing equal bargaining power, also has added meaning in that it
captures the speed of price adjustments or the intensity and effectiveness of the bargaining process in arbitrating
the price toward the equilibrium price+ The above price adjustment mechanism yields an equilibrium price: r[ t ⫽
0+5~ap ⫹ rp pt⫺1 ⫺ ax ⫺ rx xt⫺1 ! ⫹ 0+5~ac ⫹ rc ct⫺1 !+

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166 GERVAIS AND DEVADOSS

3. DATA

The assumptions of constant returns to scale in the processing and production sectors
imply that average cost is constant in each sector+ As such, output does not appear as an
element in the price equation and the pricing decision in the industry is totally indepen-
dent from output decisions+ Output determines joint profits in the industry and the farm
price divides up this profit among both groups+ Equation ~7! presents the testable hypoth-
eses that producers and processors exercise their bargaining strength to negotiate a price
to split industry’s total profit in each party’s favor+ Equation ~4! presents a truly dynamic
adjustment path towards an equilibrium price that is a function of the bargaining strength
of each party+ However, there are no reasons to believe a priori that the equilibrium price
will be reached instantaneously+ Rigidity in bargaining positions, time and other bargain-
ing related factors can prevent the farm price to instantaneously reach its equilibrium
value+
A total of three variables will be used in the empirical model: ~1! the processors net
average revenue defined as the processors’ price minus their average variable cost, ~2! the
farm price of chicken, and ~3! the chicken producers’ average variable cost+ Monthly data
on farm chicken prices and processors chicken prices in Ontario and the average cost of
chicken production were obtained from the poultry marketplace database maintained by
Agriculture and Agri-food Canada+ As noted in Introduction, the chicken marketing sys-
tem in Canada has undergone a major change beginning in 1995 with the introduction of
the bottom-up system to determine output+ Although, pricing negotiations existed from
1992 to the end of 2002, the timing of decisional aspects related to output decision have
changed and this may have resulted in different price negotiation dynamics between the
two groups+ From 1992 to early 1997, pricing negotiations occurred simultaneously to
output decisions+ To avoid potential structural change in the sample and to have a con-
stant price expectation and bargaining structure throughout, we used data on price and
cost variables from March 1997 to December 2002+
The processor chicken price net of average processing costs in Ontario ~denoted p ⫺ x!
was computed as follows+ Processing costs were estimated in two steps+ First, the index
of average monthly earnings in the poultry and meat industries and the selling price index
of electric power for quantities over 5000 KW were combined in proportions of 0+9 and
0+1, respectively, to construct a chicken marketing cost index+ Although labor and energy
do not represent all variable inputs used in processing chickens, Gordon and Hazledine
~1996! report that they constitute close to 60% of all variable costs+ The choice of inputs
in the construction of the index is dictated by data availability+ The monthly price indices
for earnings and electric power are published by Statistics Canada+ Next, the marketing
cost index must be converted into a dollar value+ Gervais and Surprenant ~2003! esti-
mated the average variable cost of processors in Canada to be $0+66 per kg in 1999+ They
admit that their estimate is at the high end of the possible spectrum and mention that
industry sources establish the figure to be more in line with $0+43 per kg+ We use the latter
estimate because marketing margins tended to be negative over some brief period had the
higher estimate been used+ The 1999 average value of the monthly processing cost index
then becomes the base index period ~1999 index ⫽ 100!+ Monthly processing costs are
computed using the 1999 $0+43 estimate and the processing cost index+ The net processor
average revenue is the difference between the wholesale price and processing cost+ Price
and cost variables in Ontario are plotted in Figure 1+ The chicken processor price is a lot
more volatile than the other series+
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 ESTIMATING BARGAINING STRENGTHS 167

Figure 1 Average Variable Cost of Production in the Chicken Farm and Processing Sectors, Farm
Price And Processor Price in Ontario from March 1997 to December 2002

4. MODEL ESTIMATION
This section provides an empirical illustration of the bargaining framework laid out in the
theoretical section+ Before proceeding with the estimation of equation ~7!, a number of
preliminary testing procedures must be implemented+ First, the stochastic properties of
the data must be investigated+ It is well known in the time series literature that price series
often exhibit a stochastic trend+10 If the price variables in the chicken industry are not
stationary, there may still exist a tendency for the variables not to drift too far apart in the
long-run equilibrium if they are cointegrated ~Granger and Engle, 1987!+11 If the vari-
ables are integrated of order one ~i+e+, not stationary!, it is important to test for cointe-
gration to avoid reporting spurious relationships between the variables ~see Maddala and
Kim, 1998, for an excellent discussion!+ Cointegration techniques are appealing in the
present context given the theoretical predictions of the bargaining model+ Equation ~7!
states that there will be a long-run equilibrium relation between the farm price, the pro-
cessor net average revenue, and the producers’ average cost+ Convergence to this long-
run equilibrium can take some time and the cointegration analysis in this section allows
for deviations from this long-run common trend+
The Augmented Dickey-Fuller ~ADF! and Phillips-Perron ~PP! unit root tests are
carried out to determine the degree of integration of the variables+ The ADF test is imple-
mented, as shown in equation ~8!, by regressing the first difference of a series on a con-
stant, the lagged level of the series and, if needed, a time trend+ Moreover, m lagged

10
See, for example, Kapombe and Colyer ~1998! for an application to the broiler industry+
11
Note that the relation defined in equation ~10! is non-contemporaneous+ However, Nielsen ~2004! shows
that the cointegration property of the data is not affected when the timing of variables in the cointegration
relation is not homogeneous+

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168 GERVAIS AND DEVADOSS

first differences of the dependent variables are also used to ensure that residuals ~«t ! are
white noise+

m
Dyt ⫽ a ⫹ bt ⫹ ryt⫺1 ⫹ ( gj Dyt⫺m ⫹ «t + ~8!
j⫽1

Failure to reject the null hypothesis of a unit root ~r ⫽ 0! from the ADF test indicates that
the variables are nonstationary+ The PP test involves estimating a similar equation as in
equation ~8!, but it uses a nonparametric correction for serial correlation of the residuals
~Maddala & Kim, 1998!+
Both unit root tests were used on the level of all variables to assess their degree of
integration+ Pretesting procedures confirmed that a time trend was not required in the
implementation of the unit root tests+ The number of first differences used in the ADF test
or the truncation lag parameter in the PP test was set at the highest significant lag order+
The results of the ADF test are presented in Table 1+ The first column indicates the name
of the variable and the second column indicates the lag length m in equation ~8!+ Based on
a 95% critical value of ⫺2+89, the null hypothesis of a unit root in the price and cost
variables cannot be rejected according to the ADF test+ Results of the PP unit root tests
are also presented in Table 1+ Using the same deterministic structure as in the ADF tests,
the results support the hypothesis of a unit root in the level of price and cost variables+
Given the stochastic nature of the price and cost data, cointegration techniques are
used to compute the long-run bargaining relationship identified in equation ~7!+ As men-
tioned before, the notion of cointegration is appealing in the present context because the
bargaining solution involves a dynamic adjustment path to the equilibrium+ We adopt the
two-stage Engle-Granger ~EG! cointegration technique to estimate the bargaining rela-
tionship ~Hamilton, 1994!+ Unit root testing procedures suggest that the autoregressive
parameters defined in equation ~5! can be set to one; i+e+, rp ⫽ rx ⫽ rx ⫽ 1+ Equation ~7!
simplifies into

rt [ g0 ⫹ g1 ~ pt⫺1 ⫺ xt⫺1 ! ⫹ g2 ct⫺1 ⫹ et ~9!

where g1 [ u0~u ⫹ f!, g2 [ f0~u ⫹ f!, and g0 [ g1 ~ap ⫺ ax ! ⫹ g2 ac + Note that the
coefficient d has been subsumed in the variables in equation ~9! using historical data ~d ⫽
0+736, Agriculture and Agri-food Canada!+
The theoretical model predicts that the sum of the relative bargaining weights equals
one; i+e+, g1 ⫹ g2 ⫽ 1+ Therefore, we must apply this linear restriction when estimating
equation ~9!+ However, inference about the validity of this restriction is complicated by
the fact that the distribution theory for OLS estimates under cointegration is non standard

TABLE 1+ Unit Root Testing

ADF PP
Variable Lag Statistic Lag Statistic
Farm price 1 ⫺1+65 1 ⫺1+30
Processors’ net price 0 ⫺1+93 1 ⫺2+14
Producers’ average cost 1 ⫺1+47 1 ⫺1+41

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 ESTIMATING BARGAINING STRENGTHS 169

~Hamilton, 1994!+ Nuisance parameters arise from two potential problems: ~1! endo-
geneity of the regressors and ~2! autocorrelation in the residuals+ The former issue may
not be too problematic in the current context given the timing of the cointegrated vari-
ables in equation ~9!+ The second issue may be significant and must be corrected before
undertaking hypothesis testing+ Saikkonen ~1991! suggests augmenting equation ~9! with
leads and lags of the first difference of the independent variables to eliminate the effects
of the potential correlation between the cointegrating relation and the error terms+ Thus,
equation ~9! needs to be rewritten as:

rt [ g0 ⫹ g1 ~ pt⫺1 ⫺ xt⫺1 ! ⫹ g2 ct⫺1

j⫽w j⫽q
⫹ ( tj D~ pt⫺1⫺j ⫺ xt⫺1⫺j ! ⫹ j⫽⫺q
( zj Dct⫺1⫺j ⫹ eI t ~10!
j⫽⫺w

The impact of autocorrelation in the residuals on inference is accounted for by using

the estimates of equation ~10! and correcting the test statistics by a factor of k [ s[ e2 0C 2 ;
where s[ e2 ⫽ ~T ⫺ 2!⫺1 ( e[ t2 and C [ s[ u2 0~1 ⫺ zZ 1 ⫺ {{{ ⫺ zZ n ! is computed from the
regression of e[ t on n of its own lags and a random error term denoted by u t , with mean
zero and variance su2 + The usual t and F statistics can be compared with the usual t and F
distributions once corrected by the factor k 0+5 and k, respectively+
If prices are not cointegrated, the linear restriction between the relative bargaining coef-
ficients has no meaning from an empirical standpoint given that a stable relationship
between the variables does not exist+ Hence, the first step is to test the degree of integra-
tion of the residuals generated by the OLS regression of equation ~9! applying the linear
restriction on the bargaining relative weights+ Rejection of the null hypothesis that the
residuals have a unit root would imply that prices adhere to a stationary long-term rela-
tionship+ The second step is to test the linear restriction that the relative bargaining coef-
ficients sum to one using equation ~10!+
The asymptotic distribution of the ADF test statistic applied to the residual series in
equation ~9! depends on the number of right-hand-side variables in equation ~9! and whether
a constant and0or a time trend is included+ The test statistic in absolute value is 3+87 and
is higher than the critical value at the 5% and 10% significance levels ~3+77 and 3+45,
respectively! ~Maddala & Kim, 1994!+ The Phillips-Ouliaris ~1990! test for cointegration
yields a statistic in absolute value of 36+98 which is higher than the critical value at the
5% significance level of 26+08+ The two residual-based tests suggest that the three vari-
ables in equation ~9! are cointegrated+
The residual-based tests have been criticized because they were found to have low
power in many instances+ Some point out that the low power of these tests is due to the
“common factor restrictions” ~see, for example, Ericsson & MacKinnon, 2002!+ The Engle-
Granger methodology ignores equation dynamics and implicitly assumes that short-run
and long-run responses of the farm price following changes in pt ⫺ xt and ct are identical+
In other words, the common factor restriction in the residual-based test imposes restric-
tions on the dynamics of the relationship between the variables involved that may turned
out to be false+ Ericsson and MacKinnon ~2002! suggest using cointegration tests based
on the error correction model implied by the cointegrated system+
Consider the equation:

Drt [ l 0 ⫹ l p D~ p ⫺ x!t⫺1 ⫹ l c Dct⫺1 ⫹ mz t⫺1 ⫹ u t ~11!

Agribusiness DOI 10.1002/agr
170 GERVAIS AND DEVADOSS

where z t⫺1 [ rt⫺1 ⫺ g0 ⫺ g1 ~ p ⫺ x!t⫺2 ⫹ g2 ct⫺2 + The parameter l 0 can be constrained to

zero in equation ~11! to avoid a drift in rt + Equation ~11! can be rewritten as

Drt [ l p D~ p ⫺ x!t⫺1 ⫹ l c Dct⫺1 ⫹ mrt⫺1 ⫹ wp ~ p ⫺ x!t⫺2 ⫹ wc ct⫺2 ⫹ u t ~12!

Banerjee et al+ ~1998! suggest using a t ratio to test the null hypothesis m ⫽ 0 in equation
~12! because it implies a lack of cointegration among the farm price, processors’ net price,
and producers’ average cost+ The t test statistic is 3+74 in absolute value and it is higher
than the critical value at the 5% significance level ~3+56! according to Ericsson and
MacKinnon’s ~2002! finite sample Monte Carlo study+ Finally, Boswijk ~1994! suggests
testing the joint null hypothesis m ⫽ wp ⫽ wc ⫽ 0 using a Wald test+ The test statistic is
15+71, which is higher than the critical value at the 5% significance level ~15+30!+ The
cointegration testing procedures allow us to conclude that the variables in equation ~9!
are cointegrated+
Given that the three prices appear to be cointegrated, the next logical step is to test the
validity of the linear restriction on the relative bargaining weights+ To this end, equation
~10! is estimated without imposing the linear restriction that g1 ⫹ g2 ⫽ 1+ The point esti-
mates of the slope parameters are g[ 1 ⫽ 0+216 and g[ 2 ⫽ 0+779, indicating at first glance
that processors exercise greater bargaining power than producers since g[ 1 ⬍ g[ 2 implies
that u0Z fZ ⬍ 1+ Recall that the smaller the value of u~f!, the greater is the bargaining
power of the buyer ~seller!+ Note that the sum of the point estimates is in accordance with
the model’s theoretical prediction, i+e+ g[ 1 ⫹ g[ 2 ⫽ 0+995+
The estimated variance of the residuals in equation ~10! is s[ e2 ⫽ 42+87+ The OLS
regression of the fitted error terms on its lags values yields C ⫽ 15+55, producing a cor-
rection factor of k ⫽ 0+688 n k 0+5 ⫽ 0+817+ The standard errors of g[ 1 and g[ 2 are 0+042 and
0+044, respectively; generating t values of 5+15 and 17+82, respectively+ Once the appro-
priate correction factor is applied, the t statistic for the null hypothesis that g[ 1 ⫽ 0 is 4+21,
and significant at the 95% confidence level+ The t statistic for the null hypothesis that
g[ 2 ⫽ 0 is 14+56 and significant at the 95% confidence level+ This indicates that each group
has significant bargaining power+ Is the linear restriction valid? The usual F statistic for
the linear restriction is very low at 0+014+ Adjusting the F statistic by the appropriate
correction factor ~0+688! yields an even lower statistic which ~when compared to its crit-
ical value with 1 and 48 degrees of freedom! is well below the 5% significance level of
4+08 ~Hamilton, 1994!+ Hence, we cannot reject the null hypothesis that the sum of the
relative bargaining weights is one+
Are bargaining strengths equal? To verify this hypothesis, a F test is used to test the
null hypothesis that g[ 1 ⫺ g[ 2 ⫽ 0 while constraining the sum of the two coefficients to
equal one+ Under the constraint that g1 ⫹ g2 ⫽ 1, the point estimates of g1 and g2 are
0+218 and 0+782, respectively+ The standard F statistic is 59+46, which yields a modified
F statistic of 38+95 ~k ⫽ 0+655!+ This statistic is above the 5% critical value and thus we
reject the null hypothesis that processors and producers in Ontario possess equal bargain-
ing power+ There is significant empirical evidence to conclude that Ontario chicken pro-
cessors have exercised greater bargaining power in the live chicken pricing negotiations
than Ontario Chicken producers from March 1997 to December 2002+

5. CONCLUSION
The paper presented a mechanism to explain output decisions in the Canadian chicken
industry consistent with joint profit maximization behavior+ Supply management and the
Agribusiness DOI 10.1002/agr
 ESTIMATING BARGAINING STRENGTHS 171

associated marketing rules of the farm product are consistent with a bilateral monopoly
situation between chicken producers and processors+ The issue of interest in the literature
surrounding the bilateral monopoly is the determinacy of equilibrium price+ This study
employs a dynamic price adjustment mechanism to resolve this issue+ If both parties have
unequal bargaining power, the equilibrium price of the intermediate product and each
party’s profit will explicitly depend on the bargaining powers+ Thus, any empirical analy-
sis of price discovery in a real-world bilateral monopoly requires estimation of the bar-
gaining strengths of both parties+
The empirical model analyzes the hypothesis identified in the theoretical section of the
paper, namely that the farm price is determined by the bargaining strength of producers
and processors+ A price equation was estimated for the Ontario chicken industry using
monthly data over the 1997–2002 period+ Over this period, the empirical model shows
chicken processors in Ontario have exercised greater bargaining power than chicken pro-
ducers in Ontario+ The bargaining power coefficient of processors is almost four times
larger than the bargaining power coefficient of producers+
The present analysis adds significant weight to the findings of Fulton and Tang ~1999!
that producers do not exercise clear-cut market power through supply management+ Sup-
ply restrictions at the farm level are coordinated in the chicken industry through what is
called a bottom-up approach+ Downstream processors survey market opportunities for
chicken products and relay their demands to the upstream provincial marketing boards+
Although the theoretical framework a priori assumes that market power resides with both
processors and producers, the empirical framework indicates that chicken producers did
not establish a strong bargaining position with respect to processors between 1997 and
2002+ It has been suggested in the literature ~e+g+, Barichello, 1999! that supply manage-
ment agencies generally attempt to maintain a target price based on the average total cost
of production of a representative sample of producers+ This objective is not inconsistent
with the empirical framework of our study+
A number of extensions to the current framework could be considered+ On the theo-
retical side, the assumption of complete information appears strong+ Introducing asym-
metric information would likely introduce multiple equilibria in the price bargaining
structure ~Fudenberg & Tirole, 1991!+ Without proper empirical procedures to screen the
various theoretical possibilities, it may prove difficult to estimate a bargaining model that
is consistent with asymmetric information+ Another interesting and related topic would
be to analyze the new pricing formula in the Ontario chicken industry+ Ontario chicken
producers and processors have switched in May 2003 to a formula-based live price nego-
tiated once a year+ The formula price includes three components: ~1! the feed component,
~2! the chick component, and ~3! a fixed producer margin+ The price of live chicken is
now set 18 weeks in advance of the marketing period and is based on expectations about
future feed prices+ An interesting question would be to explore how this has changed the
pricing dynamics in the industry and study the welfare implications in a framework that
considers risk preferences+ Perhaps this would provide insights into how the two parties
perceived their bargaining power was in the industry prior to 2003+

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 ESTIMATING BARGAINING STRENGTHS 173

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Jean-Philippe Gervais is an associate professor and Canada research chair in Agri-industries and
International Trade at Laval University, Quebec City, QC, Canada. His current research interests
include international agri-food trade policy and the econometrics of nonlinear time series.
Stephen Devadoss is a professor in the Department of Agricultural Economics, University of Idaho,
Moscow, ID. His research interests include agricultural trade and industrial organization.

Agribusiness DOI 10.1002/agr