The effect of wage rate changes in the food processing industry on retail and farm prices

Abstract

The food processing industry transforms raw farm output into retail food products using bundle of marketing service inputs. The marketing service cost share of consumer food expenditures exceeds the farmers' share by a substantial margin and labor costs are the largest single component of consumer food expenditures (Dunham). The objective of this study is to investigate, both conceptually and empirically, the relationship between labor costs, retail food prices and farm price. Traditional approaches to modeling marketing margins assume fixed proportions between farm and non-farm inputs -- this assumption is not maintained herein. Output supply and input demand functions for the food processing industry are specified and estimated using both normalized quadratic and translog forms of the restricted profit function. Annual price and quantity data for output, labor, raw materials and energy for the 1958-82 period are used in the analysis. Elasticities are decomposed into substitution and scale effects. In addition, the industry derived demand elasticities, which account for the endogeneity of output price, are calculated. A market equilibrium model is used to examine the effect of an exogenous wage rate change on the endogenous variables of the system. Policies affecting labor market composition are also analyzed. Sensitivity of the policy results to alternative values of the union/nonunion elasticity of substitution, the union labor supply elasticity, and the imposition of fixed proportions is examined. The translog and normalized quadratic functional forms yield vastly different results. Economic criteria favor the translog estimates. Translog estimates suggest that output supply is highly elastic, supporting the use of the CRTS assumption in industry level market equilibrium analysis. The derived demand for aggregate farm output is found to be more elastic than estimates obtained under the fixed proportions assumption. The directional effects of a wage rate change are the same as those predicted by the traditional model. However, the incidence of the change is reversed. The farmers' share of a wage rate change (i.e., the change in farm price as a proportion of the change in the marketing margin) decreases from 79% to 29% under variable proportions. Labor's cost share provides a close approximation of the effect of a percentage change in the wage rate on the wholesale/farm price ratio. This result is contrary to expectations, given the removal of restrictions on substitution and input supply elasticities, and is likely a function of (1) the large output supply elasticity and (2) the negligible total effect of a wage rate change on farm price. Since the estimated effects of a wage rate change do not differ substantially from simple cost share predictions, an approach accounting for market equilibrium price effects may not be needed.