An Analysis of the Benefits and Detriments of Contracts in Agriculture

Introduction

This synthesis attempts to address various contract approaches in agriculture. The analysis and comparison are based on the study of several works in the academic fraternity. However, the focus of this writing is on the three main sources below here:

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  • Dubois, Pierre, and Tomislav Vukina. “Growers Risk Aversion and the Cost of Moral Hazard in Livestock Production Contracts.” American Journal of Agricultural Economics 86.3 (2004):1 – 18. Print.
  • Ghatak, Maitreesh, and Priyanka Pandey. “Contract Choice in Agriculture with Joint Moral Hazard in Effort and Risk.” Journal of Development Economics 63.1 (2000):303–326. Print.
  • Zheng, Xiaoyong, and Vukina Tomislav. “Do Alternative Market Arrangements increase pork packers’ market power?” 2007. Web. 21st May 2011. An analysis of the benefits and detriments of contracts in agriculture.

Overview of contracts in Agriculture

Governments around the world have continued to encourage agriculture, especially in developing nations. This is with the understanding that agriculture continues to play a very important economic role for most of such countries. One of the ways that this is being implemented is through contract farming also termed contract agriculture. India remains one of the countries that rely heavily on agricultural production as one of their main economic sustainability activities. In India, contract farming has for some time now been applied on a large scale where initially it was a preserve of a few firms. Presently business giants like Reliance and PepsiCo have embarked on establishing and maintaining their supply chains through contract farming. A change in government policy has led to this emerging trend. The Indian government has asserted that contract farming is becoming an important arrangement that will ensure well-coordinated agricultural marketing and production activities.

While looking at the debate on contract agriculture, the type of agreement involving the contractor and the farmer continues to generate a lot of interest. A perfect balance is where the contractor or landlord and farmer or tenant have balanced benefits from the agreement. However, various schools of thought have indicated that while each of the parties in contract agriculture makes some trade-offs, it remains a business venture with each of the parties wanting to reap maximally from the agreement.

With this kind of view, likely, contract agriculture as a business initiative may not necessarily result in a win-win situation for both parties involved. As each of the parties involved makes some trade-offs, there is either some profit or loss on their part.

According to the Union Agriculture Minister of India, the contract agriculture approach being implemented in India is one where the land remains permanently owned and cultivated by the farmer.

The business sector proposes contract agriculture because it can manipulate the supply chain. Accordingly, Sabat and Pal assert that “this is meant to ensure timely availability of both quantity and quality agricultural products” (3). India has a model of contract agriculture where corporate firms such as PepsiCo supply all the farm inputs while the farmer gives his land and provides the labor. Looking at the other side of the coin is the main concern that contract agriculture is taking over staple crop production fields. These fields once produced locally consumed foods now produce food products for export. Although this results in increased export earnings, it is likely to cause food insecurity. Sustained long-term contract agricultural practices could eventually cause the country to totally rely on importation to solve the existing food insecurity issue that ironically was caused by contract agriculture.

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Currently the world is focusing on the benefits of free trade pacts or liberal markets. However, many limitations are present in this kind of set up and contract agriculture is not an exception. Government regulation in contract agriculture may be necessary to ensure that a balance is achieved. India is boasting one of the fastest-growing organized food processing sectors. With attention to this lucrative business sector, companies are now competing for a share of the same. Gulati, Joshi, and Landes suggest, “this competition has created pressure to compress supply chains; cut costs and achieve increased competitiveness in the domestic and global market” (2). Contract agriculture is therefore favored as an option to streamline procurement and logistic services at the pinnacle of organized agro-processors and retailer structures.

Conventionally farming is largely small-scale. It has been the norm that while small-scale farmers by available labor and intensive cultivation practices may be highly productive, these holders have a small surplus to market against high production and trading costs. Therefore, this high cost of agriculture poses two key challenges for such small-scale holders. The first is the high production risk associated with pest attacks and unpredictable weather conditions. The second is the lack of financial resources. Therefore, these small-scale farmers encounter situations of economic uncertainty resulting in diminished risk-bearing capacity. This scenario provides a fertile ground for contract agriculture as a consideration. In theory, though, the farmers could benefit from contract agriculture practices. On the other, hand the contractor companies have the advantage of high-quality products and an assured supply.

According to Contractual arrangements in agriculture, sharecropping as a mode of contract agriculture is a contractual arrangement that optimally trades off the costs of inducing the tenant to undertake the higher effort and lower risk. Sharecropping contracts can emerge only when there is a moral hazard in both effort and risk. (1)

This part of the synthesis focuses on sharecropping as determined by effort, risk, and moral hazard. Agricultural production will include a number of decisions that could involve moral hazards. Some examples include inputs quantity and quality, the crop mix of choice, pesticides, fertilizers, and seed. Crop mixing may increase the farmer’s profit at the landlord’s expense. Landlords on the other hand find it hard to monitor efforts as well as the application of inputs such as fertilizers. The riskiness of the product determines the type of contract. Ghatak and Pandey agree, “where both parties are risk-neutral the best type of contract is the fixed rental” (303).

According to Ghatak and Pandey, a “fixed rental contract is optimal from the point of view of incentives but it puts all the risk of crop failure on the tenant” (304). Here the tenant pays a fixed amount irrespective of their output to the landlord and keeps the residual for themselves. Therefore Ghatak and Pandey agree that “a contract that gives full incentives on high output levels and non on low level is better than a contract that gives less than full incentives on high and medium output levels”(306). However, if the effort is ignored and choice of riskiness of projects, this creates inducements for the tenant to take a greater risk.

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Ghatak and Pandey postulate, a contract that reduces the tenant’s marginal return from high outputs is best from the point of view of discouraging risk-taking. Therefore, contracts in agriculture may emerge as optimal contracts discouraging the tenant from choosing too much risk. (306)

The type of contracts whether fixed rent, sharecropping, or wage contract is determined while considering the moral hazard for the effort and risk.

Controlling factors like the tenant and landlord characteristics as well as land quality also play a part. The production’s mean and variance remains higher in farms cultivated under fixed-rent contracts as compared to sharecropping.

Based on the hog production case, the alternative market arrangement (AMA) supplier contracts ensure a considerable part of the packers’ needs. However, the spot market demand for hog declines due to these arrangements, which eventually will negatively affect the cash price.

According to Zheng and Vukina

A common feature of all AMAs is that when packers come to the spot y live hogs, numbers from the AMAs are predetermined and treated as packers’ AMAs stock. The AMAs represents packers’ long-term supply chain management decisions with some of the contracts going up to ten years. (6)

In essence, we can infer that AMAs have a detriment for those who rely on trade at the spot markets because they will not get a true value for their hog because of the market price distortion. The predefined supply of hogs available for that length of time will adversely affect the market economics within the particular industry. To this end therefore, alternative market arrangements as a type of contract in agriculture based on this hog production case study have a negative effect generally.

Dubois and Vukina conclude that;

The use of contracts to coordinate production and marketing of agricultural commodities is common practice in many agricultural sectors. The literature on the provision of incentives in firms is based on the premise that relating pay to performance increases output but at the cost of imposing risk on the agents which are reflected in higher accomplishments.

Industrial organization models for the case studies

According to Dubois and Vukina  “a study estimated that a structural model with moral hazard in the context of a tree planting labour contract indicated that incentives caused a 22.6% increase in productivity only part of which represents valuable output because workers respond to incentives by reducing quality” (3).

Based on the grower risk aversion contract as one of the case under synthesis we can describe the integrator – grower relationship model while indicating the assumptions here below

Grower preference over revenue = R

Effort = e (Effort is costly C (.))

Grower risk aversion = (CARA).

This can be determined by a utility function

Ui (R – C (e))

Based on this

Grower’s expected utility = i = Max Wi (R, (e))

= ER – bi/2 Var Re –C (e) where bi >0 = absolute risk aversion

Therefore the payment scheme function

Rit = aqit + b (f – Fit/ qit) 1 – Mit) Hit     can be written as a linear function assuming the feed conversion ratio fit = Fit/ qit as  Rit = ait – bit (fit -f)

Since observed outcome is stochastically dependant on grower’s effort (unobserved)

fit – f = (l -eit)uit  Þ Efit – f = li – eit and Var [fit] = (l – eit)2 s2

Therefore the optimal effort = eit = (1 – ¡/ s2 bibit) + Xi

This means that more risk averse growers exert diminishing equilibrium effort which affect how to allocate feeder pigs among growers.

On the other hand the model for the agent’s optimal response basing on the principal’s behaviour dictates that we derive the integrator’s function

MaxHit Ep it  = E [ pQit – Rit – wFTit – wHHit

Assuming that

P = hog market price

Total live weight from farm = Qit = kit(1 – mit) Hit

Growers payment = Rit

Feeds market price = wF

Feeder pigs market price = wH

Using the feed consumer ratio = Rit = ait – bit (fit – f)

Ep it  = Pkit (1 – mit) Hit – wF (¡ – 1/ s2 bibit + f – a/wF) [kit (1 – mit) – k0it] Hit – wHHit

= [p – wF(f-a/wF)]kit (1 – mit)Hit + wF((¡ – 1) k0it / b(1 – mit) s2 bi + [ wF(f – a/wF) k0it – wH] Hit – wF (¡ – 1) kit / bs2 bi

Based on this model more risk averse growers will receive fewer animals.

For the alternative market arrangements, the industry is modelled as comprising N packers producing pork as the homogeneous output.

Assumptions:

Quantity of live animals and quantity of pork output = qi where (i = 1…N)

The two procurement channels = q1 and AMAs q2

Therefore the packer i’s profit through period t

= pit = [Wt (qi1t + qi2t) – P1tqi1t – P2qi2t – C (qi1t + qi2t)] M where

Price of pork = Wt

Live hog payment at spot market = P1tqi1t M

Payment through AMAs = P2tqi2t

Packer i’s production cost = C(qi1t + qi2t)

Carcass weight of hog = M

The cost function can be specified as

C (qi1t + qi2t) = [ q1 + ½ q2 (qi1t + qi2t)] (qi1t + qi2t) + F

The inverse demand function is thus

Log Wt = ¡0 + hlog (Qt) + ¡1logPct + ¡2logPbt + ¡mDmt + ¡yDyt + ¡tt + ¡tsqt2 + edt

Where

Total number of hogs that N packers procure = Qt = åni=1 (qi1t + qi2t)

Inverse elasticity demand for pork = h

Price for the two main substitutes broiler and beef = Pct ang Pbt

According to the joint hazard for effort and risk contract type, we can infer that effort and risk are the actions likely to affect the probability distribution of output. Therefore, effort (e) can be described as e Î [ē, e] and risk r Î [ř, r] where ē > e ³ 0 and ř > r ³ 0.Based on the nature of the distribution function of output, W is given by F(W/e, r).

A derivative based on the density function will indicate that for all W

d/ dW [ fe(W/e, r) / f(W/e, r)] ³ 0. This implies that an increase in effort e shifts the distribution of W stochastically. The initial inference from this derivative is that the mean of distribution increases with effort. Effort can be observed as an action in this case. The tenant can also take another unobservable action in risk. Accordingly we learn that probability distribution F(W/e, r2) is more risky that F(W/e, r1). Since risk and effort are unobservable by the landlord, there arises a moral hazard in this contract. Basing on the fixed rent contract, the realized incomes for the tenant and landlord can be defined as

YT (W) = max {sw -R, 0}

YL (W) = min {w – (sw – R), w}

Assuming Ỉ is the point of binding by the limited liability then

Ỉ = R / S

The tenants expected payoff

UT = òŵw (sx – R) f(W/e, r) dw – C (e, r).

A positive probability of 1 – F(ŵ) refers to the tenant’s expected payoff as a share of their conditional mean of the distribution of output less the fixed rent payment R.

Alternatively, the tenant’s payoff is nil for F(ŵ)

The landlord’s payoff

UL = E(W) – òŵw (sw– R) f(W/e, r) dw

Considering that s = 0 the tenant gets no share of the output and to ensure positive expected payoff requires a transfer from the landlord.

Conclusion

As much as contract agriculture is seen as the emerging economically viable agricultural practice, this analysis has highlighted the major concerns especially in the livestock industry particularly the hog production. Contract agriculture remains lucrative for corporate entities because it is a business venture where profits have to be made. As such, the practice whether as alternative market agreements, grower risk aversion contracts or sharecropping or whatever another name it may be called eventually aims to benefit the contractor company more than it does for the farmer. It has been assessed that even the supposedly joint moral hazard risk and effort arrangements have an emotive benefit for the farmer. This study also reveals that the costs and benefits of any contract in agriculture can be empirically determined using available models such as those summarized in this synthesis and that the gains from any type of contract can be mathematically deduced using such models.

Works Cited

“Contractual arrangements in agriculture.” DocStoc.com, 2010. Web.

Dubois, Pierre, and Vukina, Tomislav. “Growers Risk Aversion and the Cost of Moral Hazard in Livestock Production Contracts.” American Journal of Agricultural Economics 86.3 (2003):1–18. Print.

Ghatak, Maitreesh, and Pandey Priyanka. “Contract Choice in Agriculture with Joint Moral Hazard in Effort and Risk.” Journal of Development Economics 63.1 (2000): 303–326. Print.

Gulati, Ashok, P.K Joshi, and Maurice Landes. “Contract farming in India: An Introduction.” Contract, 2010. Web.

Sabat, Suraj, and Pal Kamalika. “Rural Marketing Term Paper: Contract farming.” IFIM, 2010. Web.

Zheng, Xiaoyong and Vukina Tomislav. “Do Alternative Market Arrangements increase Pork packers’ market power?” Pork packers, 2009. Web.

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