Economics behind contracting
PIE 231, April 3-4, 2000
Contracting: Economic Viability, Risks, and
Management
Dr. Michael Sykuta
Agribusiness Research Institute
University of Missouri
A Contract is…
• A legally enforceable mutual promise to
perform an act (to do or to refrain from
doing something) that is not already
required by law.
• An institutional structure governing
(outlining the terms of) a transaction…”the
rules of the game.”
Every transaction entails a(n):
• Division of Value
• Division of Risk
• Allocation of Decision (Property) Rights
• The 3 are interdependent
Division of Value
• Gains from trade
• Sources of Value:
– Price
– Quantity
– Quality and/or Specific Product Traits
Division of Risk
• Each value source has its own set of
uncertainties that create source-specific risk
– Price Uncertainty
– Quantity
• Yield Uncertainty
• Delivery/Performance
– Quality (particularly endogenous traits)
Division of Decision Rights
• Input Decisions
• Management Decisions
(field/equipment/services)
• Timing Decisions
(planting/harvesting/delivery/pricing)
• Pricing decisions
• Performance decision
The Three Amigos
• Value, Risk and Decision Right allocations
are interdependent. Each affects the other.
All affect incentive structures.
• Key Point:
Decisions Rights are valuable in and of
themselves! The ability to make a choice
has value.
The Costs of Transacting
• Transaction costs associated with
contracting:
–
–
–
–
searching out contract partner/contracting info
negotiating terms of the contract
performance
monitoring and enforcement
• Changes in these costs are driving much of
the push for contracting
Changes in the Value Chain
• Consumers at every level are driving
demand for different dimensions of quality
and consistency
• Competitive pressures at every level call for
greater degree of coordination between
trading parties
• Traditional commodity marketing channels
are not equipped to handle these needs.
Search Costs
• Who has what you want…or, from the
producer’s perspective, who wants what you
have to sell?
• What kinds of products are out there and
how do they fit your needs?
• The more specialized your needs, the higher
the search costs…and more important the
trading partner.
Negotiating Costs
• In general, at present, the buyer is writing
the contract…and there is not much
negotiating.
• However, processors are spending a lot of
money figuring out how to design their
contracts.
Monitoring and Enforcement
• How do we verify that we’re getting what
we pay for?
– How difficult to determine (measurement costs)
– How costly is the difference?
• How can we enforce the deal?
– Go to court
– Liquidated damages
Measurement and Contracting
• Separability vs. Task-programmability
– Separability:
• Ability to measure output and reward producers
based on output quality (e.g., grade and yield)
– Task programmability:
• Ability to measure input and control ouput quality
by choice of inputs.
• Which is more cost-effective?
Changes in measurement costs
• Standard grading scales are no longer as
useful:
– No. 2 yellow corn and No. 1 red wheat don’t
give enough information.
– Imbedded character traits are where the value
lies.
– Those output traits are frequently determined
by choice of inputs.
Effects of measurement costs
• If you can tell by the input what the output
will be, it may be easier to contract for the
input…including the management package.
The bio-tech factor
• Developers of biotechnology want to
protect that value and recover the costs of
development.
Questions to consider
• What is the value in the transaction and
what is the producer’s contribution?
• How does the transaction reflect
measurement costs?
• What are the sources of risk in the deal?
Who’s bearing the risk?
• Price - primarily still the producer
• Quantity - primarily the buyer
• Quality - primarily the buyer
Sources of “Hidden” Value
• The option to default
– particularly producer’s option to invest more or
less in additional premiums throughout the
growing season.
• The timing option
– particularly delivery schedules (buyer’s call vs.
harvest deliveries)