1
Contract Farming: Synthetic Themes for
Linking Farmers to Demanding Markets
Xiangping Jia
Chinese Academy of Sciences
Jos Bijman
Wageningen University
Abstract
In the wake of emerging agro-food market and globalization, increased use of contract
farming comes forth as apposition to markets for mediating exchange between farmers
and midstream (and downstream) segments in developing countries. Contract farming
is regarded as an integrated rural development strategy and a dynamic partnership by
which small farmers can get access to market, technological and managerial
assistance. Given the mixed evidence, a multi-dimensional viewpoint on contract
farming at commodity level, territorial and sectoral level, and social-political level
needs to be synthesized. As an institutional adaptation to changing technology and
emerging global agro-food market, contract farming travels on multiple trajectories
with local viability.
Keywords: contract farming, vertical coordination, supply chain, agro-food market,
rural institutions
JEL: P51, L10, Q18
Xiangping Jia
Center for Chinese Agricultural Policy, Chinese Academy of Sciences
Institute of Geographical Sciences and Natural Resources Research
Jia 11, Datun Road, Anwai, Beijing 100101, China
Tel:(86)-10-64888985
Fax:(86)-10-64856533
email: xpjosephjia@gmail.com
Jos Bijman
Wageningen University
Management Studies Group
Hollandseweg 1
6706 KN Wageningen
The Netherlands
Tel. +31-317-483831
E-mail: jos.bijman@wur.nl
2
Contract Farming: Synthetic Themes for Linking Farmers
to Demanding Markets
1
Introduction
Producing and selling on a contractual basis is a common arrangement in
agriculture all around the world. Contract farming (CF) has existed for a long time,
particularly for perishable agricultural products delivered to the processing industry,
such milk for the dairy industry or fruits and vegetables for making preserves. Towards
the end of the 20th century, CF has become more important in the agricultural and food
industries of the developed and developing countries. Spurred by changes in
(international) competition, consumer demands, technology, and governmental
policies, agricultural systems are increasingly organized into tightly aligned chains and
networks, where the coordination among production, processing and distribution
activities is closely managed (Zylbersztajn and Farina, 1999). Contracting between
producers on the one hand and processing or marketing agribusinesses on the other
hand is one of the methods to strengthen vertical coordination in the agrifood chain
(Swinnen, 2007).
The trend towards more contract farming, and the reasons behind it, have been
extensively described for the agrifood industry in developed countries (Martinez and
Reed, 1996, Royer and Rogers, 1998). Developing countries are impacted by the same
trends in the agrifood system, and also experience an increase in CF. However, for
developing countries there are a number of developments that may lead to an even more
rapid expansion of CF. One of these developments is the rise of supermarkets in food
retailing. Over the last two decades, the number of supermarkets has grown rapidly in
the urban areas of developing countries, particularly in Asia and Latin America
(Reardon and Berdegue, 2002). Supermarkets have procurement practices that favour
centralized purchasing, specialized and dedicated wholesalers, preferred supplier
systems, and private quality standards (Shepherd, 2005). These characteristics of the
supermarket procurement systems require more vertical coordination among
production, wholesale and retails, thus favouring the introduction of CF. Another
development relevant for CF in developing countries is the reduction of the role of the
state in agricultural production and marketing. As part of market liberalization policies,
governments have often reduced their budgets for and direct involvement in providing
inputs and technical assistance as well as in marketing farm products. As markets for
the private provisions of inputs and services continue to fail, CF could solve the
problems of farmer access to inputs (Key and Runsten, 1999).
A third development refers to the ambition of donors, development NGOs and
governments of developing countries to strengthen smallholder access to markets.
These agencies consider CF as one of the main instruments to link small-scale farmers
3
to domestic and even foreign markets and thereby to reduce poverty (Dannson, et al.,
2004, IFAD, 2003, World Bank, 2007). As CF arrangements often include the
provision of inputs and technical assistance, participating smallholders can benefit
from new market opportunities that would otherwise not be available to them as they
would not produce the required quality.
The intellectual popularity of contract farming reflects the evolved thinking of
development strategies (Little, 1994). Contract farming was favored in the 1960s due
to the ideological reflection and desire to “targeting rural poor”, the internationalized
agriculture, and the dynamics of rural development strategies. The exclusion of
smallholders from the Green Revolution in the 1970s makes many commentators and
practitioners see contract farming as a viable tool to integrate small farmers into the
industrial sectors. In the late 1980s, contract farming was initiated in Africa by various
development agencies (such as the World Bank and USAID) with a perception to
avoid government-related market and price control. The following intellectual favor to
contract farming in the early 1990s was based on the emphasis of the private sector and
market-led growth. However, market liberalization and the state’s quick withdrawal
leave huge gaps between small farmers and markets.
In the wake of internationalized agriculture and radical changes in agro-food
market in developing countries, contract farming is regarded as one of the components
for integrated rural development strategy and a “dynamic partnership” by which
smaller farmers can get access to market, technological and managerial assistance
(Little and Watts, 1994). In this context, contract farming is resurging on the
development agenda as an innovative financial intermediation with the rise of
integrated supply chains, as an adapted response to the stringent food safety standards,
and as an effective tool for poverty reduction (WDR, 2008). The role of state as a
catalyst in connecting smallholders to markets is re-emphasized in the meantime.
This chapter does not aim to provide a comprehensive overview of the literature
on contract farming, as a number of authors have provided thorough reviews (Eaton
and Shepherd, 2001, Glover and Kusterer, 1990, Little and Watts, 1994). We do,
however, make an attempt to broaden the intellectual debate and to argue for the study
of multiple trajectories of contract farming. Additionally, our chapter aims to
encourage scholarly discussions on a set of core practical concerns and concurrent
theoretical questions that take us beyond the state of the art in the study of CF.
The chapter is structured as follows. To form a synthesis, it starts with the thesis
for a theoretical basis of contract farming. Then, following the procedure of dialectics,
the antithesis is given in critical reflection on the dominant theory. A
multi-dimensional perspective on contract farming is then elaborated to base the
debate within a holistic and congruent framework, our synthesis. Finally, some key
themes for research and policymaking are drawn up.
4
2
Thesis
Contracts in agriculture have three distinct functions (Hueth, et al., 1999, Sykuta
and Cook, 2001, Wolf, et al., 2001). First, they serve as a coordination device, allowing
individual actors to make decisions (e.g. on resource allocation) that are aligned or need
to be aligned with decisions of the partner(s). Coordination is meant to ensure that
products of the right quantity and quality are produced, and delivered at the right time
and place. For instance, contracts commonly specify the volume to be delivered to the
contractor in order for the producer to know how much to sow or plant and for the
contractor to know how much processing capacity to install. To a limited extent,
coordination can be obtained by financial incentives. However, more detailed
coordination requires information that cannot be transferred through prices but require
contractual provisions on the obligations of each partner and on clarifying which
partner may decide on those actions that are not stipulated in the contract. Second,
contracts are used to provide incentives and penalties in order to motivate performance.
Without proper incentives to each contract partner, no transaction will take place.
Particularly when the contractor demands specific activities from the farmer, for
instance in the case of special quality, the contract clarifies what compensation the
farmer will obtain for these activities. The contract can include an agreement on the
price, but it can also indicate what price determination mechanism will be used to
decide on the proper compensation. Third, the contract clarifies the allocation of risk.
For example, farmers can mitigate the risk of income loss due to poor yield by signing
an agreement with a contractor that specifies a portion of compensation independent of
realized yields.
Contract farming is often presented as an institutional arrangement used for
organising vertical coordination between growers and buyers-processors
(SOURCES). Vertical coordination means that the activities of sellers and buyers are
closely aligned. As supply chains (or value chains) are characterized by sequential
transactions, vertical coordination implies that the transactions upstream (such as
between producer and processor) are aligned with transactions downstream (such as
between processor and distributor). These upstream and downstream transactions
become increasingly interdependent, for example when a processor has invested in
establishing a consumer brand for his products. In order to protect this brand from
devaluation by not fulfilling customer expectations, processors try to control any
process that can negatively affect the value of their brand.1
Not all transactions with agricultural products are suitable to be governed by a CF
arrangement. As CF involves costs for both producers and contractor, these costs must
1
Vertical coordination in agrifood chains in developed countries has been widely studied in the 1990s
(Frank and Henderson, 1992, Galizzi and Venturini, 1999, Royer and Rogers, 1998), while studying
vertical coordination in developing countries is a more recent phenomenon (Swinnen and Maertens,
2007).
5
be outweighted by the benefits, and the balance of cost and benefit of CF must be
larger than with other arrangements for selling/buying the product. The cost of
carrying out a transaction between buyer and seller (in our case a farmer and its
customer) are commonly called transaction costs. Transaction costs generally increase
when more vertical coordination between seller and buyer is needed. Thus, studying
the vertical coordination requirements provides indications on why particular
arrangements will be used. The type and intensity of vertical coordination depends on
the type of products and the demands from processors, retailers and consumers. Minot
(2007) has made a useful distinction in the factors that influence the need for vertical
coordination: (1) the type of product; (2) the type of buyer; and (3) the type of
destination market.
Contract farming is a broad concept which encompasses many different types of
arrangements and contract provisions, and many different services included or not in
the agreement. All of the literature on contract farming emphasizes the diversity of
contractual arrangements between farmers and contractors. This diversity is a result of
the technical requirements of production and the associated production and transaction
costs (Simmons, et al., 2005). To structure the multiple contracting arrangement, a
typology of agricultural contracts may be helpful. A classical typology of contracts
between farmers and their customers has been made by Mighell and Jones (1963), who
distinguish between market-specification contracts, production-management
contracts, and resource-providing contracts. These contracts differ in their main
objectives, in the transfer of decision-rights (from the farmer to the contractor), and in
the transfer of risks.
A market-specification (or marketing) contract is a pre-harvest agreement
between producers and contractors on the conditions governing the sale of the
crop/animal. Besides time and location of sales, these conditions include the quality of
the product, thus affecting a few of the production decisions of the farmer. The
contractor reduces the producer’s uncertainty of locating a market for the harvest, but
the farmers continues to bear most of the risk of his production activities. The
production-management contract gives more control to the contractor than the
market-specification contract, as the contractor will inspect production processes and
specify input usage. Producers agree to follow precise production methods and input
regimes, which implies that the farmer has delegated a substantial part of his decision
rights over cultivation and harvesting practices to the contractor; he is willing to do so
because the contractor takes on most of the market risks. Under the resource-providing
contract the contractor not only provides a market outlet for the product, but he also
provides key inputs. Providing inputs is a way of providing in-kind credit, the cost of
which is recovered upon product delivery. How much decision-rights and risk is
transferred from the farmer to the contractor depends on the actual contract.
While this typology has been used by many authors, it has recently been criticized
by Hueth et al. (2007) for being of little value for understanding contemporary
agricultural contracts. Their main point of critique is that this distinction does not hold
6
in practice as most contracts combine elements of marketing (which is the interest of
the farmer) and coordinating production (which is the interest of the contractor).
Minot (1986) has discussed how the three different types of contracts can solve
particular transactional problems (when comparing contract farming with spot market
transactions). A market-specification contract can reduce the cost of gathering and
exchanging information about demand, quality, timing and price, thus reducing
uncertainty and the concomitant market risks. By increasing information exchange, a
market-specification contract reduces coordination costs (as compared to spot market
trading). Coordination costs are particularly present in the case of (1) perishable
products supplied for processing, exports or supermarkets; (2) complex quality
products; and (3) new (niche) markets. The resource-providing contract can reduce the
costs of obtaining credit, inputs and extension services, including the cost of screening
and selecting these services. This type of contract is typically applied in the case of
crops for which the quality of the output depends on the type and quality of inputs, as
well as in the case where inputs provision reduces production costs for the farmer and
thereby purchasing costs for the contractor. Finally, the production-management
contract specifies cultivation practices to achieve quality, timing and least-cost
production, thus even more economizing on coordination costs. It may also support
skills development of the producer, and thereby reduce future transaction costs.
2.1 NIE Perspective on Contract Farming
Theoretically, contract farming is often explained using the lens of New
Institutional Economics (NIE), more specifically Transaction Cost Economics (TCE).
Central in NIE and TCE is the idea that all transactions between economic actors
involve transaction costs. These costs relate to finding a market/customer, negotiating,
signing a contract, controlling contract compliance, switching costs in case of
premature termination of the contract, and all lost opportunities. Transaction costs
appear in different forms, but are mostly caused by uncertainty and/or asymmetric
information.
In the presence of high transaction costs, non-standard contracts may be effective
at reducing the overall costs in the presence of high risks and asset specificity. In
smallholder agrarian economy, NIE analysis is “open to the possibility that, under
circumstances where standard competitive spot markets for inputs and credit fail due
to high transaction costs, interlinked or interlocked transactions may be transaction
cost efficient . . . [to] allow imperfect markets to develop where the alternative is
complete market failure” (Dorward, et al., 1998).
Transaction costs are overwhelmingly present in rural economies, particularly of
developing countries, not only because of missing inputs markets and substantial
asymmetries of information in output markets, but also because of the small scale of
most farming production units compared to the size of their trading and processing
customers. Even in the case of increased mechanisation, the dominant farm ownership
structure continues to be the family farm, where farm land is owned by the nucleus
7
family, most of the labour is provided by family members and all of the management is
the responsibility of the head of the family. This model has been explained as an
efficient response to on-farm incentive problems (Binswanger and Rosenzweig,
(1986). In the presence of incentive problems under the assumptions that individuals
dislike effort, the information asymmetry makes supervision and monitoring costly.
As a result, hired labour force is perceived less efficient than family labour. Family
ownership of farmlands by smallholders is found to be efficient and egalitarian
(Binswanger, et al., 1995).
But the scattered family ownership exacerbates the transaction cost in rural
economy, and imposes challenges in the agro-food market where downstream
intermediaries face constraints in the delivery of proper quantities and qualities. In the
context of overwhelming transaction costs and information asymmetries, the simple
market exchange is found to be inefficient. Contract farming is thus an institutional
response to the high transaction costs related to transactional risks and coordination
costs.
Contract farming should not be considered as a form of vertical integration, but it
should rather be specified as “vertical coordination”. Vertical integration implies
bringing the transaction within the boundaries of the firm, thus eliminating contractual
exchanges or market exchanges (Perry, 1989). But under a contract farming
arrangement, the ownership of the farm does not change. The downstream processors
or retailers do not take ownership of farm assets, but do specify in more or less detail
the use of those farm assets.
But similar to vertical integration, contract farming arises (partially) from
transaction economies – which are associated with the process of exchange itself – and
market failure that consists of imperfect competition and asymmetric information.
From viewpoint of transaction cost economics, for example, farmers’ careful use of
chemicals and nutrient-enhancing seed varieties is “asset specificity” that is costly to
exchange in spot market. In the form of vertical coordination, contract farming
substitutes contractual exchanges for a market exchange. Such contractual
arrangements “bridge the gap between vertical integration and anonymous spot
markets” (Perry, 1989).
In order to economize on production and transaction costs, transaction parties
(bilaterally or unilaterally) choose the most efficient institutional and organizational
structure (Williamson, 1985). These governance structures can be classified on a
continuum ranging from spot market to hierarchy (or vertical integration). In between
these extremes, many so-called hybrid arrangements can be found, combining price
(as the dominant governance mechanism in markets) with authority (as the dominant
governance mechanism in a hierarchy). Contracts are a typical hybrid governance
structure.
Hybrid governance structures are typically characterized by three elements:
pooling, contracting and competition (Ménard, 2004). The pooling resources refers to
aligning the deployment of individually owned assets as well as joint investments.
8
Pooling results in interdependencies which requirs bilateral coordination for efficient
resource use. Competition refers to the continuation of some form of competition
between individual partners in the hybrid governance structure. This competition can
be both among different farmers participating in the contract farming scheme and
between farmers on the one hand and their customer on the other hand (so-called
vertical competition). Different from vertical integration, where the function of
markets is replaced by the function of managerial discretion, a hybrid arrangement
continues to make use of the motivational and coordinational impact of prices. While
hybrid arrangements are distinctly different from market and hierarchy, there still is a
broad range of different organisation structure that fall within this category, such as
short or long term contracts, bilateral or multilateral contracts, consortia and strategic
alliances, and all sorts of joint ventures. It is the combination of (risk of) opportunism
and (risk of) miscoordination that eventually determines the particular governance
characteristics of the hybrid. For example, in their investigating in China’s emerging
farmer cooperatives, Jia et al. (2010) find that farmers in China’s cooperatives mostly
pool their decision-making in marketing inputs and outputs but still retain the
majority of decision rights of production at the backyard. As a mixture of market
governance and vertical coordination, individualism is the optimal organizational
structure in China’s farmer cooperatives.
3
Antithesis
Although contract farming can reduce transaction costs, it cannot completely
solve the problems of opportunism and underinvestment in specific assets. As long as
there is information asymmetry, one party may exploit an exchange at the expense of
the other party. At regional and national level, contractors frequently seek market
monopolies or concessions from the government to protect their investments. At
individual level, small farmers, who face increased dependency and indebtedness with
contracts, might be exploited by monopsonistic traders. On the other hand, farmers
might divert the supported inputs to non-contracted use or sell their contracted produce
to others. This type of market leakage is a common problem and has led to the failure
of many contracting schemes (Eaton and Shepherd, 2001). The downstream traders,
processors, or retailers will not invest in physical and/or human assets if they face the
risk of opportunism by the farmers. To sum up, the “vertical coordination” of contract
farming does not remove the possibility of opportunism and hold-up, and leads to
weakened ex-ante investment incentives.
Contract farming attracts to NGOs and donors because, as a “private-sector”
commercial venture, it is considered to be financially sustainable. Moreover, contract
farming assumes a market orientation as the initiative of the contracting schemes
resides with the downstream customer. But the record of contract farming reveals that
market instability and management problems frequently make contracting schemes
unsustainable in the long run (Little, 1994).
9
The “antithesis” associated with contract farming reflects that the contractual
arrangement does not only constitute of a business model involving different
economic actors seeking an efficient and effective exchange model. CF should be
placed in the wider scope of rural development, where public agencies as well as
NGOs may play a major role in promoting and structuring CF schemes. To better
understand and improve the use of contract farming as a development strategy, a
comparative approach that recognizes the alternative market contracting structures and
dynamics of governance helps understand the synergistic relationship between
theories and empirical findings (Joskow, 2005, Ménard and Klein, 2004). In this
respect, the NIE approach to industrial organization fails to explain the multiple
trajectories of capitalist development of agro-food market (Hart, 1997). A
multi-dimensional framework that includes formal and informal elements of the
institutional environment as well as existing social capital and social norms is needed
(see Figure)
[INSERT FIGURE HERE]
4
The Multi-dimensional Scope of Contract Farming Analysis
4.1 Commodity Dimension
Contract farming varies with the attributes of agricultural commodities. The
biophysical characteristics of a commodity affect the transaction costs in agro-food
markets. Also the degree to which the crop production cycle involves technical
sophistication and equipment specialization (i.e. asset specificity), to which inputs
require specific capital and labor complementarities (i.e. complexity), and to which
quality is difficult to measure (i.e. uncertainty) affect transaction costs (Figure, left
side). For example, simple marketing contracts are often used for fruits and vegetables
between farmers and traders because of the perishability and price volatility. In
comparison, for poultry meat and vegetables-for-processing, farmers enter into
production contracts where specific standards are required by downstream processors
and retailers because farming activities have to be coordinated with processing and
marketing activities to prevent losses due to a lack of synchronisation. Some crops
(e.g. cotton) that demand specific inputs (e.g., specific agrochemical combined with
proprietary (BT) seeds) also favour production contracts.
Jaffee and Morton (1995), in their exploration on the high-value crops in
Sub-Saharan Africa, conclude that the organization and the performance of private
marketing and processing are commodity-specific. The distinctive techno-economic
characteristics of individual commodities influence the level of uncertainty and asset
specificity. Vertically integrated or contract-based systems have institutional
advantages for commodities that demand more investments in physical or human
10
assets and whose difficult-to-measure quality needs to be safeguarded through
sequential stages of the supply chain.
In general, food safety and quality standards favour more vertical coordination
and therefore more contract farming. Food safety and agricultural health standards
have become an increasingly important influence on the international competitiveness
of developing countries, especially for high-value agricultural and food products
(Jaffee and Henson, 2005). While public standards and market policies represented by
international organizations are crucial in regulating the market, there has been a rapid
rise in private standards that have reshaped markets in developing countries.
Furthermore, as the main link between consumers and the food chain, retailers are
responsible for translating consumers’ demands back up the chain and for organizing
the flow of products back down to consumers (Fulponi, 2007). The replacement of
global private standards imposed by multinational retailers for domestic private (or
even public) standards reshapes the market structure and affects agricultural contracts.
But the commodity-based approach has a limitation in that the politico-economic
and social contexts of contract production are not properly specified. An overemphasis
on commodity characteristics cannot capture the significance of political, historical,
and social contexts of contract farming. Success and failure have often more to do with
the (non)sustainability of particular ventures than with technological and
commodity-specific characteristics (Little and Watts, 1994). Furthermore, individual
commodity-specific observations lead to fragmented evidence. Cross-commodity
studies comparing contract provisions are needed (Hueth, et al., 1999).
4.2 Territorial and Sectoral Dimension
Writings on contract farming using a NIE perspective have mainly concentrated
on the efficiency effects of different governance structures. However, the analysis at
transaction level is incomplete in neglecting the pre-existing market power that
heavily affects contractual arrangements (Figure 1, right side). Existing market
structures matter for farmers’ bargaining position, and affect the sustainability of
contractual arrangements. Rather than being separate, the exploration of territorial and
sectoral dimensions complements the commodity-specific analysis at commodity and
household level.
The concept of supply chain is relevant here, as most transactions between
farmers and their first customers (traders or processors) can only be understand when
the transactions between traders/processors and retailers are included in the analysis.
As the retailers are nowadays the dominant actors in the food market, particularly
where it concerns value-added products like meat and vegetables, the bargaining
power of these supply chain actors need to be taken into account. The literature on
global value chains can inform the impact of power asymmetry in supply (or value)
chains on the governance of the different transactions and thus on the type and content
of contracts being used (Gereffi, et al., 2005).
11
In addition, local social and cultural heritage affects the type and scope of contract
farming arrangements. While the changing bases and forms of globalization impose
exogenous effects, territorial endogeneity at local level that is mediated by inherited
structures, institutional complexities and spatial differences, confounds the analysis
due to the difficulties of partitioning mixed effects of globalization and localism. This
2
ambiguity further hinders the puzzle of multiplicity of farming styles. Future
research on contract farming therefore needs to go beyond traditional value chain, and
to combine commodity-specific and sectoral dynamics, and, consequently, to reveal
the diversity of agro-food market and territorial settings.
4.3 Social-political Dimension
Market power at sectoral and supply chain level, and socio-cultural elements at
territorial level, however, are only one dimension determining contractual forms
(Figure). Behavioural norms that are rooted in rural communities, with its embedded
social capital, are also decisive. Agricultural contracts feature distinctive simplicity,
and their enforcement pervasively relies on informal mechanism – for example,
conventions, reputations, and repeated interaction (Allen and Lueck, 2002). Neither
the traditional production-market perspective nor the NIE approach to organization is
able to cover the full concept of contract farming. While the NIE approach fails to
explain the origins of agrarian settings, the production-market perspective cannot
explain how adaptive institutional arrangements may support (or undermine) rural
development. Nor do they answer how social norms can be mobilized to facilitate the
sustainability of contract arrangements (Lazzarini, et al., 2004). To better understand
the multiple trajectories of contracting in agro-food market, studies on local networks
3
and institutions are crucial (Hart, 1997). Such studies, however, are scarce.
2
Menard and Klein (2004) remark the variation in agrifood organizations in United States and
European Union from a viewpoint of history, path dependency and local conditions. For example,
European farms tend be smaller than US farms and more tightly interwoven with urban
agglomerations. So European agriculture is more closely tied with local economic, demographic, and
cultural differentiation.
3
The propositions of new institutional economics in the agrarian literature is criticized for their crude
separation of purely economic relations and those involving extra-economic coercion or
‘non-economic’ forces (Hart, 1997). Quite often, the enforcement of agrarian contract invokes a
particularly crude form of extra-economic coercion, for example the interlocked input and credit. In her
illuminating article, Hart (1997) suggests: “[T]he processual approach taking shape in the agrarian
literature grounds the exercise of power in specific institutional and political-economic contexts. A key
insight is that struggles over material resources, labour discipline, and surplus appropriation are
simultaneously struggles over culturally constructed meanings, definitions, and identities. Social
institutions are conceived of not as bounded entities of social structures, but as multiple, intersecting
arenas of ongoing debate and negotiation, the boundaries of which are fluid and contested . . . . [The]
processual understanding of multiple trajectories at different societal levels provides a means of
12
5
A Development Agenda
A myriad of studies on contract farming have sought to explain its existence,
economic efficiency and distributional effects (Glover, 1994, Glover and Kusterer,
1990, Henson, et al., 2008, Key and Runsten, 1999, Little and Watts, 1994). The
intellectual popularity of contract farming is increasingly responded by the operational
development strategies (WDR, 2008). To complement with the richness of the
literature and to draw a multi-dimensional perspective into the analysis of this
institutional arrangement, the following attempts to highlight important themes that
invite further elaboration.
5.1 Employment Effects, Labor Decision and Transformation
Contract farming is by nature an institutional variant in agrarian economy that
peasants are relegated to being hired on their own land. Discovering the disguised
wage relationship between contractors and growers is crucial to observe the dynamics
of rural transformation in the context of globalization and the emerging agribusiness.
Farmers might contract with domestic retailers (or processors) directly as independent
suppliers. They might also work as tenants for parastatal entities. Alternatively, they
may transform to wage-earning classes as casual workers (on a task-by-task basis) or
permanent workers (on multiple tasks). As a result, globalization and liberalization
sweep agrifood market in developing countries and affect the dynamics of agrarian
society.
The employment effects of contract farming have on-farm and off-farm elements.
The on-farm employment is regarded as a major benefit of contract farming
investments because of the labor-intensity of crops themselves (Little, 1994). To the
extent that farmers are vertically coordinated with downstream traders, the pathway by
which agriculture is transformed varies. The more a smallholder is integrated – in other
words, the less she diversifies her sources of income – the more likely farming will
evolve into a wage-based activity without changing the land property rights. But
strong coordination may imply increasing dependency and indebtedness. The on-farm
employment effects are therefore influenced by the extent to which transaction costs
are reduced. Policy interventions that mitigate risk and support ex-ante investments
promote the on-farm employment associated with contract farming.
Contract farming also creates indirect off-farm opportunities. When transaction
costs are (partially) mitigated with contractual arrangements, processors, traders or
retailers get incentives to invest in physical and human asset specificity (e.g. packing,
storage, transportation, extension service and other supporting services), which
generate spillovers to labour demand in the rural economy. Since most of the
processing facilities for products like fruits, vegetables, sugar and tea are located near
navigating between the determinism of ‘only one thing is possible’ and the voluntarism of ‘everything
is possible’. . . ”
13
production zones, contract farming has high non-farm employment effects.
Nevertheless, Little (1994), after reviewing a line of studies on contract farming in
Africa, concludes that the non-farm employment effects are tied closely to the type of
commodity produced and whether or not it requires processing or other value-added
activities. For example, the contracted sugar and low-perishable vegetable schemes in
Kenya has a worker-to-contract grower ratio of 1:6; for 6 contracted growers, 1
non-farm employment is generated. But for fresh-produce schemes, the spillover
effect is not significant. Little (1994) therefore argues that, unlike the agro-industrial
schemes, the fresh-producing contracting schemes employ few off-farm workers.
Little’s conclusion, however, is rather static. With the improved information and
logistic technology, such commodity-specific constraints are changing. The emerging
agro-food market imposes both opportunities and challenges to smallholders. In
deploying and developing the supply chain, the modern retailers not only shape the
production and market, but also affect labour division. The coordination of farmers
with downstream retailers and processors shapes the civil society at social dimension
in rural economy, especially the distributional effects that we shall present in the next
section.
5.2 Equity and Social Dimension
The rural farm and non-farm activities targeted in poverty reduction may have
variable impacts in terms of distributional effects (Ravallion and Datt, 2002, Start,
2001). As contract farming has long been voiced as a poor-targeted tool, its
distributional effects should be examined from a broad perspective. Nevertheless,
farmers are facing a mix of opportunities and challenges in the transforming agro-food
markets. A line of evidence in Central and Eastern Europe, South America and Africa
shows that the exclusion of small farmers is widespread where incentives and
capacities are insufficient (Dolan and Humphrey, 2000, Humphrey, et al., 2004,
Maertens and Swinnen J, 2009, Weatherspoon and Reardon, 2003). By contrast, a
growing body of evidence shows income improvements of small farmers in
developing countries when they are complying with standards along the agro-food
supply chain. Such pro-poor institutions feature the various usage of vertical
contractual arrangements. For example, Dries and Swinnen (2004) find that the rise of
contracting improves small farmers’ access to credit, technology, and inputs; the
compliance with high standards in vertically coordinated supply chains implies
increasing benefits for small farmers.
In addition, market structure determines the performance and distribution of
various market segments of the supply chains. In an extreme case of a single
monopsonistic multinational company, Maertens et al. (2008) found complete
exclusion of small farmers, which the authors called a “worst case scenario”. In a case
of distinctive agro-food market in China, a great number of upstream farmers,
midstream trading firms and processors/retailers are in fierce vertical competition
(Huang, et al., 2007). By observing the fruit and milk sector in China, Huang et al.
14
(Huang, et al., 2010, Huang, et al., 2008) find no exclusion of small farmers and
4
increasing coordination in modern marketing chains all the way to the farm level.
In his review article on contract farming in Africa from development perspective,
Little (1994) notes that the benefits of contract farming have accrued to larger and
more profitable plantations whose proprietors tend to be urban or semi-urban-based
farmers rather than local peasants; poorest farmers in the region are rarely recruited as
contract growers. Furthermore, employment demand transforms towards more skilled,
educated and knowledge-equipped farmers. Returns of labor in contract farming are
low, and contract farming becomes a mode of income diversification for poor farmers.
If the capitalist industrialization proceeded with the global supply chain affects the
social formation by dominating industry and the urban bourgeoisie, the distributional
effects would be a haunting agrarian question in any substantive sense.
Small farmers may have substantive cost advantages, particularly in
labor-intensive, high maintenance, and production activities with relatively small
economies of scale (Birthal, et al., 2005). Furthermore, processors may prefer a mix of
suppliers in order not to become too dependent on a few large suppliers (Swinnen,
2007). Contract farming may “have future perspective when effectively organized”.
The inequality issue about contract farming is certainly not a black or white debate.
The inequality effects may not be the original or sole cause as the interwoven effects
between contractual forms and commodity-territorial-social complexities results in
difficulties in explaining the existing mixed picture. The diversity of contract farming
arrangements and varied success show a mixed picture and a dilemma to balance
monopsonistic buyer and smallholders’ benefit. The agribusiness firms indeed
recourse to monopsonistic power to contain side selling by farmers. But countervailing
mechanisms are also needed to protect the interests of contracting farmers. The nuance
calls for a continuing search for alterative institutional innovations of aligning
farmers’ and companies’ incentive and of reducing transaction costs and uncertainty
(Poulton, et al., 2005).
5.3 Multiple Trajectories and Dynamics of Contract Farming
The globalization imposes mixed opportunities and challenges to developing
countries, where domestic and regional markets may evolve to different pathways in
response to the changing situation. A “bimodal” market segment of modern and
traditional supply chains was predicted by Jaffee and Henson (2005: 99). Nevertheless,
despite the centrally coordinated global interfirm division of labour involving global
outsourcing blessed by FDI, there exists a much more nuanced and heterogenous map
within the agro-food system (Goodman and Watts, 1997). The process of restructuring
in regional and national agro-food markets is situated at multiple scales. Future
4
While little evidence was found that smaller farmers were discriminated by contracting firms in
China (Miyata, et al., 2007), there is a tendency toward selecting a small number of medium-to-large
firms (Hu, et al., 2004).
15
research calls for an interdisciplinary perspective which combines NIE and social
capital literature to illustrate on the embeddedness of local complexities and on the
emphasis of uneven and spatially differentiated impacts of globalization.
The multiple trajectory allows for a viable role of the state. Government efforts
can become cost-effective by coordinating activities along the supply chain
(WorldBank, 2006). The involvement of local government streamlines responsibilities
and reduces the enforcement problem of complying with food safety standards. The
shortcomings of this mode have also been noted. The lack of interagency cooperation
among the contracting company, village cadres, and farmers may eventually lead to a
collapse of the venture (Eaton and Shepherd, 2001).
A topic less touched upon in current literature is the interaction between
agricultural production-market organizations and technology. For example, advances
in measurement technology allow for automatic sorting and grading into different
quality classes. Such a technological progress makes the use of quality-based payment
relatively attractive (Hueth, et al., 1999). For agricultural products that rely mainly on
physical properties for quality measurement (e.g., shape, size or volume),
technological progress undermines contract farming because processors can fulfill the
transaction at spot and open markets. Furthermore, the traditional role of the state in
providing “public goods” to address market failures (e.g., the under-provision of
inputs by the private sector) is likely to be reassumed by markets because of the
technology progress. Since market failure partly arises from the property of
non-excludability or non-rival externalities of private investments and from
informational problems, technological progress – particularly the information and
communication technology (ICT) – may allow for providing the previously
non-excludable services and goods at reasonable costs (Dorward, et al., 2006). ICT,
when applied in contract farming arrangements, affects agrarian society and social
class. While localized social capital and social norms reduce transaction costs, the
emerging information technology reduces the importance of collective action
efficiency benefits, and thus may undermines the sustainability of farmer cooperatives.
Contract farming needs thus to be examined from a dynamic perspective, with the
changing viewpoint of the state’s role, technology progress, and social-political
complexities.
6
Conclusion
In the context of technological progress and market liberalization, the domain and
boundary of the study of the organization of agricultural production, distribution, and
marketing have been changing. The increasing need for vertical coordination leads to
an increase in the use of contracts as opposed to markets for mediating exchange
between producers and their processing/retail customers. Emphatic rhetoric to the
contrary, contract farming represents the antithesis of free market forces.
16
As an hybrid arrangement between vertical integration and open spot market,
contract farming faces the same contractual dilemma’s as other incomplete contracts,
viz. prohibitive costs of specifying the full range of contingencies and restraining
opportunistic behavior. As Williamson (1971) insightfully notes, the advantages of
such vertical coordination “are not that technological (flow process) economies are
unavailable to non-integrated firms, but that integration harmonizes interests . . . and
permits an efficient (adaptive, sequential) decision process to be utilized . . . . ”.
This paper synthesized a variety of expositions on contract farming. Rather than
serving as a review on existing thoughts, we base the origin and evolution of contract
farming on New Institutional Economics. A multi-dimensional viewpoint on contract
farming at commodity level, territorial and sectoral level, and social-political level are
elaborated to integrate this institutional adaptation into a broader context.
The resurgence of contracting farming is far more than an instantaneous response
to the emerging global agro-food regime. Rather, contracting farming is reconfigured
in new institutional relations and new divisions of labors such that contracting out
production activities is a driving force at social dimension. To analyze contract
farming, a comparative governance approach that recognizes the alternatives and
dynamics of governance structures helps to understand the synergistic relationship
between theories and empirical findings (Joskow, 2005). To better understand the
idiosyncracy and dynamics of contract farming, a multi-dimensional perspective (at
commodity-specific, territorial and sectoral, and social-political level) needs to be
elaborated in more empirical research.
The enthusiasm and inflated expectations about the development potential of
contract farming should be constrained. Contracting schemes work well when they are
adapted to local contextual complexities. Having a great number of variants, contract
farming is far more than a tentative response to the imbalance between the
concentrated (downstream) supply chain and the dispersed (upstream) growers, but an
embedded institutional arrangement with local viability. After all, the diversity and
variations of contract farming are rooted in specific political and economic structures,
and are linked to specific agricultural commodities and production processes. Food
travels over long physical and social distances and its production, processing and trade
remains a highly distinctive economic sector.
17
BIBLIOGRAPHY
Allen, D.W., and D. Lueck. 2002. The nature of the farm: Contracts, risks, and organization in
agriculture. Cambridge and London: The MIT Press.
Binswanger, H.P., K. Deininger, and G. Feder (1995) Power, Distortions, Revolt and Reform in
Agricultural Land Relations, ed. J. Behrman, and T.N. Srinivasan, vol. 3B. Handbook in
Development Economics. Amsterdam, Elsevier.
Binswanger, H.P., and M.R. Rosenzweig. 1986. "Behavioral and Material Determinants of
Production Relations in Agriculture." Journal of Development Studies 22(3):503-539.
Birthal, P.S., P.K. Joshi, and A. Gulati. (2005) "Vertical coordination in high value commodities:
implications for the smallholders." Washington, DC, IFPRI, 85.
Dannson, A., C. Ezedinma, T.R. Wambua, B. Bashasha, J. Kirsten, and K. Sartorius. (2004)
"Strengthening farm-agribusiness linkages in Africa. Summary results of five country
studies in Ghana, Nigeria, Kenya, Uganda and South Africa." Rome, FAO, 6.
Dolan, C., and J. Humphrey. 2000. "Governance and Trade in Fresh Vegetables: The Impact of UK
Supermarkets on the African Horticulture Industry " Journal of Development Studies 37(2
):147 - 176
Dorward, A., J. Kydd, and C. Poulton, eds. 1998. Smallholder cash crop production under market
liberalisation: A new institutional economics perspective Wallingford: CAB International.
---. (2006) "Traditional Domestic Markets and Marketing Systems for Agricultural Products."
Background Paper for the World Development Report 2008. The World Bank.
Dries, L., and J.F.M. Swinnen. 2004. "Foreign Direct Investment, Vertical Integration, and Local
Suppliers: Evidence from the Polish Dairy Sector." World Development 32(9):1525-1544.
Eaton, C., and A.W. Shepherd. (2001) "Contract farming: Partnerships for growth." FAO
Agricultural Services Bulletin. Rome, FAO, 145.
Frank, S.D., and D.R. Henderson. 1992. "Transaction Costs as Determinants of Vertical
Coordination in the U.S. Food Industries." American Journal of Agricultural Economics
74:941-950.
Fulponi, L. (2007) The globalization of private standards and the agri-food system, ed. J.F.M.
Swinnen. Global supply chains, standards and the poor. Wallingford, UK, CABI.
Galizzi, G., and L. Venturini, eds. 1999. Vertical relationships and coordination in the food system.
Heidelberg: Physica Verlag.
Gereffi, G., J. Humphrey, and T. Sturgeon. 2005. "The governance of global value chains." Review
of International Political Economy 12(1):78-104.
Glover, D.J. (1994) Contract Farming and Commercialization of Agriculture inDeveloping
Countries ed. J. von Braun, and E.T. Kennedy. Agricultural commercialization, economic
development, and nutrition. Baltimore, MD, Johns Hopkins University Press for
International Food Policy Research Institute (IFPRI).
Glover, D.J., and K.C. Kusterer. 1990. Small farmers, big business: Contract farming and rural
development. London: Macmillan.
18
Goodman, D., and M. Watts, eds. 1997. Globalising food: Agrarian questions and global
restructruing. London and New York: Routledge.
Hart, G. (1997) Multiple trajectories of rural industrialisation: An agrarian critique of industrial
restructuring and the new institutionalism, ed. D. Goodman, and M. Watts. Globalising
food: Agrarian questions and global restructruing. London and New York, Routledge.
Henson, S., S. Jaffee, J. Cranfield, J. Blandon, and P. Siegel. (2008) "Linking African smallholders
to high-value markets: practitioner perspectives on benefits, constraints, and interventions."
Working Paper. World Bank, 4573.
Hu, D., T. Reardon, S. Rozelle, P. Timmer, and H. Wang. 2004. "The Emergence of Supermarkets
with Chinese Characteristics: Challenges and Opportunities for China's Agricultural
Development." Development Policy Review 22(5):557-586.
Huang, J., S. Rozelle, X. Dong, Y. Wu, H. Zhi, X. Niu, and Z. Huang. (2007) "Agrifood Sector
Studies China: Restructuring agrifood markets in China - The horticulture sector " Part A meso-level study. London, Regoverning Market Program, IIED.
Huang, J., Y. Wu, Z. Yang, S. Rozelle, J. Fabiosa, and F. Dong. 2010. "Farmer Participation,
Processing, and the Rise of Dairy Production in Greater Beijing, P.R. China " Canadian
Journal of Agricultural Economics (In press).
Huang, J., Y. Wu, H. Zhi, and S. Rozelle. 2008. "Small holder incomes, food safety and producing,
and marketing China's fruit." Review of Agricultural Economics 30(3):469-479.
Hueth, B., E. Ligon, and C. Dimitri. 2007. "Agricultural Contracts: Data and Research Needs."
American Journal of Agricultural Economics 89(5):1276-1281.
Hueth, B., E. Ligon, S. Wolf, and S. Wu. 1999. "Incentive Instruments in Agricultural Contracts:
Input Control, Monitoring, Quality Measurement, and Price Risk." Review of Agricultural
Economics 21(2):374-389.
---. 1999. "Incentive Instruments in Agricultural Contracts: Input Control, Monitoring, Quality
Measurement, and Price Risk,." Review of Agricultural Economics 21(2):374-389.
Humphrey, J., N. McCulloch, and M. Ota. 2004. "The impact of European market changes on
employment in the Kenyan horticulture sector." Journal of International Development
16(1): 63-80.
IFAD. (2003) "Promoting Market Access for the rural poor in order to achieve the millennium
development goals." Rome, IFAD, February 2003.
Jaffee, S., and S. Henson (2005) Agro-food exports from developing countries: The challenges
posed by stardards, ed. M.A. Aksoy, and J.C. Beghin. Global agricultural trade and
developing countries, The World Bank.
Jaffee, S., and J. Morton, eds. 1995. Marketing Africa's high-value foods: Comparative experiences
of an emergent private sector. Iowa: Kendall/Hunt Publishing
Jia, X., Y. Hu, G. Hendrikse, and J. Huang. 2010. "Centralization or Individualism: The decision
rights in Farmer Cooperatives in China." Paper presented at "Institutions in Transition –
Challenges for New Modes of Governance". June 16-18, IAMO Forum 2010 Halle (Saale),
Germany.
Joskow, P.L. (2005) Vertical Integration, ed. C. Menard, and M.M. Shirley. Handbook of New
Institutional Economics. The Netherlands, Springer.
19
Key, N., and D. Runsten. 1999. "Contract Farming, Smallholders, and Rural Development in Latin
America: The Organization of Agroprocessing Firms and the Scale of Outgrower
Production." World Development 27(2):381-401.
Lazzarini, S.G., G.J. Miller, and T.R. Zenger. 2004. "Order with Some Law: Complementarity
versus Substitution of Formal and Informal Arrangements." Journal of Law, Economics,
and Organization 20(2):261-298.
Little, P.D. (1994) Contract farming and the development question, ed. P.D. Little, and M.J. Watts.
Living under contract: Contract farming and agrarian transformation in Sub-Saharan
Africa. Wisconsin, The University of Wisconsin Press.
Little, P.D., and M.J. Watts, eds. 1994. Living under contract: Contract farming and agrarian
transformation in Sub-Saharan Africa. Wisconsin: The University of Wisconsin Press.
Ménard, C. 2004. "The economics of hybrid organizations." JITE 160(1):1-32.
Ménard, C., and P.G. Klein. 2004. "Organizational Issues in the Agrifood Sector: Toward a
Comparative Approach." American Journal of Agricultural Economics 86(3):750-755.
Maertens, M., L. Colen, and J.F.M. Swinnen. (2008) "Globalization and poverty in Senegal: A
worst case scenario?" LICOS Discussion Paper. Leuven, Belgium, LICOS Center for
Institutions and Economic Performance, 199.
Maertens, M., and Swinnen J. 2009. "Trade, Standards and Poverty: Evidence from Senegal."
World Development, forthcoming.
Martinez, S.W., and A. Reed. (1996) "From Farmers to Consumers; Vertical Coordination in the
Food Industry." Washington, DC, ERS/USDA, AIB 720.
Mighell, R.L., and L.A. Jones. (1963) "Vertical Coordination in Agriculture." Washington, DC, US
Department of Agriculture, Economic Research Service, Farm Economics Division.
Minot, N. (2007) "Contract Farming in Developing Countries: Patterns, Impact, and Policy
Implications." Ithaca, NY, Cornell University, Case Study #6-3.
Minot, N.W. (1986) "Contract Farming and its effects on small farmers in less developed
countries." East Lansing, MI, Michigan State University, Department of Agricultural
Economics, 31.
Miyata, S., N. Minot, and D. Hu. (2007) "Impact of contract farming on income: Linking small
farmers, packers, and supermarket in China " MTID Discussion Paper. Washington D.C.,
International Food Policy Research Institute (IFPRI), 00742.
Perry, M.K. (1989) Vertical integration: Determinants and effects, ed. R. Schmalensee, and R.D.
Willig, vol. 1. Handbook of Industrial Organization, Elsevier Science Publishers B.V.
Poulton, C., A. Dorward, J. Kydd, N. Poole, and L. Smith (1998) A new institutional economics
perspective on current policy debates, ed. A. Dorward, J. Kydd, and C. Poulton.
Smallholder cash crop production under market liberalisation: A new institutional
economics perspective Wallingford, CAB International.
Poulton, C.D., A.R. Dorward, and J.G. Kydd (2005) The Future of Small Farms: New Directions
for Services, Institutions and Intermediation. Imperial College, London. International Food
Policy Research Institute (IFPRI) & Overseas Development Institute.
20
Ravallion, M., and G. Datt. 2002. "Why has economic growth been more pro-poor in some states of
India than others?" Journal of Development Economics 68(2):381-400.
Reardon, T., and J.A. Berdegue. 2002. "The Rapid Rise of Supermarkets in Latin America:
Challenges and Opportunities for Development." Development Policy Review
20(4):371-388.
Royer, J.S., and R.T. Rogers, eds. 1998. The industrialization of agriculture. Vertical coordination
in the U.S. food system. Aldershot: Ashgate.
Shepherd, A.W. 2005. "The implications of supermarket development for horticultural farmers and
traditional marketing systems in Asia (revised paper)." Paper presented at
FAO/AFMA/FAMA Regional Workshop on the Growth of Supermarkets as Retailers of
Fresh Produce. Kuala Lumpur, October 4-7, 2004.
Simmons, P., P. Winters, and I. Patrick. 2005. "An analysis of contract farming in East Java, Bali,
and Lombok, Indonesia." Agricultural Economics 33(s3):513-525.
Start, D. 2001. "The Rise and Fall of the Rural Non-farm Economy: Poverty Impacts and Policy
Options." Development Policy Review 19(4):491-506.
Swinnen, J.F.M. (2007) The dynamics of vertical coordination in agri-food supply chains in
transition countries, ed. J.F.M. Swinnen. Global supply chains, standards and the poor.
Wallingford, UK, CABI.
Swinnen, J.F.M., and M. Maertens. 2007. "Globalization, privatization, and vertical coordination in
food value chains in developing and transition countries." Agricultural Economics
37(s1):89-102.
Sykuta, M.E., and M.L. Cook. 2001. "A new institutional economics approach to contracts and
cooperatives." American Journal of Agricultural Economics 83(5):1273-1279.
WDR. (2008) "Agricultural for Development." World Development Report. The World Bank.
Weatherspoon, D.D., and T. Reardon. 2003. "The Rise of Supermarkets in Africa: Implications for
Agrifood Systems and the Rural Poor." Development Policy Review 21(3):333-355.
Williamson, O.E. 1985. The economic institutions of capitalism. New York: The Free Press.
---. 1971. "The Vertical Integration of Production: Market Failure Considerations." American
Economic Review 61(2):112-123.
Wolf, S., B. Hueth, and E. Ligon. 2001. "Policing Mechanisms in Agricultural Contracts." Rural
Sociology 66(3):359-381.
World Bank, T. 2007. World Development Report 2008: Agriculture for Development. Washington,
DC: The World Bank.
WorldBank. (2006) "China's compliance with food safety requirements for fruits and vegetables:
Promoting food safety, competitiveness, and poverty reduction." Report. The World Bank,
39766.
Zylbersztajn, D., and E.M.M.Q. Farina. 1999. "Strictly coordinated food-systems: exploring the
limits of the coasian firm." International Food and Agribusiness Management Review
2(2):249-265.
21
Figure. Determinants of contract farming
Technology
Techo-Economic
Attributes
of Commodity
 Uncertainty
 Asset Specificity
 Complexity
Institutional
Environment and the State
Sectoral
Structure
Transactional
Attributes
Territorial
Environment
Institutional Environment
Infrastructural
Environment
Bargaining Power
Source: Adapted from Poulton et al. (1998) and Williamson (1985)
Governance
Contractual Arrangements
-Form
-Terms