Question

Suppose it is 2030 and two large food processing firms have established facilities in United States. These companies have invested in state-of-the-art processing facilities for a range of new vegetable and greenhouse fruit crops and are targeting high value markets with an emphasis on freshness and quality. Farmers have been encouraged to diversify into these horticultural crops, making long-term commitments through the construction of greenhouses, produce washing stations, etc. The food processing firms will only source product from ‘preferred suppliers’ and require producers to sign a contract to be on the preferred supplier list.
Discuss the economic functions of a contract in this situation and explain how information asymmetry, risk aversion, asset specificity, and hold-up are relevant considerations in the design of efficient contracts. Discuss the advantages and disadvantages of different types of contractual arrangement from the perspective of the processor and of producers.

Answer 1

Designing of meaningful and efficient contracts requires a well balanced approach to several economic rationalities for taking care of asymmetry (unequal access to information), risk aversion (opportunism and bounded rationality), asset specificity (costs for a specific transaction), and hold-up (apprehension of increase in bargaining power of a counter party due to increased collective efforts) between / among parties to the contract.

To strike a balance between contract objectives and contract means in light of the aforesaid dimensions, the contract need to focus on:

• Increased co-ordination – Right products are produced and supplied at the right time and at the right place. This is ensured by timely distribution of relevant information (information symmetry). Decisions related to centralized v. non-centralized decision making; availability of production schedules; etc. are covered under this aspect.
• Motivation – There is some sort of economic motivation for co-ordination in the contract. For eg., bonuses or penalties.
• Reduced transaction costs – The co-ordination and motivation are provided at lowest possible costs. This is ensured by quality testing, advising, formation of associations, etc

Types of contracts & implications:

Contract Type	Meaning	Processor	Producer
Limited Management	Producer gets limited input support from processor and sell final produce to the processor without any price guarantee	No market risk but exposed to blip in supplies and qualities	There is no intervention of the processor. However the market risks are also on the producer.
Full management	Producer gets maximum input support from processor with income guarantee provided quality parameters are met.	Regular supply at pre-set quality levels. Market risk and reward belongs to the processor	No price risk at the cost of increased control and monitoring by processor.

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