Contract farming in Costa Rica: opportunities for smallholders?

Transaction costs and other market failures are widely present in the agricultural sector of emerging economies and negatively affect to low-income smallholders, making difficult their integration into dynamic agri-food supply chains. Earlier literature mentions contract farming as an economic institution with the potential to incorporate smallholders into more advanced markets and strength supply chain integration. However, the application of contract farming in some countries of Latin America has shown diverging experiences and the mere presence of contracts does not assure the sustainability of trade relationships. This research seeks to analyze the effectiveness of contract farming as a market institution between smallholders and agro-processing firms in Costa Rica. The research aims to identify and analyze the following key issues: (1) structural characteristics of the two typical agri-food supply chains for non-traditional products, namely pepper ( Piper nigrum L.) and chayote ( Sechium edule Sw.); (2)patterns of behavior adopted by the agents for adapting or adjusting to the market where they operate under given contractual arrangements; (3) effectiveness and rationale of the current contractual arrangement; and (4) opportunities and constraints for improving the contractual arrangement between the firm and the farmers. To address these issues, we rely on an analytical framework based on the Structure-Conduct-Performance approach, and a modeling assessment of organizational strategies under monopsonic market conditions. These frameworks enables us to analyze and explain the different strategic interactions between two parties (firm and farm), given the set of expected asymmetries of information and transaction costs that they are facing.In Chapter 2 we first analyze the causes of market failures in developing countries and the emergence of alternative institutions as response to such market failures. Contract farming is a form of governance that emerges in response to market failures for credit, insurance, information, factors of production, outlet produce; and transaction costs associated with the search of prices and markets, transfer of technology, and distribution of bargaining power, monitoring and enforcement in a transaction with a second party (Grosh, 1994; Key and Runsten, 1999). For the next actor in the chain, namely the buyer firm, contracts assures him a continuous flow of product, at the right moment, with the desired characteristics, and without operating the whole production operation. Therefore, `contracts take an intermediate position between spot markets and full vertical integration, and correspond to certain level of supply chain management, as a suitable mechanism for distributing risk between the contracting parties. The literature points out three main non-exclusive categories for contracts, namely market specification, production management and resource-providing contracts. Resource-providing contracts are particularly important for enforcing sustainability criteria or for promoting quality upgrading. The selection of a specific type of contract depends on the type of commodity, the characteristics of the contracting parties, and the prevailing market conditions at a certain period of time. Moreover, uncertainty, bargaining power, asset specificity and enforcement are key issues for the selection of supply chain governance regimes. The opportunities for reaching and maintaining a win-win situation through an agreement depends on the level of mutual trust, the exchange of information between agents, the relative distribution of bargaining power, and the enforcement costs of the contractual terms. Successful integration of small and medium size farmers into export markets seems to depend particularly on the type of contract they maintain with the firm. This contract determines their income levels, degree of autonomy and the level of risk they accept or share with the firm, and influences their willingness to invest in quality improvements or resource conservation measures. Dynamic chain advantages can only be maintained when contracts enable farmers to adapt to these changing market demands. Besides, non-price factors implicit in the contract may positively affect farmers, by improving the efficiency in their production systems and contractual relationship.In Chapter 3we analyze the rationale and effectiveness of different types of contractual regimes, under two market configurations, between small-scale producers of pepper and agro-processing firms in the Northern region of Costa Rica. Particular attention is given to the incentives derived from contracts for the adjustment of production systems and livelihood strategies. Pepper is an attractive diversification activity for smallholders because it is a labor-intensive crop, does not require complex technologies or machinery, requires detailed attention and frequent disease control through the cropping cycle, and can reach high, fairly stable yields per hectare. This gives family farms a competitive advantage compared to large commercial plantations. A major drawback for small farmers are the high entry costs during the start-up phase, necessary for initial investments in crop establishment and the long maturation time before the first harvest. Contracts may be helpful as a strategy for overcoming these constraints and permit market access at reduced levels of uncertainty (Dorward, 2001).In the Costa Rican pepper sector we can distinguish two different market situations (competitive market and local monopsony) and three types of contractual arrangements (written contracts, verbal commitments and none agreement).The data analysis has been conducted making use of the Structure-Conduct-Performance framework (Bain, 1968; Martin, 1993) for the operations on the pepper market, followed by a statistical analysis of household and production characteristics to identify the determinants and effects of contract choice, and to estimate the importance of contracts for resource use efficiency. We conducted a survey amongst pepper producers using a semi-structured questionnaire to obtain data on production systems and marketing arrangements. We successfully collected data from 50 producers, which represented 65% of all pepper producers related to three processing companies.he analysis of market channel choice indicates that income-constrained farmers require contracts especially in the early phase of the establishment process of perennial crops as a guarantee for their investment efforts. In subsequent phases and under more competitive market conditions, producers prefer verbal commitments to written contracts. Furthermore, in the absence of penalties, pepper farmers with delivery commitments may become disloyal to their buyer in markets with increased competition. Most farmers keep selling the major share of the harvest to their fixed buyer but deliver small volumes to competitors as well. Consequently, contracts fulfill rather different roles during the farm household life cycle and are shaped differently under various market conditions. The analysis has also revealed that the sources of income have a clear effect on farmer's contract choice and bargaining power. Income diversification enables farmers to increase their asset specificity in pepper crops, even without the insurance provided by contracts. Besides, farmers with contracts are definitely investing more inputs and time in soil maintenance activities on their pepper plots. Resource-providing contracts in the competitive market have a stronger effect than simple market specification contracts in the monopsonistic segment. This confirms the literature regarding the importance of resource-providing contracts and vertical integration for sustainable agricultural intensification (Kuyvenhoven and Ruben, 2002). Budget-constrained farmers that intend to tailor their investment decisions in line with the designed technological package may substitute for their default in fertilizer use with additional labor investments in soil maintenance activities. Farmers without agreements can still be efficient pepper producers, but maintain substantially lower investments for resource management.The effect of contracts under different market situations indicates that local monopsonies might generate rather perverse incentives for making fixed investments in pepper plantations compared to situations where competition between buyers exists. We have recorded yields per hectare that are substantially lower in the monopsony region, even when farmers use more inputs. Local monopsonies could favor a transition towards more capital-intensive production systems, especially when relying on resource-providing contractual regimes that (temporarily) reduce input costs. This points to close complementarities between the decisions on technology choice and the type of market organization. Finally, farmers with contracts are usually better informed and more committed to the agreement with the buyer. However, the loyalty of these farmers is likely to be more related to their lack of bargaining power rather than to the availability of market information.In Chapter 4 we determined the critical factors that make chayote producers eligible for export delivery to traders-processors and we analyze the impact of contracts on quality performance and loyalty relations within the chayote supply chain. Indigenous vegetables, like chayote, represent an increasing share of non-traditional exports from Costa Rica. Farmers' possibilities to become engaged in global agro-food chains depend on the relationships established with packers and (inter)national brokers. Farmers who are able to deliver better quality and stable amounts tend to become preferred suppliers. Harvesting the crop at an immature stage and quick delivery to exporters improve post-harvest shelf-life and quality, since storage affects the firmness, appearance, flavor and nutritional value (Marín-Thiele, 1997). Contractual agreements may be helpful to reduce farmers' uncertainty and are intended to increase their loyalty towards the processor-exporter. While prices paid to the farmers are only slightly higher than those of the national market, other purchase conditions - like the terms of payment, the provision of credit for inputs and the frequency of collection - are equally or more important for the decisions regarding outlet choice (Hart and Holstrom, 1987). Furthermore, additional services ( i.e. seed, credit and technical assistance) enable farmers to improve their product quality at relatively low costs, whereas can be helpful to control farmers' opportunistic behavior (Chiarelli et al. , 2002). Farmers who deliver chayote to exporters make higher amounts for inputs and labor use, but face delays before receiving their final payment. Therefore, specialization in chayote production is only a feasible option when delivery contracts provide sufficient certainty. We use an analytical framework based on the Structure-Conduct-Performance approach (SCP) (Bain, 1968; Martin, 1993). Robust parameter estimates from binary regressions are presented to examine the determinants of farmers' engagement in export production. Tobit and Logit models are used to examine the probability of contractual engagements between producers and exporters, and to analyze the key factors influencing quality performance and loyalty. Field data were collected from chayote producers located in approximately fifteen villages in the valley of Ujarrás in central Costa Rica. 120 farmers were selected using a stratified sampling technique of a total population of 450 chayote producers, separated in two categories: traditional chayote producers and IDA settlers.Contracts provide an important device for improving security and enhancing the involvement of smallholders in international marketing chains. Farmers delivering under (in)formal contracts with processors/exporters have better access to credit, critical inputs and information, enabling them to benefit from economies of scale and scope. Producers' preferences for a certain processor-exporter are determined by the price paid for their product, but non-price factors (such as access to credit, technical assistance and market information) appear to be equally or more important. Moreover, prices appear to be positively related to export contracts, and these contracts in turn provide incentives for the intensification of chayote production systems. The existence of a contract improves the certainty for the producer, enabling investments in land improvements and better crop management. No direct relation was found, however, between contractual delivery and the quality of the produce, but a strong impact on loyalty was confirmed. Therefore, contracts influence farmers' production systems and household revenues in two different ways. In the first place, quality is improved as a result of better land use and more labor available for crop management and handling. This is mainly guaranteed through the selection of recently settled farmers with larger families as contractual partners. In the second place, loyalty is increased especially when these farmers can be ensured high delivery frequency. The latter is particularly important to maintain post-harvest quality and reduce rejection rates. Loyalty with processors/exporters requires contractual arrangements including provisions for technical assistance and market information as well as adequate facilities for timely product delivery and payment regimes.In Chapter 5 we analyze the dynamics of contracts in the pepper supply chain of Costa Rica. There are no spot markets for pepper and since 2001 only one processor buys fresh pepper from producers under defined quality conditions. Yet, rejection rates are in average of 10 percent of each delivery. This is a very sensitive issue for low-income farmers and one of the most common sources of distrust with the processor that tend to discourage the continuation of the relationships. Product rejection is mainly caused by two factors: (1) deficient transport conditions and (2) immature pepper included in the deliveries. Since most farmers act individually at the moment of the delivery, these two factors cause rejection rates that are partially out of their control. We explore possible forms of collective action amongst farmers with the aim of increasing the quality of pepper by improving transport conditions and organizing monitoring at the point of collection. This could reduce rejection rates and increase the farmers' bargaining power. Yet, the costs of organizing collective action should be less than the potential income increase that results from a reduction of refused pepper and/or the received price premium. We conduct the analysis for 19 farm-households from El Roble settlement; since this was the only group that started a peasant organization when market conditions changed from a competitive situation in the year 2000 to a monopsonistic market in the year 2001. We design a non-linear integer simulation model inspired by the modeling approach proposed by Dorward, (2001), which can maximize the processor's and farmers' gross income (value of sales less value of variable and fixed costs, not including labor, capital and land costs). We compare different delivery scenarios searching for hybrid organizational forms, and assess the associated trade-off between governance costs and benefits that could optimize farmers' income and processors' profit.Our model scenarios simulate the effects of collective action under initial monopsonic market conditions[1]. The model results indicate that low procurement prices of fresh pepper can make the farmers breach the group contract, even between different seasons in the year. It is furthermore shown that group contracts are only rational when higher prices prevail. To justify the group contracts, the costs of organizing collection and transport and the membership fee should be lower than the gains reached from the lower rejection rates. If the price is too low, or the organization costs are too high, the farmers may prefer individual contracts, even if the rejection rates are high. At higher prices, they have an incentive to organize the collection and transport of the pepper through the group. The model shows that the firm should not overuse its bargaining power beyond this self-enforcing price range as the farmers might easily breach the contracts. Furthermore, group contracting can be beneficial for risk-averse farmers in either the low or high season. We also simulate what type of governance structure is chosen when the selling price is endogenously established in the model and the income of the processing firm and the farmers is maximized. This analysis demonstrates that under certain conditions the incomes of the monopsonic processing firm and the farmers' association are jointly maximized by a group contract, enforced by low opportunistic behavior from both agents. The model shows that the processing firm is better-off dealing with a group contract instead of a multiple set of smaller individual contracts when farmers show low opportunistic behavior; even in the monopsonistic market situation. The latter outcome is important in the sense that collective action might be needed only under certain market conditions, but not all the time. The model forecasts a breach of the group contract under conditions of low supply of fresh pepper just because it becomes too expensive or unattractive. However, if the production remains stable throughout the year, with regular weekly supplies and limited season variation, group contracts will be preferred all the time. For the future development of pepper production in Costa Rica, an increase in productivity and stabilization of production throughout the year is required, with the aim of increasing (and especially stabilizing) the frequency of transactions, to improve the trust between actors, encourage low opportunistic behavior, and thereby strengthening the prospects for vertical integration between the parties. This can be done by changing the present market-specification contract for a production-management contract. Otherwise, under irregular supply through the year seasonal contracts will be still the best scenario.In Chapter 6 we present the most important findings of this thesis and some related policy implications. The present research emphasized inthe analysis of supply chains for the pepper and chayote case studies by focusing on differences in the characteristics of the commodities as well as the types of farm households and the derived implications for market configuration and contract choice . This comparison enabled us to yield insights on the endogenous character of the selected contractual arrangements (Escobal et al. , 2000) and draw pertinent conclusions regarding the efficiency and equity effects of supply chain cooperation.Our analysis of farmers' contract choice in both supply chains led us to identify three major functions of contracts, namely (1) a security device to enable farmers to take up a new production activity and to gain access to specialized markets; (2) a provision of incentives for investment and thus increase the asset-specificity on the farmer's side; and (3) a provision of information about the structure of the market where they operate, which is very important to prevent false expectations and adverse selection problems. These functions yield certain effects on the farmers' decisions regarding resource allocation and supply chain integration. We therefore discussed the implications of contracts for guaranteeing smallholder access (equity), for production efficiency, and for the long-term sustainability of supply chain cooperation.Finally, we draw some public and private roles for enhancing supply chain integration. While contracts are essentially private, there is still an important place for public action to safeguard the efficiency, equity and sustainability of supply chain cooperation. Contract farming can become an integral part of agrarian policy-making, where the government, together with farmers and firms, joins efforts and interests in order to promote an inclusive strategy of local sustainable development. This strategy should include public interventions for regulating market access ( i.e. definition of a framework for legal enforcement and recourse), providing information and control ( i.e. definition of minimum public grades and standards), and promoting farmers' organization. Moreover, governmental support is required for supply chain coordination towards product and process upgrading are of utmost importance. Through these interventions, a framework can be implemented to enhance bargaining power and reduce the institutional risk for smallholder producers willing to participate in contract farming.[1] As soon as all farmers, in a specific location, form a group or a cartel, the market condition changes to a bilateral monopoly.