Contract Farming: Sweet and Sour (Part 1, the Sweet)

I recently had a good discussion with one of my friends – a recent M.A. Economics graduate from Vanderbilt University who happens to also write an economics blog called “One-Dollar Economist” (click to visit his facebook page) – about a contract farming project he and his colleagues are working on. The nature of his company (and by that, I mean the one that employs him and NOT owned by him) itself is profit-oriented, but the project is lauded for its social innovation. “Contract Farming”, by definition, is an agricultural production carried out in accordance to an agreement between farmers and a buyer (usually an agricultural company). The farmers promise to provide a certain type and quantity of agricultural produce at an agreed price as specified in the contract. The buyer (the company) controls and assesses the quality of the product, and in many cases, the buyer also provides feedback, necessary inputs and technical assistance. It sounds marvellous, and it is gaining popularity (or probably it is already popular?) in developing nations. However, since I am not specialized in development economics, I knew very little about contract farming per se. At the same time, I still think that it is well within the scope of focus of Economind, and while I have not done much research on the subject, I did give it some serious thought. The reason why this is such an intriguing topic is because contract farming, in essence, is a form of agricultural transformation aiming to promote the economic well-being of all stakeholders in the partnership. The benefits can as well spill over to non-participants, an externality that must be accounted for. So, for the sake of a better and more comprehensive understanding of the concept, let’s formally break down what it really brings to the table. Note that below, while detailed, is still a non-exhaustive list.

Why is “Contract Farming” so sweet?

  1. Reducing future uncertainty: One of the downside of free market is its inherent future risk. While economic forecasting is possible, the margin of error can be quite large. Ultimately, nobody knows for sure what tomorrow will be like. Even a 1% possibility of misforecast can spell catastrophe, if not at the macro level, then at the grassroots. Farmers usually have little knowledge of the broader economy and coupled with usually large degree of obscurity about the future, it gives rise to anxiety and greater vulnerability to exploitation by the more economically savvy middlemen. That is when “contract farming” comes to the rescue. It eliminates future uncertainty for farmers by locking the selling price, constraining it from swinging. This has various implications. On the farmers’ side, one of it being the ability to better manage their personal finance and prepare for tomorrow. Future planning is important. Knowing they can afford better healthcare and education for their children and knowing that they can use their saving to invest in a new farmland or business in a few more years can lead to a more efficient and effective decision making regarding nutrition, health, spending, reproduction, migration, and so forth. Another beneficial outcome is likely the ability to get re-finance at a lower interest rate due to the more stable income and the simple fact that the loan-seeking farmer is associated with a trust-worthy entity (i.e. ==> higher credit rating). For the buyer (the company and its shareholders) as well, contract farming allows them to gain access to the desired quantity of agricultural produce without the need for hiring land and labour which will incur turnover and excess capacity (having too much unemployed farmland and labour when demand falls) risks, meaning the buyer is less susceptible to abrupt change in business environment. Of course, the systematic risks like climate change and political instability are still present to all stakeholders.

  2. Assured access to larger market outlet: With weak physical infrastructure and soft infrastructure in developing nations, getting finished products directly to the market is usually a challenge for farmers. It gives rise to middlemen who add little to no value to the supply chain. Still, the fact that they link farmers to buyers warrants a charge on the service. This lowers the overall attainable profit for farmers, and in some extreme cases, it leads to price coercion, meaning middlemen keeps ‘offer price’ to farmers as low as they possibly can to maximize their own profit. The inability to directly deliver their products to the market as well as the small size of the market within their vicinity increases the cost and risk of farming. Contract farming – though it does not immediately connect farmers directly to the market – is a far better alternative than having to deal with nameless and overexploiting middlemen. Contract farming creates a more favourable business environment for farmers in general since agricultural companies usually have access to larger market. This assures product outlet at a reasonable price for farmers. Likewise, it either significantly reduces or completely eliminates some of the notorious economic barriers such as transportation cost, lack of information on market price, and fierce competition from foreign imports and large agricultural companies, which narrow/restrict access route of small producers to the market. Furthermore, by speeding up the flow of products from farmers to the market, contract farming solves one of the most fundamental drawbacks in semi-modern agricultural practice – the storage problem. Think about it. The lack of proper access to the market implies production surplus, but then, storing unprocessed perishable goods is no easy task. It requires relevant technical knowhow to achieve optimal result and ensure acceptable quality. Rice, for instance, will lose its moisture content over time, degrading its quality and lowering its price. Pest, humidity, sunlight, and several other factors need to be considered during the storing process. In our discussion, my friend made a good point. Since some rice farmers nowadays employ agricultural machinery to harvest, they obtain their yield in bulk all at once. Without immediate access to the market, it will complicate the storing process which is definitely not ideal. Contract farming alleviates the problems mentioned. The ability to sell agricultural yield right away reduces the need for storage. It also maximizes the sales revenue, increases financial security, and allows farmers to liquidate their farming outputs faster so they can use the earnings for other purposes.

  3. Access to primary and intermediate inputs: A rather well-known challenge for development practitioners. With many projects aiming to improve farmers’ livelihood, the first milestone is usually to improve the quality and marketability of their outputs. However, that would require not just technical advice, training, and intervention during process, but also ease of access to input market (proximity, affordability, completeness of information, etc). After all, garbage in garbage out. Inferior input, inferior output, bad outcome. Regardless, the barrier to input market in many low-income countries remains a widespread and persistent challenge. I used to attend as an observer in a training session at commune level on the topic of effective poultry farming. Of course, the techniques presented truly deserved kudos, but the project later on came to a stalemate for one simple reason: ‘inputs were largely imported’. It simply means the project would only go well if donors continued to provide fund to the practitioners. It is thus not sustainable. When a project is not sustainable, we need to ask one simple question: “what is the point of going through all the painstaking processes in the first place?” Because if farmers could not attain self-dependency with the taught techniques, would it not have been better to just give the millions of dollars donation as a lump-sum transfer to the farmers directly? Would it not have been better to engage in other more fruitful projects? Many projects failed for this reason and so much resource was wasted. Contract farming done right has the ability to correct this contagious economic disease. It can attract suppliers of various inputs to establish themselves within the locality, and this will ensure a thriving ecosystem and a healthy production chain. Only when both backward links (input market) and forward links (output market) are properly established can sustainability be ensured. Hence, this point is a merit of a good practice of contract farming. BUT, a sloppy implementation will make no difference from the failed project I mentioned.

  4. Knowledge transfer and promotion of self-dependency: Contract farming, through the provision of training, technical advice, and various supports are without doubt just different forms of knowledge transfer from buyers to farmers. Since such practical knowledge is highly relevant to their livelihood, it implies that contract farming, on top of providing stable income, also expands farmers’ capacity and is conducive to self-dependency. In other words, contract farming nurtures, not just employment in agriculture, but the human resource factor as well. This is of prime importance because it enables farmers to steer away from traditional and low-yield agricultural practice. It unlocks the true potential of the land and capital, raises the expected earnings, and thus, brings a healthier balance to the labour market. Simply put, by elevating income and thus closing earning gap, contract farming helps retain a sizeable workforce (farmers) in agriculture, slows down the drain of labour by industries like garment and construction, and sustains food price in the domestic market. Of course, the point on self-dependency is subject to criticism which we will discuss in the second part of our article about the sourness of contract farming.

  5. A precursor of industrial agriculture: The goals of different contract farming projects may vary, but the general direction, ultimately, is towards promoting specialization (single-crop farms) and standardization of agricultural production. It marks the dawn of transition towards more intensive and more heavy machinery dependent farming. Eventually (but probably far into the future), we would hit a stage just like in the US where less than 2% of the population is employed in agricultural sector. This means that agricultural production would become so efficient, and the gigantic scale of production would bring about economies of scale. Consequently, average cost per unit of yield falls significantly and labour productivity rises to a new level. Compensation, likewise, increases substantially. It also frees up labour force for more advanced and possibly the so-called nascent industries (infant industries which, if well-protected and -supported at early stage, will grow into one of the cornerstones of the nation’s economy), and of course, once food security is ensured, the economy can now shift its focus towards other sectors. The once agricultural based economy might transform into a more industrialized and probably service-based economies; hence, promoting growth and overall social welfare.

Everything has a “BUT”, and it just happens that there are even more “BUTs” in economics. Contract farming sounds like god-sent. BUT, it comes down to the actual practice, the attention to details, the quality of the project staff, the cooperation and amenability of farmers and their knowledge retention rate, the climate conditions, the political support, the coordination with all parties, the enforcement of contract, and many hidden agricultural and economic costs. Soon, we will talk about them, and one by one, we will taste the sour side of the fruit. As a first-look for the next part of the article, here is a non-exhaustive list of the shortcomings of contract farming:

The SOUR parts (soon to be discussed):

– Lack of agricultural diversity due to the strategic focus on a single crop (monoculture)

– Environmental degradation from the use of agrochemical to lower labour cost and improve productivity

– Lower long-term self-dependency (counterfactual to the point raised earlier in the pros of contract farming)

– Possibility of the buyer monopolizing the market, i.e. locking farmer in the company’s own ecosystem

– Adverse selection problem (Inferior farmers are more likely to join)

– Survival of the fittest (Less capable farmers are more likely to be excluded)

– Cost of coordination, quality assurance, aligning knowledge, and enforcing contract

– Systematic Risks (climate change, political turmoil, world market shock)

I hope you have learned something new from the article. Look forward to the second part.