Contract Farming: Sweet and Sour (Part 2, the Sour)

**First draft (27/12/2016)

The article still needs some cutting and trimming. Hopefully, all will be done next year!


***Final revision (03/01/2017)


In the first part of our article about contract farming, we explored its sweetness, the favorable outcomes (theoretically driven and some empirically proved) obtainable through the practice of contract farming. We anchor our discussion on 5 pillars: Uncertainty reduction, Assurance of access of large markets, Access to intermediate and primary inputs, Transfer of knowledge and promotion of self-dependency, and Contract farming as a precursor of more advanced form of economy. While the benefits are numerous, contract farming, like anything else in life, has its downsides just as many as its upsides. That is to say it is a sweet and sour sort of mixture. The purpose of the second part of the article is thus neither to directly challenge the proponents of contract farming nor to refute the pronounced merits, but rather, to invoke some humility as well as some exercise of caution against possible pitfalls of contract farming, especially at the early phase of its application within the context of developing countries.

Why is “Contract Farming” also sour?

Not a pretty sight

Contract farming, in essence, is one of the many alternatives to the pervasive practice of traditional agriculture throughout most developing nations. The reason it has been widely recognized and promoted by various non-governmental organizations and private firms alike is, without doubt, its effectiveness in raising quantity and quality of agricultural produce. As attest by many empirical findings, it has been quite successful in achieving the favorable ends practitioners desire. However, I am still concerned about the reliability and accuracy of much of the assessment done on contract farming. My worries materialise in three recurring mistakes in social research in general: (1) there are always other forces in play, acting as confounding factors that make it seem like contract farming is effective (developing countries tend to have a bad case of multiple projects being clustered in the same areas, and thus, obscuring the degree each project is contributing to the final single outcome usually coded in binary – success for 1 and failure for 0); (2) successful projects tend to attract more research, and likewise research that validates interesting correlations tend to get more attention and thus more likely to be published, the so-called “publication biased”; (3) people often do not possess a good understanding of abstract and measure of counterfactual (things that could have happened had the one that happened did not), and this could confound other more optimized options (i.e., maybe a strategy involving rice fish farming coupled with agricultural subsidy is even more cost-effective). Of course, these remain as merely some of my conjectures, and they should be taken with a grain of salt (I want to include them nonetheless as food for thought). Probably, the bottom-line here is that success story should not be generalized and that evaluation should be conducted on a case-by-case basis, and this idea leads us to the first taste of sourness of contract farming:

  1. Theory of the second best: Geographical conditions, time period, degree of cooperation from farmers, education level, initial income, culture, public institutions, and many other factors influence the outcome of contract farming. Since these elements vary from country to country (i.e. culminate into what we usually call “context”), so can the outcome of the exact same application in two different regions or countries. When assumptions change, when new conditions are introduced, it is of utmost importance that we do not treat solutions to our problems as being standardized. Contract farming adopted in a new country might also require a new set of approaches to flesh out its true potentials. Unlike physics, where close to ideal inputs and methods produce close to ideal outcomes, certain economic and social programs demand a rather counter-intuitive way of thinking. To better illustrate, let’s look at how physics approach a real world problem and see if the analogy would make sense in economics. In physics, when computing the amount of energy needed to propel an object, we can assume frictionless ground and still get the final calculation close to what it should be in reality (where friction is present). In economics and social projects like contract farming, things are not that straightforward. Having one condition unsatisfied implies that the outcome can either be close to or swing wildly away from the ideal. Think about OPEC. OPEC can be viewed as a monopoly in the oil market. It raises oil price to maximize its revenue, but that also reduces output. This is bad for consumers. Let’s suppose there exists a benevolent sovereign who want to correct this market distortion by coercing OPEC to lower its price (i.e. leading to higher production due to higher inventory turnover rate). Of course, the aim is to get as close as possible to perfect competition which would, based on common sense, yield near optimal outcome (maximizing utility). However, perfect competition assumes explicitly the absence of externalities. Since oil is notorious as a source of pollution, the no-externalities assumption is violated. Thus, getting to competitive price would not lead to any greater social well-being as intended. On the contrary, it would result in more pollution and erode any potential consumer gain. So, you see, contract farming suffers from the exact same problem. Observing a successful project in one country is not a greenlight for anyone to replicate it in another because it might give off an unexpected outcome if even one of the assumed conditions (in the first country) is unmet in the second. So, I advise practitioners to study contract farming on a case-by-case basis as mentioned earlier and avoid over-generalization of methodology. Hence, preliminary research and cost-benefit analysis are to be executed prior to project implementation, not the other way around.

    The first take-home lesson which I believe is fundamental to any sort of social projects and programs is that there exist many constraints and adverse effects that should not be overlooked. Do keep in mind that not every limitation of contract farming is consistently present in all iterations of the project nor is its degrees of influence on the outcomes. That is to say, different contract farming projects come with different mix of merits and demerits depending on the initial settings and the various factors along the way. Notwithstanding, it is worth pondering over all the possible shortcomings and complication that may arise. Below is a non-exhaustive list of some more of the sour parts of contract farming (in no specific order), partly of my own thinking and partly extracted from an ADB report on the failure and success accounts of contract farming done in Thailand (see reference)

  2. Price tag: This came to me just recently. It was that one night in a pub with a couple overpriced drinks and overly excited friend (whose nightlife sucks) when a rather attractive singer with too much makeup sang “Price tag”. It is kind of funny how you spontaneously and constantly think about economics. On that note, many economists went mental and I hope I can escape the same fate. Joke aside, contract offer price is usually below the (projected) market price. Think of it as a risk premium charged by the buyer. However, this really depends on the type of crop. Potato, for instance, suffers from less price volatility due to its high demand and common consumption on the global market. Thus, when the future arrives and the actual price is much higher than the settled price, contract farmers face an incentive to side-sell their products on the open market. This is a moral problem that, if widely practiced, can jeopardize the future of contract farming. Hence, it calls for more flexible offer price (allowing for price to behave as a function of the output market performance; i.e. give farmers additional payment during low season when price is high), higher contract enforcement cost and cooperation from the government to attract more buyers so to avoid falling into a “monopsony” situation. The price tags of crops are also related to many other issues that are further discussed below.

  3. Monopsony: While monopoly means single supplier/producer, “Monopsony” arises when there is only one buyer (demander/consumer) in the market. Think of it as just another monopoly defined in reverse. Monopsony is not healthy from economic perspective (though there are particular instances that it is beneficial for the overall economy, we will keep it for later articles). It increases the possibility of the sole buyer monopolizing the market, i.e. locking farmers in the company’s own ecosystem. This lacks of competition among buyers, in other words, gives the monopsony excessive power to set price, which ultimately deteriorate farmers’ livelihood. Moreover, the monopsony might morph into the sole provider of inputs, which further worsens the problem of “low long-term self-dependency,” and thereby beats one of the main purposes of contract farming. A single buyer is also more susceptible to external shock. While it is getting higher return, it is also subject to greater loss due to the larger risk component emerging from owning the whole market. Systematic risks like climate change and political instability will spell doom faster in this case. Therefore, it is for all parties’ benefits that we encourage the existence of more than one buyer. What we need is competition within and between sectors as it makes possible more alternatives (the ability to switch to another buyer if growers feel they are being oppressed by the current one), and thus, less price coercion. That is to say It induces competitive environment among buyers of agricultural produce (for land, for input, for farmers, etc); thus, bidding up price as close as possible to the market price. Of course, we still fear systematic risks, but we should also expect every buyer to possess diverse investment portfolio, and since each buyer owns just some percentage of the market, the damage (at the very least, agriculture-related risk) can then be cushioned. Monopsony is indeed a potential issue not to be neglected.

  4. The intern (first-timer) problem: Contract farming requires immense diligence, patience, and possession of minimum foundation of knowledge that enables farmers to effectively absorb and retain new information. Getting these elements in place should mark the first challenge in any agricultural training intended for farmers. At the same time, it is necessary for practitioners to recognize the crucial role experience plays at the point of entry in determining farmers’ capacity to deliver and adapt. As stated in a study by Wiboonpongse and Sriboonchitta (1998) on contract farming in Thailand, experienced farmers were likely to find production of the newly introduced Japanese cucumbers and maize seed relatively easy. The story of course turns very sour for inexperienced farmers when it comes to new crop type. Farmers working with new crops are like interns on their first day being exposed to the real office environment. There are all sorts of unmet expectation, disappointment, frustration, anxiety, and other fear factors coming to knock them off their socks. Farmers have to deal with new methods, new equipment, new schedule, new commitment, and the introduction of precise deadline and quality expectation. The extra layer of work required implies higher risk during the first few years of practice, and in my honest opinion, I think both parties in contractual agreement should brace themselves for failure. First-time growers can get easily discouraged and revert back to their old crops. Likewise, first-time buyers can easily over-rate the hardship and failure, and then quit. Blame shifting will likely be a common occurrence. People feel frustrated and they find solace in scapegoating. Recognizing the initial constraints and having ready quality feedback will thus be helpful in constructing due strategies to sort out possible problems. If the story of contract farming in Thailand (from ADB discussion paper published in July 2008) teaches us anything at all, it is that contract farming is prone to failure for at early stage, and it is a matter of assessment and feedback quality that decides its degree of success in subsequent stages.

  5. Underestimating the power of Data: Rather than a downside of contract farming itself, this section is intended as a cautionary tale, a pseudo-fact derived from my observation of my own country, Cambodia. The tendency to cluster multiple projects into one region, the low quality and sometimes irresponsible delegation of data gathering tasks, the lack of usable data in general, the confusing coordination, and the understatement of data analysis process are nothing less than remarkable in many development projects and programs. Together, they make up one of the major flaws that undermine the accuracy and coherency of statistical analysis in development research. Heck, development research itself is way underrated and the focus has been mostly on groundless policies passed on the basis of popular demand. If you ask me to list one and only one thing that I have learned from half a decade spent in the field of economics, one thing that I have learned from my supervisor, it is none other than the power of data. Assuring high quality data (by paying close attention to the gathering and processing stages of data) is equivalent to assuring the quality of record keeping, analysis, assessment and feedback. Mediocre record keeping and evaluation result in poor quality assessment and feedback on projects. They obscure the merits of certain actions. They blur the inefficiency and the shortcomings from the start to finish. When feedback is of low quality, so is the level of adjustment and fine-tuning of the subsequent application of contract farming. Feedback is thus one of the most, if not the most, vital components in all fields of study and implementation. Like stated earlier, I expect contract farming to experience the same sort of issue just like any other development project did, and probably, it will fail the first time. But, that is not the same thing as saying it will fail the second time and continue to achieve subpar outcome. With high-quality assessment and reaction, the loss can be avoided in two ways, either to through making changes to the practice or giving up entirely. Either way, on-spot response to feedback promotes greater operative and allocative efficiency. On this note, I strongly encourage practitioners to strengthen their data quality through any means deemed necessary.

  6. Meeting the standard quality for export: If production is not aimed at export, then the question of importance is whether or not the local market and its related infrastructure are advanced enough to support contract farming. Quality is then only determined by domestic standard, and farmers are mostly knowledgeable about that. However, when the whole industry is exposed to global market, global standard quality assurance becomes a big issue for any new contract farming project to explore. Quality (safety and conformity to the ISO) is indispensable if a country wants to gain access into big markets like Japan, the United States, and members of the EU. This usually ends up putting immense pressure on inexperienced farmers and increases the likelihood of early exit from the contract. To really comprehend the nature of the problem, you have to imagine yourself being a farmer. Let’s just say you own a small plot of land, a few brain-damaged cows and some growth-stunt chickens, not that this is relevant to our discussion or anything, but just for the fun of it. And by the way, your partner nags you every day about being poor. So, given the systematic risks present for all parties (irregular rain pattern, drought, flood, soil erosion, and others common features of climate change), assuring high-quality crops can be a real challenge, especially when international grading depends more on appearance of the crops than other attributes. Odd-shape potatoes, for instance, are way cheaper than the perfect-shape ones. That, coupled with inexperience, can really pull off a great fiasco. Contract farming can thus be risky for smallholders (those who own very small plot of land) whose income is normally not diversified (a single egg in a basket with a hole big enough for an egg). It is thus also a matter of contract enforcement, the rigidity of contract, and sympathy from the buyer side. What margin of error should the buyer be willing to accept? Can the government intervene to correct this problem? These are just a couple of questions out of many concerning the output’s quality standard.

  7. Two in one, “Survival of the fittest” and “Adverse selection”:Survival of the fittest” is simply a fancy way to say that capable farmers are more likely to survive the test of time (and contract). Farmers who do not possess sufficient physical and emotional constitutions for the tasks are subject to exclusion. In that regard, contract farming can be a selective process that ultimately favours farmers who would have succeeded anyway with or without support. Though empirically, there has not been definitive proof – as shown by the study on contract farming in Thailand – it remains an issue ponder worthy because less capable farmers can be those among the poorest. And remember, different contexts imply a different mix of challenges and possible outcomes which in turn demands a case-by-case formulation of strategy. With respect to “Adverse Selection”, it is mostly a concern pertaining to the agricultural company (i.e. the buyer) because the assistance and security (that comes at the cost of lower than average market price) provided by the buyer are often more appealing to less capable farmers, especially those in need of credit; though eventually, only adaptable farmers stay. This lowers potential effectiveness and optimal revenue (profit maximizing) for the buyer (the agricultural company). One way to address these two challenges is to create a farmer group that represent all farmers in the region. In that way, it not only assures a package-like offer of labour and land (with mix of high-grade and low-grade farmers) that lowers the likelihood of exclusion of poor farmers, but it also diversifies the risk and decentralizes responsibility for the buyer (meaning all farmers are involved, not only the ones likely to fail).

  8. Environmental degradation: Contract farming tends to focus on monoculture (cultivation of a single crop) and cash crop. This lack of agricultural diversity due to the strategic focus on a single crop type (for ease of management, training, finding market, etc) is conducive to deterioration of soil fertility, a potential side-effect that sorely needs attention as contract farming often causes formerly self-subsistent farmers to rely entirely on local market for food (i.e., instead of planting food crops, farmers now have to exchange cash crops for money and then money for food at the local market). Consequently, it undermines the sustainability of contract farming. The problem is worsened as contract farming also heavily utilizes agrochemical to lower labour cost and improve productivity. Even if organic fertilizer, for instance, is promoted, the incessant application of fertilizer (either organic or chemical) per se is bad for the soil capability to self-rejuvenate its nutrient contents and causing soil pH level to be too low or too high. This subsequently results in falling yield over time on top of many other issues including the cost of correcting the over-optimal fertility level, resuscitating the land, etc. Organic (chemical-free) production, while it may sound appealing, also entails its own unique problem. Organic catalyst may not be as potent since it releases nutrients at slower rate. So, when confronting climate risks, it can lead to lower yield and undesirable crop appearance, especially of easily discernible crops like eggplant, tangerine, etc., which can reduce the sale price significantly.

  9. Diseconomies of scale: At early stage, the practice of contract farming is equivalent to integrating outputs but not production process. This implies that initially, economies of scale is not at aggregate level but at individual farmer level. Of course, since a large proportion of farmers in developing nations are smallholders, economies of scale will occur at very small production size (per farmer), and diseconomies of scale will kick in very fast. In other words, with the absence of production cap, individual farmer owning a subpar and low capacity (small size) plot of land might find their the per yield cost-efficiency rising at first but only to fall very quickly as production expands. To put it differently, they hit the peak early and fall early. That is why mass production by a single entity is better at spreading cost, pooling risk, and retaining economies of scale advantage. So, the question for agricultural companies engaging in contract farming, for the sake of quality and efficiency, is how large of a production size should the company set for each farmer? What is the organizational structure suitable for each locality? What sort of farming arrangement should be set forth to optimize outcome? These remain major questions, and the lack of data and prior region-specific research are real challenges to our ability to arrive at conclusive answers.

  10. Free-riding: The lack of corruption-free business environment can become a huge issue later on in the stage of contract farming development. With weak governmental and legal institutions to enforce contract and fair competition, the tragedy of prisoners’ dilemma kicks in. This is a classical behavioural economics problem. Consider contract farming group A and B vying for market share. Each company has the incentive to steal farmers’ produce from one another. If company A gets into a contract with farmers, contract farming requires the company to invest its resources (raw materials, technology transfer, etc) in farmers. Thus, for company A to be profitable, it would have to offer lower price to farmers. Company B, on the other hand, can choose between two strategies. First, to engage in the same deal as Company A does, incurring cost for itself and earning low profit. The nature of the competition between the two companies per se will drive profit down for both companies. Or, secondly, B can offer slightly higher price to farmers in contract with company A to entice the farmers to side-sell their outputs. Of course, this would yield greater net earnings for company B simply because it acquires products with little expense. With weak contract and high cost of contract enforcement (due to the lack of proper legal framework), farmers as well face a strong incentive to side sell their outputs. Ultimately, it is possible that company B will gain at the loss of A. If there is not support from the government to properly prevent and resolve the issue (and if the public servants show sympathy with the farmers and promote impartial solutions in favor of farmers), company A will have no choice but to exit the market, and the economy will run with sub-optimal outcome and loss in the long run.

  11. Inferior infrastructure: Provision of quasi-public goods such as irrigation and physical infrastructure will lower the fixed cost for firms and increasing the effectiveness of contract farming. Public sector thus plays a significant role in contract farming. But, the lack of interest, lack of transparency and budget in poor nations are typically major obstacles to the success of contract farming projects.

  12. Systematic risks: Systematic risks are high in poor nations; hence, the large risk premium. They come in different forms: climate change, proneness to political turmoil, lack of economic diversification (vulnerable to world market volatility), etc. These are risks that cannot be pooled and diversified, unless the investors have substantial equities in many other countries with weakly correlated economic performance. Thus, systematic risks pose a severe crippling effect on a country in need of high-standard investment. The variance of future outcome is also large. Coupled with the deficiency of intra-country research, the uncertainty component is formidable, to say the least. Therefore, contract farming in the global south is normally exposed to greater unpredictability and more dramatic failure. Perseverance from all parties involved is the key element to long-term sustainability. Of course, persistence and high morale only last if future application has sufficient feedback to improve the next possible outcome, and that brings us back to the issue of data and research availability we discussed earlier.

There are numerous other issues of relevance, and they are all interconnected. The challenges raised make up merely the peak of the iceberg. The cost of standardizing contract, regulating contract compliance, the issue of price stability and credit provision, cost of coordination, knowledge alignment, and many others are barriers to successful contract farming. Understanding of such issues thus will undoubtedly contribute to higher likelihood of achieving desired outcome, leading to the expansion of economic pie for stakeholders and beyond. Of course, no pessimists have ever won a war, but pessimism is also the source of prudence. After all, optimists who indulge in complacency and fantasy are no better than pessimists. The right balance is needed, and cliché as it may sound, it is the main reason why we need to view contract farming as sweet and sour, as having both desirable and adverse qualities. For only when we properly comprehend its ups and downs, can we distinguish between disease and symptom, and only then, can we apply appropriate treatment, fine-tune the process, and offer sustainable means to a long-lasting prosperity.

I hope you have learnt a great deal (or at least something) from the article. While the issue might not concern you personally, knowledge does come in handy at time. Being able to understand does not necessarily imply the ability to effectively execute, but such a statement is only relevant when knowledge and practice are oil-and-water-like mixture. The reality is that knowledge of various aspects of life intermingles and so are the applications. Economists will gain much from understanding some science, so they can forecast the rate of technological growth. Scientists likewise need to understand some economics so they can work their way around economic and social barriers impeding their research. And while it is hard to convince and justify the need to learn more and know more, and the only thing I can do is to trust myself and my learning that this article will serve you later in life in one way or another. Until next time!



Songsak Sriboonchitta & Aree Wiboonpoongse, “Overview of Contract Farming in Thailand: Lessons Learned”, ADB Institute Discussion Paper No. 112: