Contractual Relations in Agricultural Markets Mohammad A. Jabbar, ILRI Christopher Delgado, ILRI and IFPRI Nicholas Minot, IFPRI Paper presented at the workshop on “Unleasing markets for agricultural growth in Ethiopia” MoARD-IFPRI, Addis Ababa, May 18-20, 2005

Presentation outline Commodity characteristics that determine forms of marketing Changing conditions that need new institutions Producer coops, marketing coops and contract farming as marketing institutions Potential and constraints for smallholder participation in contract farming

Institutions Dictated by Specific Needs Form of marketing depends on needs for exchange, different for different commodities and situations –Spot market (cash and carry) –Forward purchase of specific lots (futures markets, where risk is greater and quality can easily be specified in a contract) –Contract sales on a regular basis (including coops)—where both buyer and seller benefit from assured market

Concerns: Production Risk Seasonality and culture in production and consumption, e.g. milk Production risk due to weather, disease outbreak and mortality Variations in quality outcomes

Concerns: Market Risks Price volatility/sharp seasonality Market events abroad beyond local control Unequal market power among participants Sellers of perishables subject to extortion Buyers of perishables subject to fraud

Information: The Key to Contractual Forms If buyer can know everything about what is being sold, little need for contracting in most cases –But can be hard to predict future when one will need to buy –Quality issues may be important but not easily observable at sale –Trust and reputation of product is key to what buyer will pay

Different Commodities Have Different Institutional Needs for Marketing Milk: highly perishable, hard to know bacterial, fat content at sale, need to mix many batches in one cooler with associated risks for all, but still possible to take small destructive samples for testing at sale Fruits and vegetables: similar to milk, but less perishables and bulking is less of a risk; quality easier to observe at sale time

Other Commodities Meats: Quality (fat, flavors, tenderness) harder to observe at live sale, especially for pigs and poultry; destructive sampling usually not possible except at great cost Grains: Quality fairly easy to observe at sale except where specialty traits like lysine are an issue (exception may be seed, where certification is necessary)

Also Changing Situations: Market Chains Become Longer Quality grades and standards harder to maintain across several spot markets in chain Capital and input supply harder to link to final sale (e.g. credit becomes more necessary while repayment is harder to enforce) Marketing/price risks grow relative to production risks

Producers Coops: The Usual Form of Milk Marketing to Cities Invented in Denmark in 19 th century Producers get higher prices and buyers lower prices for a given quality than in spot markets Sellers less subject to extortion and get better markets in flush period Buyers less likely to get adulterated milk and get lower prices in dry period Everyone wins and net gain finances coop

Marketing Coops: frequent for fruits and vegetables Gets economies of scale in input supply and shipments of perishables Helps brand output Helps handle characteristic of market being flooded at harvest through sharing cold storage Not very helpful for credit Net gains to buyers and sellers together over spot markets are modest, so not as prevalent as coops for dairy

Contract Farming (CF) Common for Poultry and Pigs, Sometimes Veg Livestock has very high capital requirements; pig, broiler and egg prices very volatile Quality requires hard to monitor labor and input use over long cycle CF supplies capital and extension in mode where repayment is easier to enforce; shares production risks, and reduces price risks Only schemes that work over time have balance of power between buyers and sellers

Spot Markets Work Well for Grains, & Veg if No Processing Usually not enough gains in contracting to compensate both buyers and sellers for extra cost (except for seed) Same is true for veg unless presence of a processing industry means some buyers will pay in order to guarantee their supply lines and to improve uniformity of inputs to their industrial plants

What Does Contract Farming Do? CF is one type of vertical coordination or farmer-buyer linkage in the market The mechanism usually allows –Transmission of market information to farmers –Facilitation of technical assistance to farmers –Provision of inputs, credit and other services to farmers –Verification of production methods and quality assurance to consumers –Lower market volatility to all

Commodity Characteristics For Which CF Works Best Perishable, subject to high price volatility and market risk, e.g milk, poultry, vegetables, fruits New crops destined for new markets so require good technical and market information, e.g. vegetable and fruits for niche markets, new seeds High costs of monitoring intensive production methods and quality, e.g. poultry, vegetables Purchased input cost a high share of output value and high investment cost, e.g poultry, milk, vegetables

Criteria For Defining Forms Of Contract Farming Types of partners involved: farmers, private investors, intermediaries, credit agencies, public sector organisations How risks, benefits and obligations are shared How contract agreements are made, enforced, monitored, and how disputes are settled

Cooperatives vs. Private Integrators? Coops work well when farmer buy-in is key, credit is not a big issue, but capital investment in infrastructure (such as cooling) is too large for local farms CF with private integrators works well when technical assistance throughout each production batch is important, quality and uniformity is key, suppliers credits are a binding constraint, and price volatility is a problem for BOTH buyers and sellers

Potential Smallholder Benefits From Contract Farming Access to better inputs, technology and advisory services to produce better quality outputs Access to capital and credit to overcome financial and liquidity constraints Quality assurance for inputs and products and better health control Reliability of market outlet and prices

Potential Problems/Cost To Smallholders From CF Inequitable share of risk – mortality, production loss Loss of earning potential when market price rise above contract price Loss of autonomy and inability to diversify production when opportunity may come Absence of regulatory support to resolve disputes

What Needs To Be Done To Make Contract Farming Work? Be sure that conditions exist that give return to CF—no point in trying in net gain to buyers and sellers combined is not enough to finance the high cost of CF Create regulatory environment to encourage practice of CF, especially – So that contracts are transparent and assure equitable sharing of risks and benefits –So that contracts provide adequate incentive and safeguard to all parties not to default –To support proper contract enforcement and resolution of disputes due to contract violation

Thank You