Benefits to Farmers from Contract Farming

A. Market Access

The most important constraint faced by smallholders is the lack of assured market with fair price. For farmers, technical constraint in transforming from a traditional crop to a new crop is less inhibiting than market constraint. Therefore, one of the principal motives for smallholders to enter into a contract farming arrangement is the promise of a steady and increased income from having an assured market. Contract farming arrangements serve to link farmers to distant markets where the demand for and price of crops are often more favorable.

Market access can also result in the expansion of growing areas. In a banana contract arrangement in Thailand, farmers without contracts in the same area were observed to be cultivating smaller areas since they had limited market opportunity to sell produce. Once farmers entered into contract farming, they doubled their growing areas and brought unused land into production (author's field visit, 2004).

B. Increased Incomes

Contract farming promotes farming of non-traditional crops that are sold for a higher price and may be grown without significant extra effort. Although contract farming is not applicable to all crops in all stages of market development, numerous empirical studies from around the world demonstrate that contract farming can lead to improved income of same-crop-growing without contract. Income generated by organic rice farming in Thailand is 70% to 100% higher than conventional farming (Setboonsarng et. al, 2006). Glover and Ghee (1992) and Glover and Kusterer (1990) in their studies in Southeast Asia, Latin America, and Africa confirmed that the majority of contract farming efforts appear to contribute to smallholders' welfare by improving income. Such arrangements enable farmers to forecast income levels, which aids in planning (White, 1997).

C. Reduction in the Risk of Price Fluctuations

Increased income in contract farming is generally accompanied with lowering price risk for farmers. In agriculture, prices can fluctuate drastically from region to region and within a growing season. Smallholders have little access to information and face the risk of loosing substantial income if prices fluctuate downward. In contract farming, however, a predetermined price for the crop is generally established during contract negotiations at the onset of the growing season. As a rule, firms typically purchase the crop that falls within specified quality and quantity in accordance with the contract, and farmers are not subjected to incur losses in sales due to price fluctuations. In this respect farmers can lower their price risk in addition to gaining market access (Binswanger et al., 1995; Baumann, 2000; Eaton and Shepherd, 2001).

D. Credit and Financial Intermediation

Lack of access to credit remains a large constraint in improving agricultural productivity. Formal credit markets in rural areas of developing countries seldom exist, and where they do exist banks are reluctant to lend to smallholders. Even in areas where microfinance institutions exist, these institutions tend to offer loans to microenterprise and not to agriculture production.

The production of non-traditional cash crops generally entails greater expense than production of traditional subsistence crops. Firms are in a better position to provide credit than banks since they usually possess greater ability to monitor and enforce credit and therefore overcome problems caused by financial market imperfections. Additionally, firms may extract the debt that farmers owe from the payment of the procured crop (Key and Runsten, 1999). Firms can also lend to farmers in-kind, e.g., seeds and modern inputs (Baumann, 2000). In cases where firms do not extend loans to farmers, banks often accept the contracts as collateral (Glover and Gee, 1992). As in Thailand, government policy can also play a role in encouraging such a strategy.

E. Timely Inputs and Production Markets

In remote areas with low inputs and limited transportation infrastructure, timely access to inputs is a significant problem for smallholders. Lack of non-traditional inputs and production resources such as improved seeds, fertilizers, or tools is a common constraint for productivity improvement of smallholders. Underdeveloped inputs and product markets may make it difficult for firms to obtain the desirable quantity and timely delivery of crops. To achieve projected yields and desired quality, contracting firms frequently undertake measures to ensure that contracted producers have timely access to inputs including seeds and fertilizers, in addition to training support and the monitoring of proper crop husbandry practices (FAO, 1999; Baumann, 2000; Eaton and Shepherd, 2001). While farmers benefit from timely access to inputs and markets, firms benefit from ensured delivery of the quality products.

F. Monitoring and Labor Incentives

It is argued that smallholder contract farming is more efficient than other forms of institutional arrangement for production, as production efficiency depends largely on the work efforts of the laborers. In large farms or plantations where laborers are employed, the cost of supervision is generally high and hired laborers may be motivated to shirk job responsibilities (Eswaran and Kotwal, 1985). In small family farms, laborers have the incentive to work conscientiously for the sake of their own family's wellbeing (Hayami and Otsuka, 1993; Hayami, 2003). Booth (1998) and Hayami (2003) reported that although Thailand started canned pineapple production relatively recently, production had surpassed that of the Philippines, previously the world's leading exporter. Whereas the Thai system is based on contract farming, Philippine production is largely based on the plantation system. In this respect family-run ventures appear to be equally or more efficient than plantations based on hired labor. It appears that contract farming can evolve to mitigate extensive monitoring and labor supervision costs.

G. Reduction of Production Risk for Farmers

Contract farming arrangements facilitate risk sharing in the case of production failure due to uncontrollable circumstances including poor weather or disease. Through contractual arrangements, the risk of total income loss due to crop failure can be reduced for farmers. Where production problems are widespread as a result of uncontrollable events, firms will often defer the repayment of production advances until the following season (Eaton and Shepherd, 2001).

In addition, upon contract authorization, subsidies may be provided to diminish risk during the startup of the new enterprise. Glover and Kusterer (1990) report that for smallholders, whose contracts were subsidized in the early years of their participation, extension from the contracting firms was important in reducing yield risk.

H. Introduction of Higher-Value Crops

According to Baumann (2000) small-scale farmers are often reluctant to adopt new technologies and diversify from traditional crops due to the possible risks and costs involved. Through contract farming, firms can provide the support needed for smallholders to shift from subsistence agriculture to market-oriented production (Eaton and Shepherd, 2001; Patrick, 2004). Since agro-business firms possess a vested interest in the production of high-value crops, their contractual arrangements often facilitate the introduction of new production techniques and further measures that serve to upgrade agricultural commodities (Baumann, 2000).

The function of many introduced measures is to increase productivity while preparing crops to achieve the high-quality standards required by international markets. Manarangsan and Suwanjindar (1992) report that farmers in Thailand contracted to grow palm oil, pineapples, and asparagus gained new technical knowledge from training programs financed by the firms and were closely supervised and instructed on crop management.

The aid provided to smallholders by agro-business often includes training and assistance in crop production, soil and water management, bookkeeping of inputs and outputs, and at times even gender awareness training. More recently, firms have introduced traceability systems into contractual arrangements. The value-added benefits of the skills passed on to farmers continue after agreements have expired. Glover (1987) attests that aside from straightforward technology transfer, farmers gain experience of “the system” through contract farming. Farmers can become astute in learning how markets work, how to manage accounts, and run their farm as business.

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