Evolution of Contract Farming - Market and Institutional Failure

Agriculture sectors in developing countries, in particular those found in transitional economies such as the Lao PDR and Cambodia, are characterized by market failure and institutional failure. Market failure arises from the endemic lack of information on market demand, price, production technology, and credit, all of which stem mainly from low-level infrastructure development. Institutional failure is largely a result of economic transformation from a socialist central control system to a market-driven system. This section reviews the theoretical basis for the emergence of contract farming.

Institutional Failure, Market Failure, and Contract Farming

Institutions are defined as rules of the game in a society or, more formally termed by North, “the humanly devised constraints that shape human interaction” (1990). Institutions affect the performance of the economy by their effect on the costs of exchange and production (North, 1990). According to new institutional economics, institutions evolve to minimize the costs of resource allocation (Williamson, 1979). Williamson (1979) also suggests that different governance structures and contracting forms arise depending on the frequency of transactions, the level of certainty to which transactions are subject, and asset specificity.

Warning and Soo Hoo (2000) emphasize the role of transaction costs and imperfect information in determining the structure of agrarian institutions. Key and Runsten (1999) and Patrick (2004) suggest that contract farming has evolved to ensure the participation of smallholders unable to gain access to spot markets due to market failure in credit, information, factors of production, marketing, and so forth.

Simmons (2002) states that three factors contribute to transaction costs:

• Bounded rationality—differences in information between contracting parties
• Opportunism—either party taking advantage of the other
• Asset specificity—risks associated with protecting “sunk costs” in processing plants, logistical systems, market development or, for smallholders, the cost of protecting investments in specialized machinery and knowledge (Simmons, 2002, citing Dorward, 2001)

As Simmons (2002) writes: “In the absence of these factors, contract farming may not occur since buyers could acquire produce in spot markets that would be instantly and perfectly responsive to their demands.”

In the case of agricultural products with special attributes that are often difficult to measure, contract farming and vertical integration may lead to better control of inputs, resulting in more uniform product attributes and a reduction in the cost of measuring quality, grading, and sorting of the products (Martinez, 2002). To facilitate transactions in environments where spot markets fail to address information and institutional failure, contract farming and vertical integration are increasingly being adopted as a supply chain governance strategy.

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