Contract Farming as Partial Insurance

That is the title of a new working paper of mine coauthored with my former doctoral students Yu Na Lee (University of Guelph Food, Agricultural & Resource Economics) and Lindsey Novak (who is joining the Department of Economics at Colby College in a few weeks). Here is the abstract:

The institution of contract farming, wherein a processing firm contracts out the production of an agricultural commodity to a grower household, has received much attention in recent years. We look at whether participation in contract farming is associated with lower levels of income variability for a sample of 1,200 households in rural Madagascar. Relying on a framed field experiment aimed at eliciting respondent marginal utility of participation in contract farming for identification in a selection-on-observables design, we find that participation in contract farming is associated with a 0.2-standard deviation decrease in income variability. Looking at the mechanism behind this finding, we find strong support for the hypothesis that fixed-price contracts explain the reduction in income variability associated with contract farming. Then, because the same assumption that makes the selection-on-observables design possible also satisfies the conditional independence assumption, we estimate propensity score matching models, the results of which show that our core results are robust and that participation in contract farming would have greater beneficial effects for those households that do not participate than for those who do, i.e., the magnitude of the average treatment effect on the untreated exceeds that of the average treatment effect on the treated. Our findings thus show that participation in contract farming can help rural households partially insure against income risk via contracts that transfer price risk from growers to processors.

For me, writing this paper was a way of marrying two of my long-standing research interests, viz. contract farming (see Bellemare, 2010; Barrett et al., 2012; Bellemare, 2012; Bellemare, 2015; Bellemare and Novak, 2017, and Bellemare, 2017) and price risk (see Bellemare et al., 2013; Bellemare, 2015; Bellemare et al., 2016; Bellemare and Lee, 2016; and a soon-to-be-(re)released working paper with Yu Na Lee and David Just).

What I find fascinating is that, having found that (i) participation in contract farming is associated with higher incomes (Bellemare, 2012), we now find that (ii) participation in contract farming is also associated with more stable incomes. I can’t think of many assets, propositions, of what have you which offer both a higher expected return and a lower variance!

I also like the fact that we show how contracts can be used to help resolve market failures in developing countries. This is something which, as far as I can tell, dates back in theory to Stiglitz’s (1974) article on sharecropping, in which he showed how sharecropping contracts can serve to partially insure tenants against production risk. Here, contract farming helps partially resolve insurance market failures by transferring price risk from the agents to the principal, and it does so via fixed price contracts. We formally test this using Acharya et al.’s (2016) method to test for mechanisms, and we find that the presence of fixed price contracts in the data appears to be the only mechanism whereby contract farming offers partial insurance.

Every time I finish writing an article on contract farming, I always think this is the last I’ll have to say on the topic. And yet, the topic keeps pulling me back in. It’s the gift that keeps on giving. Maybe I should buckle down and write a book on the topic.

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