Last updated on February 5, 2021
I realized last week that I hadn’t blogged in over two months. And given that I have a new article out which I consider to be among my very best pieces of economics, I thought now would be a good time to dust off this blog.
Before I get into details, the paper is titled “Contract Farming as Partial Insurance.” It is coauthored with two of my former PhD students, Yu Na Lee and Lindsey Novak. Here is the abstract:
A core result of contract theory is that contracts can help transfer risk from one party to another, the latter insuring the former. We test this prediction and explore the mechanism behind it in the context of contract farming, the economic institution wherein a processor contracts the production of a commodity to a grower. Specifically, we look at whether participation in contract farming is associated with lower levels of income variability in a sample of 1,200 households in 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 0.20-standard deviation decrease in income variability. Using mediation analysis to look at the mechanism behind this finding, we find support for the hypothesis that fixed-price contracts—which transfer all price risk from the grower to the processor—explain the reduction in income variability associated with contract farming. Because the assumption that makes our selection-on-observables design possible also satisfies the conditional independence assumption, we estimate propensity score matching and doubly robust weighted regression estimators, the results of which show that our core results are robust and that participation in contract farming would likely be more beneficial for those households that do not participate than for those who do. Our findings thus support the notion that, in a context where formal insurance markets fail, contracts can serve as partial insurance mechanisms.
I said above that this paper is among my very best pieces of economics, and I believe it is so for several reasons.
First, this paper successfully combines two strands in my research agenda: (i) the study of agricultural value chains, and (ii) the study of price volatility.
Second, the paper looks at a classic research question in economics dating back to at least Stiglitz’s (1974) paper on share tenancy, viz. Can bilateral agreements (i.e., contracts) to remedy market failures? In the context of this paper: Do people rely on contract farming arrangements to partially insure against price risk given insurance market failures?
Third, the paper starts from a simple theoretical model to derive testable implications, which it then tests using data. There was a time when empirical papers in development economics clearly stated their theory before discussing any empirics, and that is a throwback to that era of development economics. And one of the things that comes out of the theoretical model is that the mechanism whereby people enter contract farming in order to partially insure is through fixed-price contracts. We use mediation analysis at the end to test that hypothesis, and we find that fixed-price contracts (as opposed to, say, a portfolio balancing approach where income from contracting is negatively correlated with income from other sources) appear to be the only mechanism (statistically speaking, that is) explaining the relationship between participation in contract farming and income volatility.
(Also, and this may well be idiosyncratic, but I have been in love with applied contract theory since I was an undergraduate, and this is my finest piece of applied contract theory.)
Finally, and more importantly for policy, although we find that participation in contract farming is associated with a roughly 16 percent decrease in income volatility on average, the effect would be greater for those who do not participate (about 21 percent) than it is for those who actually participate (about 11 percent).