Agricultural Contracting: Trading Autonomy for
Risk Reduction
Nigel
Key
James
MacDonald
Corbis
Farming is a risky business. Sharp
changes in farm production or farm prices, driven
by the vagaries of weather and disease, sudden shocks
to export markets, or the introduction of new technologies,
can lead to striking changes in a farmer’s
income in a short period of time. Agricultural contracts
can shift such risks from farmers to contractors,
and facilitate farm expansion. For these reasons,
more and more farm output is being produced under
contract. But farmers who contract often give up
something they prize—the autonomy that comes
with making management decisions.
Agricultural contracts are agreements
between farmers and their commodity buyers that
are reached before harvest or the completion of
a livestock production stage. They govern the terms
under which products are transferred from the farm,
and might specify the date of delivery, product
price, and required production practices. Contracts
create closer linkages between farmers and specific
buyers, and may afford the contractor (buyer) greater
control over agricultural production decisions.
The growth in contracting has come
largely at the expense of spot (or cash) markets,
where farmers retain full autonomy and receive prices
based on prevailing market conditions and product
attributes at the time of sale. In the case of hogs,
the risk reduction provided by contracts is valuable
to risk-averse farmers, who seek to avoid widely
fluctuating input and output prices. But hog farmers
also appear to value autonomy highly—ERS research
shows that a moderately risk-averse producer would
need to be paid a price premium of nearly 12 percent
to give up the autonomy of independent production.
Recent Trends in Contracting
While the share of farms that
contract has remained steady, the share of production
under contract has grown. In 2003, only 1 in 10
U.S. farms held a contract—a share that has
remained stable since at least 1991. However, contracts
covered 39 percent of the value of agricultural
production in 2003, up from 11 percent in 1969,
28 percent in 1991, and 36 percent in 2001. Large
farms are far more likely to use contracts. Only
6 percent of small farms (sales under $250,000)
used contracts in 2003, compared with more than
60 percent of very large farms (at least $500,000
in sales). In turn, contracts covered 20 percent
of production from small farms and just over half
of all production from very large farms.
The trends toward contracts and
production on larger farms are parallel: family
farms with at least $500,000 in real sales (2003
dollars, adjusted for inflation) accounted for 45
percent of production by 2003, up from 32 percent
in 1989 (nonfamily farms held another 14 percent,
up from 6 percent in 1989). In the early 1990s,
contracts covered a quarter of crop production and
a third of livestock production; by 2003, they covered
31 percent of crop production and 47 percent of
livestock production (see “Production
and Marketing Contracts Defined”). Almost
all (96 percent) contract crop production is covered
by marketing contracts; production contracts are
common only for crops grown for seed and for some
vegetable and flower production. By contrast, production
contracts covered 71 percent of contract livestock
production, where absentee contractors can exercise
much more effective control over genetics and production
decisions.
Contracts offer several advantages to food buyers.
First, they can be used to ensure uniformity in
commodity attributes, stabilize production volumes,
and induce the spread of improved varieties, leading
to reduced production and processing costs and lower
consumer prices. Second, because contracts are frequently
used to coordinate the production of differentiated
products (such as high-oil corn, branded lean beef,
or organic produce), they can expand the variety
of food and agricultural products.
Contracts can have subtle and far-reaching impacts
on farmers and the organization of farming. Here,
we focus on the effects of contracting on a farmer’s
income risk, and the associated impacts on farm
structure and farmer autonomy.
Production
and Marketing Contracts Defined
ERS analyses distinguish production contracts
from marketing contracts. Under a production
contract, the farmer provides services to
the contractor, who usually owns the commodity
under production. For example, contractors
in poultry production usually provide chicks
to the farmer, along with feed and veterinary/transportation
services. The farmer then raises the chicks
to maturity, whereupon the contractor transfers
them to processing plants. Contractors often
provide detailed production guidelines,
and farmers retain far less control over
production decisions. The farmer’s
payment resembles a fee paid for the specific
services provided, instead of a payment
based on the market value of the product.
Marketing contracts focus on the commodity
as it is delivered to the contractor, rather
than the services provided by the farmer.
They specify a price or a mechanism for
determining the commodity’s price,
a delivery outlet, and a quantity to be
delivered. The pricing mechanisms sometimes
limit a farmer’s exposure to price
risks, and they often specify price premiums
to be paid for commodities with desired
levels of specified attributes (such as
oil content in corn, or leanness in hogs).
The farmer retains control over major management
decisions and hence retains more autonomy
than is available under production contracts.
A forward marketing contract, frequently
used in grain and livestock production,
typically establishes a base price before
harvest and provides for delivery of a given
quantity of a good within a specified time.
A futures contract is an agreement to trade
a commodity with specified attributes at
a specified time. Futures are distinguished
from generic forward contracts in that they
contain standardized terms, trade on a formal
exchange, and are regulated by overseeing
agencies.
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Income Risks in Agricultural
Production
Income from farming is risky.
Price risks arise from unanticipated changes in
output or input prices, while yield (production)
risks result from unpredictable events (like drought,
flood, pest infestations, or disease) that affect
the quantity of production.
The hog market provides a striking example of price
risks, as embodied in average prices for finished
hogs (the value of production per hundredweight
(cwt)), total costs, and net returns for a typical
independent feeder-to-finish producer from 1993
to 2003. Feeder hogs usually weigh about 50 pounds,
while finished hogs usually weigh about 250 pounds.
Prices for finished hogs ranged from over $65/cwt
to less than $17/cwt (in 1998 dollars) from 1993
to 2003, and usually varied by $10-15 during any
given year. Costs, largely driven by fluctuations
in feed and feeder pig prices, ranged from $30/cwt
to $55/cwt, and fluctuated widely during any single
year. Consequently, net returns varied widely over
1993-2003: farmers who added 200 pounds per hog
earned up to $32 per hog, but also could have lost
as much as $35. With most production now on farms
marketing more than 5,000 hogs a year, these fluctuations
imply substantial income risk.
Risk can reduce farm production and efficiency and
lower farm household income. Years with low returns
(such as 1998-99) can lead to farm business failure
and to financial stress for households without income
from other farm enterprises or off-farm work. Banks
may be reluctant to advance credit to businesses
in extremely risky markets, or during downturns.
Greater price risks require farmers to devote more
time and effort to marketing decisions that could
otherwise be devoted to farm production or family.
Farm operator households can limit their exposure
to risks by altering production techniques, diversifying
the farming operation, combining on-farm and off-farm
work, or by using contracts that shift risks to
buyers.
Contracts Can Reduce
Farmers’ Risks
Since contract fees are usually
not tied to market prices, production contracts
can eliminate most or all of the output price risk
facing farmers. Production contracts can also largely
eliminate input price risks, because contractors
provide the inputs that comprise most of the operating
expenses. In 2003, contractors provided inputs representing
over 80 percent of operating expenses under broiler
production contracts, and over 70 percent of operating
expenses under hog production contracts. Contracts
could also eliminate production risk; however, most
hog and poultry production contracts retain some
production risk because they typically adjust base
payments to reflect feed efficiency and death losses.
Empirical analyses confirm that hog and poultry
production contracts can greatly reduce risk. Some
studies compared actual contract and independent
production, while others compared contract production
with simulated independent producers using the same
technology but facing price fluctuations for inputs
and outputs. The studies found that price risk caused
most of the income risk, that contracts can reduce
90 percent or more of price risk, and that some
contracts can substantially reduce yield risk.
Marketing contracts can also greatly reduce a farmer’s
output price risks. Forward marketing contracts,
frequently used in grain and livestock production,
establish a base price before harvest and commit
the farmer to delivery of a given quantity within
a specified time. Forward contracts can set an exact
price, or they can set a “basis” price,
tying a contract price to a price in the futures
market, plus or minus a specified amount (the basis).
Farmers can then offset the price fluctuations in
the contracted crop by hedging with the purchase
of a futures contract, thus eliminating price risks.
Marketing contracts can also mitigate risks from
input prices and yields. Product payments can be
based in part on input prices. Some crop contracts
commit farmers to deliver the production from a
particular acreage rather than an outright quantity.
Under such acreage contracts, the producer still
obtains revenue only from the amount delivered,
but does not have to make up production shortfalls
by buying in the cash market to fulfill contract
terms.
Contracts, Risk, and
Farm Structure
Contract producers in any given
commodity tend to be much larger than independent
producers. Recent research suggests that contracts
can facilitate farm expansion, partly through risk
reduction.
By reducing price risks, production and marketing
contracts can make it easier for farmers to obtain
credit and thus expand operations. Banks lend more
to contract producers than to independent producers,
even when producers have the same amount of financial
wealth. Because contract producers can call on greater
financial resources, they can generate significantly
more production than independent producers who have
similar levels of wealth. For example, among the
least wealthy farmers, contract producers are able
to obtain $1.60 in loans for every $1.00 in wealth,
while independent producers from the same wealth
group borrow $0.40. Production contracts almost
eliminate the need for short-term credit to finance
operating expenses, thereby allowing the farm to
redirect some borrowing to other farm activities.
Since very large farms tend to be operated by households
that derive most of their income from farming, contracts
also serve to reduce household income risks from
operating at such a large scale. As a result, expanding
use of contracts may be one factor driving the shift
of production to larger farms.
Since risk reduction benefits farmers, we would
expect them to pay something for it; that is, we
would expect them to accept contracts offering lower
returns than they could expect from independent
production. However, our research shows that contract
production (lower risk) frequently yields higher
returns than independent production (greater risk),
even when contract and independent operations produce
very similar products. At first glance, this suggests
either that farmers do not value risk reduction
or that contract operations produce output of superior
quality. A more plausible explanation is that contracts
force farmers to give up their highly prized autonomy—and
farmers must be paid to do that.
Autonomy Matters to
Farmers
Farmers may derive satisfaction
from noncontract production because it offers independence,
a sense of responsibility, and pride from self-determination
in farm management. Farmers who value such independence
would need to be compensated by contractors in order
to give up the satisfaction from independent production.
ERS recently investigated the tradeoff that hog
farmers make between risk reduction offered by contracts
and loss of autonomy. The evidence suggests that
farmers place great value on both autonomy and risk
reduction. A risk-averse farmer is willing to accept
a lower average income in exchange for less income
variability. Comparing the variation in net returns
under independent and contract hog production, we
estimate that the risk reduction offered through
a typical production contract was worth about $2.61/cwt
to a moderately risk-averse farmer, or 4.9 percent
of the average price for market hogs during the
1990s.
To estimate the value farmers place on autonomy,
we used USDA’s Agricultural Resource Management
Survey of hog producers to estimate the difference
in net returns between contract and independent
production. If risk reduction was the only factor
influencing farmers, we would expect contractors
to offer lower prices to contract producers, and
contract producers would realize lower returns from
hog production than independents. But instead, our
estimates indicate that for moderately risk-averse
farmers, the expected return from contract production
exceeded the expected return under independent production
by $3.68/cwt. Since we might expect hog farmers
to willingly give up $2.61/cwt for the risk reduction
provided by a contract, and we find that they instead
receive a premium of $3.68/cwt to accept a contract,
the difference between the two estimates ($6.29
per cwt) reflects the value of autonomy.
Estimated
risk and autonomy premia by degree of risk
aversion for hog farmers |
|
Risk
premium |
Autonomy
premium |
Degree
of risk aversion |
Dollars/cwt |
Percent
of average price |
Dollars/cwt |
Percent
of average price |
Risk-neutral |
0.00
|
0.0 |
3.68
|
6.8 |
Moderately
risk-averse |
2.61
|
4.9 |
6.29 |
11.7 |
Strongly
risk-averse |
5.22
|
9.7 |
8.90 |
16.6 |
Notes: The average price for
1988-1997 was $53.75 per hundredweight (cwt)
gain in 1998 dollars. The risk premium is
the value that a farmer would be willing to
pay for the risk reduction provided by a contract.
The autonomy premium is the value that a farmer
would have to be paid to give up independence
in decisionmaking. |
Farmers are not unique in valuing
autonomy highly; other studies have demonstrated
individuals’ willingness to pay for the opportunity
to be self-employed and make management decisions.
For example, a recent study of nonagricultural employment
found that individuals were willing to give up about
35 percent of their income in order to be self-employed
rather than to be paid employees.
Looking Ahead
Farm production is shifting from
smaller to larger family farms and from spot markets
to contracts. Technological developments may underlie
much of the shift to larger farms, but expanded
use of production and marketing contracts supports
that shift by reducing financial risks for farm
operators. For farm operators, contracts provide
benefits from reduced risks, but also impose costs
from loss of managerial control and reduced autonomy.
However, the gains to contractors
from contract production have been substantial enough
to support the additional compensation that must
be offered to farmers to surrender some of their
autonomy under contracts. With substantial gains
to contractors, continued expansion of contracting
is likely, with its associated implications for
farm size and for farm operator risks and returns.
In some commodities, that expansion may build on
itself and accelerate: as spot markets in some commodities
become quite thin, even producers who would prefer
to farm independently and use spot markets may seek
contract alternatives. In turn, USDA price reporting
systems, traditionally based on spot market transactions,
may need reconfiguring to deal with markets in which
most transactions occur through contracts.
Agricultural Contracting
Update: Contracts in 2003, by James MacDonald
and Penni Korb, EIB-9, USDA, Economic Research Service,
January 2006
"How Much Do Farmers Value Their Independence?”
by Nigel Key, Agricultural Economics 33(2005):
117-126
Contracts, Markets,
and Prices: Organizing the Production and Use of
Agricultural Commodities, by James MacDonald
et al., AER-837, USDA, Economic Research Service,
November 2004
"Agricultural Contracting and the Scale of
Production,” by Nigel Key, Agricultural
and Resource Economics Review, Vol. 33, No.
2 (October 2004), pp. 255-271
Did
the Mandatory Requirement Aid the Market? Impact
of the Livestock Mandatory Reporting Act, by
Janet Perry, James MacDonald, Ken Nelson, William
Hahn, Carlos Arnade, and Gerald Plato, LDP-M-135-01,
USDA, Economic Research Service, September 2005
"Losing
Under Contract: Transaction-Cost Externalities and
Spot Market Disintegration," by Michael
J. Roberts and Nigel Key, Journal of Agricultural
& Food Industrial Organization, Vol. 3, No.
2, Article 2, 2005
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