Economics of contracting

1
Economics of contracting

• Based on presentation by
• Dr. Michael Sykuta

2
A Contract is

• A legally enforceable mutual promise to perform
  an act (to do or to refrain from doing something)
  that is not already required by law.
• An institutional structure governing (outlining
  the terms of) a transactionthe rules of the
  game.

3
Every transaction entails a(n)

• Division of Value
• Division of Risk
• Allocation of Decision (Property) Rights
• The 3 are interdependent
• Use Hershey-WalMart deal to illustrate

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Division of Value

• Gains from trade- how do Hershey and WalMart
  share profits?
• Sources of Value
• Price
• Quantity
• Quality and/or Specific Product Traits

5
Division of Risk

• Each value source has its own set of
  uncertainties that create source-specific risk
• Price Uncertainty
• Quantity
• Yield Uncertainty
• Delivery/Performance
• Quality (particularly endogenous traits)
• If it doesnt work out, who loses what?

6
Division of Decision Rights

• Input Decisions
• Management Decisions(field/equipment/services)
• Timing Decisions (planting/harvesting/delivery/pri
  cing)
• Pricing decisions
• Performance decision
• Hershey decides what candy and what price
  WalMart measures performance

7

• Value, Risk and Decision Right allocations are
  interdependent. All affect incentive structures.
• Key PointDecision Rights are valuable in and of
  themselves! The ability to make a choice has
  value.

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The Costs of Transacting

• Transaction costs associated with contracting
• searching out contract partner/contracting info
• negotiating terms of the contract
• performance
• monitoring and enforcement
• Changes in these costs are driving much of the
  push for contracting
• larger scale hog production makes contracting
  worth the trouble

9
Changes in the Value Chain

• Consumers are want dimensions of quality and
  consistency
• Competitive pressures call for greater
  coordination timing in hog plants
• Traditional commodity marketing channels are not
  equipped to do this

10
Search Costs

• Who has what you want or, from the producers
  perspective, who wants what you have to sell?
• high-oil corn
• What kinds of products are out there and how do
  they fit your needs?
• The more specialized your needs, the higher the
  search costs - the more important the trading
  partner.

11
Negotiating Costs

• Often, one side writes the contract and there is
  not much negotiating.
• Designing contracts not easy

12
Monitoring and Enforcement

• How do we verify that were getting what we pay
  for?
• How difficult is it to determine (measurement
  costs)
• How costly is the difference?
• How can we enforce the deal?
• Go to court
• Liquidated damages

13
Measurement and Contracting

• Directly Measure output and reward producers
  based on output quality (e.g., grade and yield)
• Indirectly Measure inputs and control output
  quality by choice of inputs
• Which is more cost-effective? Depends
  pollution control focuses on inputs most ag
  stuff on outputs (exception sprays)

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Changes in measurement costs

• Standard grading scales are often inadequate
• No. 2 yellow corn and No. 1 red wheat dont give
  enough information.
• Imbedded character traits have value
• Those output traits are frequently determined by
  choice of inputs.

15
The bio-tech factor

• Developers of biotechnology want to protect that
  value and recover the costs of development.

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Questions to consider

• What is the value in the transaction and what is
  each partys contribution?
• How does the transaction reflect measurement
  costs?
• What are the sources of risk in the deal?

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Whos bearing the risk?

• Price - primarily still the producer
• Quantity - primarily the buyer
• Quality - primarily the buyer

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Sources of Hidden Value

• The option to default
• The timing option
• particularly delivery schedules (buyers call vs.
  harvest deliveries)

19
Raising Heifers

• Many farmers outsourcing heifers
• Often retired dairy farmers doing it
• What must be in the contract

20
Final Thoughts

• Generally one side wants the contract worse than
  the other
• They must provide some value to get the other
  party to accept
• Sometimes both parties want it badly
• In all contracts the small print is important