Contract Farming, Smallholders, and Rural Development in Latin America: The Organization of Agroprocessing Firms and the Scale of Outgrower Production

World Development Vol. 27, No. 2, pp. 381±401, 1999 Ó 1999 Elsevier Science Ltd All rights reserved. Printed in Great Britain 0305-750X/99 $ ± see front matter

PII: S0305-750X(98)00144-2

Contract Farming, Smallholders, and Rural Development in Latin America: The Organization of Agroprocessing Firms and the Scale of Outgrower Production NIGEL KEY and DAVID RUNSTEN * Stanford University, Stanford, CA, USA Summary. Ð This paper demonstrates how contract farming functions as an economic

institution and explores the causes of the observed variation in the scale of outgrower production in Latin America. We outline how market imperfections and transaction costs in¯uence the decision of agroprocessing ®rms to contract-out, vertically integrate, or use spot markets to obtain raw product. The paper demonstrates how market conditions are likely to be associated with particular outgrower characteristics under contract farming. An analysis of the Mexican frozen vegetable industry illustrates determinants of successful and unsuccessful small-scale contracting and suggests alternative policies to promote contract farming with smallholders. Ó 1999 Elsevier Science Ltd. All rights reserved.

1. INTRODUCTION Contract farming has been discussed as having the potential to incorporate low-income growers into the modern sector. It has been argued that agroindustrial ®rms can provide via contracts the credit, inputs, information, and services smallholders need to cultivate and market lucrative nontraditional crops (Morrissy, 1974; Glover, 1984; Goldsmith, 1985; Williams and Karen, 1985). In addition to raising the incomes of growers, contract farming may also create positive multiplier e€ects for employment, infrastructure, and market development in the local economy. The potential bene®ts of contract farming are being given renewed attention in the wake of economic reforms that have reduced public expenditures for credit programs, staple crop price supports, input subsidies, and government research and extension programs (Dirven, 1996; Schejtman, 1996). While contract farming promises signi®cant bene®ts for growers in many cases, recent studies have highlighted circumstances in which members of the rural population have realized only limited gains, or have been directly or indirectly harmed by contract farming (e.g.,

Glover and Kusterer, 1990; Little and Watts, 1994). In the African context, contract farming has been observed to disrupt power relations and increase tensions within farm households ± especially between male head-of-households and their wives and children (Carney and Watts, 1990). Contract farming has also been critiqued as being a tool for agroindustrial ®rms to exploit an unequal power relationship with growers. While farmers usually enter into contracts voluntarily, they may, over time, invest ®xed resources into production or alter their cropping patterns so as to become overly dependent on their contract crops. When this is the case, growers face limited exit options and  reduced bargaining power vis-a-vis the ®rm, which may force them to accept less favorable

*

This paper results in part from research commissioned by the Economic Commission on Latin America, see Runsten and Key, 1996. Fieldwork in Mexico was funded by the Ford Foundation, the Kellogg Foundation, and the Center for US-Mexican Studies at the University of California, San Diego. Final revision accepted: September 14, 1998.

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or ``exploitative'' contract terms. Overreliance on cash crops can also make households more vulnerable to food shortages and price ¯uctuations. At a macroeconomic level, collusion between the state and powerful agroindustrial ®rms may skew policies and state resources away from, or against, the best interests of the peasant class (Watts, 1994). An assessment of the impact of contract farming on rural development must weigh social and economic tradeo€s at the household, regional, and national levels. In many environments, the impact of contract farming on rural development depends importantly on the types of growers with whom the agroprocessing ®rms contract. If ®rms choose to contract primarily with large-scale commercial farms, then poorer members of the rural population fail to bene®t directly from contract arrangements. In the context of liberalized land markets, contract farming that excludes smallholders can lead to more concentrated land ownership and displacement of the rural poor. The way contracts Ð and the income earned from contracting Ð is distributed within a rural community can have important implications for economic and social di€erentiation within that community (Korovkin, 1992). These issues are particularly important in Latin America where a heterogeneous rural population characterized by an unequal distribution of income, productive assets, and human capital presents a varied portfolio of potential growers from which ®rms can choose their clientele. Recent experiences in Latin America have been mixed regarding the extent to which agroindustrial ®rms have incorporated smallholders into the production process. Despite the highly labor-intensive nature of most processed crops, many ®rms shun smallholders, preferring to contract with larger capitalized growers (Runsten and Key, 1996). Often, these large-scale contract farmers hire-in seasonal laborers who are themselves smallholders. Although most ®rms appear to favor contracting with larger growers, there have been several examples of agroindustrial ®rms contracting simultaneously with both large and small landholders (Bivings and Runsten, 1992). There are also examples of ®rms contracting exclusively with smallholders, and some have even found it pro®table to contract with microfundistas who cultivate cash crops on plots of less than one hectare (Von Braun, Hotchkiss and Immink, 1989; Glover and Kusterer, 1990).

This paper explores the causes of the observed variations in the scale of outgrower production and the success of smallholder contract farming. We begin by discussing how contract farming functions as an economic institution, cataloging the incentives of ®rms to contract out, vertically integrate their production, or use spot markets. We examine how various market imperfections and transaction costs tend to favor outgrowers with certain characteristics. We then relate the grower characteristics favored by the ®rms (e.g., having access to family labor, or being highly risk averse) to the characteristics associated with either small or large-scale growers, thereby identifying the factors which will tend to encourage or discourage contracting with smallholders. In this paper, the scale of outgrower production in contract farming is treated as an outcome of economic decisions made by both ®rms and farmers. Firms decide their organizational strategy Ð whether to contract farm, vertically integrate production into a plantation style operation, or to purchase product on the spot market Ð so as to maximize pro®ts. The ®rm's decision to contract depends strongly on the terms and conditions of the contract that it is able to negotiate with growers. These terms and conditions also determine the characteristics of the growers who accept the contract. Hence, the ®rm's decision to contract (versus vertically integrate or use spot markets) and outgrower characteristics (e.g., scale of production) are linked, and both are in¯uenced by many of the same factors. An understanding of what causes ®rms to choose contract farming over other organizational strategies and an appreciation of agroprocessors' incentives for contracting with smallholders are important in designing policies to in¯uence the outcome of contract farming schemes. In the next section, we describe the factors that motivate both ®rms and growers to enter into contracts. Contract farming is explained as an institutional response to imperfections in markets for credit, insurance, information, factors of production, and raw product; and in transaction costs associated with search, screening, transfer of goods, bargaining and enforcement. Throughout the paper, we use examples from Mexico to substantiate our analysis. In Section 3, we discuss the case of frozen vegetable contract farming in Mexico's Bajõo region to illustrate how the forces impacting the scale of produc-

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA

tion can interact in practice. We discuss some of the most important factors favoring large and small growers in the frozen vegetable market. We then examine the case of Frigorizados La Huerta, outlining how this ®rm has been able to pro®tably contract with smallholders. In the ®nal section, we draw on both the theoretical discussion and case study to inform our conclusions about how policy interventions can be used to encourage ®rms to contract with poor farmers. 2. CONTRACT FARMING AS A RESPONSE TO MARKET IMPERFECTIONS Firms can use a variety of institutional arrangements to obtain a supply of raw product for processing or marketing. These arrangements vary by the extent to which the successive stages of input supply and production are combined under the ownership or control of the ®rm. At one extreme, non-integrated food processors rely completely on spot markets for their crop supply. For reasons we discuss later, nonintegrated ®rms tend to be concentrated in industries that process staple crops Ð examples include producers of maize tortilla ¯our or balanced animal feeds. At the other extreme, fully integrated plantation-style operations completely manage production and hire in labor to cultivate on land controlled by the ®rm. Banana plantations in Central and South America are typical examples of large, vertically integrated ®rms. Contract farming is an intermediate institutional arrangement that allows ®rms to participate in, and exert control over, the production process without owning or operating the farms. Firms can choose to contract for di€erent reasons, and their motivations will be re¯ected in the type of contracts they choose. The contracts we discuss in this paper fall into three, not mutually exclusive, categories: marketspeci®cation, resource-providing, and production management (Minot, 1986). Market speci®cation contracts are pre-harvest agreements that bind the ®rm and grower to a particular set of conditions governing the sale of the crop. These conditions often specify price, quality, and timing. Resource-providing contracts oblige the processor to supply crop inputs, extension, or credit, in exchange for a marketing agreement. Production management contracts bind the farmer to follow a particular production method or input regimen, usually in ex-

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change for a marketing agreement or resource provision. In this section, we analyze contract farming from a new institutional economics perspective, drawing on a body of literature which views the formation of institutions as a response to missing markets in an environment of pervasive risks, incomplete markets, and information asymmetry (e.g., Bardhan, 1989). The unifying principle of this school of thought is that there are important costs not just in production, but also Ð due to imperfect markets and information costs Ð in transactions. This work has demonstrated how observed class structures, labor and tenancy relations, and agrarian institutions can be the outcomes of rational economic behavior in the context of missing or imperfect markets. Here we consider how the organizational structure of agroprocessing ®rms and the characteristics of contract farmers may be in¯uenced by imperfections in the markets for credit, insurance, information, factors of production, and the raw product, and by transaction costs associated with agricultural contracts. (a) Credit Access to credit and the structure of the credit market are important in the context of contract farming because the nontraditional crops purchased by agroindustrial processors are generally much more costly to produce per hectare than traditional crops, and most growers require credit to ®nance their production. While traditional crops can usually be cultivated using a level of input intensity appropriate to the ®nancial resources of a household, cash crops often require a strict and intensive input regimen and necessitate large labor inputs for harvest and planting that cannot be met with family labor alone. Table 1 displays the costs of producing traditional and nontraditional crops in Mexico in 1993. Average per-hectare out-of-pocket expenses were US$258 per hectare for the traditional rainfed maize, whereas average out-of-pocket expenses for the cash crops listed range from US$661 per hectare for sugar to US$10,379 per hectare for strawberries ± more than the annual incomes of most campesinos1. Agroindustrials are well suited to act as lenders to growers. In fact, agroindustrials often have a superior ability to monitor and enforce credit contracts and have lower default costs than do banks. Unlike banks, agropro-

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Table 1. Costs and returns per hectare for selected traditional and nontraditional crops in Mexican ejidos, 1992± 93(US$) a Non-traditional

Traditional

Fertilizer Pesticides Seed or seedling Machinery Other costs Labor Hired labor Expenses (1) Expenses (2) Expenses (3) Revenue Return

Maize (rainfed)

Maize (irrig.)

Rice

Bean

Sugar

Tobacco

Broccoli

Tomato

Strawberry

79 45 65 55 0 109 13 244 258 353 931 673

89 148 90 55 170 219 22 552 600 771 1287 687

20 62 116 177 81 190 13 456 481 646 1150 669

67 52 133 137 60 352 17 449 509 801 1467 958

210 94 59 88 26 368 50 477 661 845 1867 1206

265 420 201 401 204 465 85 1491 1886 1956 2936 1050

246 234 286 574 137 619 66 1477 1886 2096 2676 790

133 202 94 663 811 1109 29 1903 2225 3012 6193 3968

241 263 2333 651 2194 5219 90 5682 10379 10901 18667 8288

Variable de®nitions. other costs: include use of water, electricity, assorted materials, miscellaneous costs; hired labor: average share of total labor hired by household; expenses (1): all purchased inputs (excluding land, labor, credit and insurance); expenses (2): expenses (1) plus hired labor (not including family labor); expenses (3): expenses (2) plus family labor valued at market wage; revenue: total expected revenue; return: return to land, family labor and capital (revenue - expenses (2)). a Crop production costs refer to the following state, geographic zone, season, and technology:rainfed maize: Michoacan, Tierra Caliente, spring-summer, rainfed;irrigated maize: Michoacan, Tierra Caliente, spring-summer, irrigated; rice: Nayarit, Santiago, spring-summer, irrigated;bean: Michoacan, Bajõo, fall-winter, irrigated;sugar: Michoacan, Meseta, perennial, irrigated;tobacco: Nayarit, Santiago, fall-winter, irrigated;broccoli: Guanajuato, region 1,2,3, fall-winter, irrigated;tomato (red): Guanajuato, region 1,2,3, spring-summer, irrigated;strawberry: Guanajuato, region 3, semi-perennial, irrigated.

cessors can extract a grower's debt directly from the crop revenue before the grower receives his payment. Because alternative markets for the product are often very thin, growers will often be forced to sell their crop to the ®rm. In addition, defaulting on a loan from a ®rm means that not only will the delinquent borrower sacri®ce future credit, he will also likely sacri®ce future business with the ®rm. Moreover, the processor can be assured that the credit will be spent on production because the loans are usually distributed in kind or in the form of vouchers, and the ®rm often monitors the use of inputs. The relationship between the ®rm and grower can also reduce other lender and borrower transaction costs, which may represent a signi®cant portion of the total cost of the loan (Adams and Nehman, 1979). The credit contract can be transacted at the same time as the farming contract and does not require any trips to a bank Ð administrative costs are minimized for the ®rm and time and transportation costs are minimized for the borrower. In addition, collateral requirements are eliminated or reduced for the reasons discussed above, so the

borrower can avoid notary and other collateral titling fees. Low monitoring, enforcement, and other transaction costs often place agroindustrial ®rms in a position to compete with formal and informal lenders. The ®rms can earn, via resource-providing contracts, the premium farmers are willing to pay for credit. Equivalently, ®rms can obtain raw agricultural product at below-market prices, in exchange for credit. Hence, credit market transaction costs present an incentive for ®rms to contract rather than use spot markets. If an inecient credit market causes high credit costs that are re¯ected in the spot market price of the good, the ®rm also has an incentive to vertically integrate production and ®nance its own production, rather than use spot markets. Firms can earn the highest returns to their ®nancial services from those growers willing to pay the most for credit. A strong argument can be made that those willing to pay the most for credit will be smallholders. Poorer producers generally are less able to self-®nance, are more likely to be restricted in their access to formal loans by their inability to satisfy lender collat-

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA

eral requirements, and consequently will be more likely to resort to the expensive informal sector2. To the extent that smaller, poorer farmers are willing to pay more for credit, ®rms will have an incentive to contract with them. On the other hand, as we will discuss below, risk of default and transaction costs associated with providing credit will mitigate the bene®ts of contracting with smaller growers. Moreover, if lending is not pro®table for the ®rm (due to competition from subsidized government credit programs, government regulations on lending, or excessive lender transaction costs) then the ®rm will contract only with producers able to ®nd their own sources of ®nance. This will tend to favor larger growers to the extent that they have better access to ®nancial resources. (b) Insurance The market for insurance is also important in the context of contract farming because the nontraditional crops purchased by agroindustrial contractors tend to be signi®cantly riskier than traditional crops. The higher costs associated with nontraditional crops impose a greater income risk on producers, even when these crops have the same, or somewhat less, variability in pro®ts as traditional crops. In fact, nontraditional crops grown in developing countries tend to have more variable pro®ts because they have both more variable yields and more variable prices3. Yields are more variable because nontraditional crops are more susceptible to pest and climatological hazards. Nontraditional crops tend to be genetic hybrids, with seeds often developed to resist the pest and weather stresses speci®c to the places they are developed, rather than the local environment4. Prices tend to be more variable for nontraditional crops because: the higher variability in nontraditional crop yields increases the variability of market supply; many markets for such crops are thin, exaggerating the price e€ects of supply change; governments do not regulate the price of non traditional crops (unlike some traditional staples); nontraditional crops have a less-developed market infrastructure, meaning that surplus production in one region of the country can less easily compensate for de®cit production in another region, leading to greater regional price swings; and nontraditional crops are often perishable, restricting the ability of producers to store these crops to cope with price ¯uctuations.

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Frequently in developing countries, and especially for lower income producers, formal institutional strategies for smoothing consumption Ð crop insurance, formal credit markets, or commodity futures markets Ð are unavailable or have high associated transaction costs5. In addition, the informal methods of coping with risk that are available to low-income farmers are often costly and inecient. For example, informal credit is usually much more expensive than formal credit, making it prohibitively expensive for most insurance purposes. Households facing high borrowing costs or constrained in their ability to borrow may attempt to smooth consumption through the accumulation and depletion of productive assets, which can increase costs and detrimentally a€ect productive eciency (Rosenzweig and Wolpin, 1993). Similarly, liquidity-constrained households may choose ``risk management'' strategies to lower the variability of household income such as choosing crops with a lower yield or price variability, diversifying crops (increasing the number of varieties), scattering plots, seeking o€-farm employment, migrating, and sharecropping. These strategies can have costly negative e€ects on productive eciency (Alderman and Paxson, 1994; Morduch, 1994; Walker and Jodha, 1986). Contracting ®rms are often in a position to insure growers against price and yield ¯uctuations because: they are able to diversify their production sources geographically so that covariant ¯uctuations in yields caused by weather, pest infestations, ¯ooding, livestock invasions, etc. ``cancel'' each other; they have access to inexpensive ®nancial resources with which to smooth ¯uctuations in pro®ts; and their participation in the production process allows them to provide insurance with low transaction costs and to avoid some of the moral hazard problems associated with crop insurance. Agroindustrial ®rms that insure producers against price risk can earn the premium that risk averse farmers are willing to pay to reduce their risk6. The ®rm can earn this risk premium by o€ering the grower a forward contract. Risk-averse farmers are willing to accept a guaranteed future price for their crops that is lower on average than what they would have received on the open market. By providing forward contracts to producers, i.e. by setting prices in advance of planting, ®rms can eliminate growers' price risk7. To an extent, ®rms can also insure producers against yield risk by

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using contingent claim contracts that forgive (at least some) debt in case of crop failure. By providing insurance via contracts, ®rms can obtain products at prices below the average spot market price. Hence, imperfect insurance markets provide an incentive for the ®rm to contract or vertically integrate rather than use spot markets. From the discussion in this section it can be argued that ®rms will ®nd it more pro®table to contract with those farmers willing to pay more for insurance. More risk-averse producers will accept more favorable contract terms (from the ®rm's perspective) in exchange for insurance. Risk aversion, or the willingness to pay to reduce income risk, is generally held to be negatively correlated with income. Fluctuations in income for poor peasant farmers can have severe e€ects on welfare and can lead to a loss of assets including livestock and land (Hazell et al., 1986). Since risk aversion is negatively correlated with income, and since poorer producers are generally less able to utilize ecient means of coping with risk, there is an incentive for ®rms to contract with lower-income producers. As we discussed above, the ®rm can insure growers against price risk via a forward contract, and against production risk via a contingent claim contract. Firms can relatively easily and costlessly eliminate price risk for growers. On the other hand, contracts that protect growers against production risk expose the ®rm to moral hazard, and require that the ®rm monitor grower behavior. Firms can reduce moral hazard and monitoring costs by requiring the grower to bear a signi®cant share of the production risk. Larger, wealthier growers are better able to bear risk. Consequently, when yield risk is important and producers must bear a share of this risk, ®rms will have an incentive to contract with larger growers. (c) Information (i) Production information±technology, timing, and quality Ecient production requires that growers have information about the optimal cultivation techniques Ð when and how to apply chemicals, when to water, weed, rotate crops, etc. Ecient production also requires that growers have information about the needs of the ®rm ± when it requires a supply of raw product; what chemicals are permitted in the production

process to meet export standards; and what are its desired crop characteristics, such as texture, shape, ¯avor, color, variety, etc. Missing markets for information can slow adjustments on the part of growers and result in costly crop supply and quality shortfalls for ®rms that rely on spot markets for their product supply. Product and factor markets transfer information about supply and demand via prices, but prices may not eciently transfer complex and rapidly changing information. Firms may require a precisely timed supply of crops, or have complex quality needs that cannot be eciently communicated via product and factor markets. While ®rms may have access to the latest production technology, growers may be reluctant or unable to adopt these innovations, raising the product price for ®rms. Firms can cope with missing markets for information, and eciently communicate product and technology information to growers, by either internalizing the production process or by employing production management contracts. Frequently, when production is information intensive and growers lack the resources to acquire the information themselves, contracts will specify the use of ®rm-employed extension agents who both communicate the ®rm's needs and monitor the behavior of growers. Under certain conditions, missing markets for information can cause product markets to break down completely (Akerlof, 1970). This situation can occur when there is asymmetric information between the buyer and seller regarding the quality of product. An important example for contract farming results from the regulation of pesticides on fruits and vegetables exported to a country with stringent pesticide regulations, such as the United States. While it is possible for exporting ®rms to test and detect the level and types of chemical pesticides used in production, it is usually prohibitively costly to do so. At the same time, it is often pro®table for growers to overapply or misuse pesticides in production. When it is too expensive for processors to detect pesticides, and growers have an incentive to violate pesticide regulations, the market fails. Firms can overcome this market failure and assure product quality by producing the crop themselves or by employing production management contracts that allow the ®rm to monitor production8. While there is no clear implication for optimal scale due to missing markets for informa-

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA

tion about the production process, case studies demonstrate that larger producers are generally better educated and better informed about the latest production technologies, pesticide regulations, consumer quality preferences, etc. (Bivings and Runsten, 1992). Larger producers have an advantage over smaller producers in that ®xed cost associated with acquiring information can be subtracted from a larger revenue base. To the extent that ®rms rely on producers themselves to acquire production information about the production process, larger producers will have an advantage over smaller ones. Moreover, because smallholders are less able to bear the risk of crop loss, they may be more likely to overapply pesticides in an attempt to minimize pest damage. If smallholders are more likely to violate pesticide regulations, they will be less desirable growers from the ®rm's perspective.

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labor, will be relatively less ecient than cultivation by self-supervised farmers, ceteris paribus. A processor can take advantage of the selfsupervising characteristic of family operated farms by purchasing the product on the market or by contract farming. Just as plantation-style operations have a labor cost disadvantage compared to family farms that use self-supervised family labor, larger producers who hire in labor incur supervision costs (and labor search costs) that place them at a disadvantage relative to smallscale, self-supervised producers. Hence, in terms of labor supervision, the optimal scale of outgrower production will be determined by the amount of land that can be cultivated by family labor. (d) Factors of production

(ii) Work e€ort and labor supervision

(i) Specialized inputs Ð machinery, chemical, or genetic inputs

The cost of labor supervision is a fundamental determinant of the ®rm's organizational strategy and has been used to explain agricultural land tenancy contracts (Eswaran and Kotwal, 1985), agricultural labor contracts (Vandeman et al., 1991), and crop contracts (Androkovich, 1989). Models of labor supervision assume that hired workers o€er an amount of e€ort that is a function of the amount of supervision applied. E€ort is de®ned as a measure of the quality of labor Ð how hard or carefully work is performed. Hourly wage labor must be supervised if workers have an incentive to shirk and if it is impossible to perfectly observe individual labor e€ort levels ex post. That is, without supervision it is impossible to know exactly the level of e€ort applied by a laborer working alone or in a team due to stochastic or unobservable determination of labor output. More supervision is required when the incentive to shirk is greater, or when the quality of work is more important Ð for example, when the work is particularly unpleasant, or when low e€ort can damage crops or machinery. Household labor used on family farms or labor paid on a piece-rate basis does not require supervision because these workers are residual claimants on their labor, receiving the total product of their labor rather than a ®xed wage. Hence, in situations where piece-rate labor is not practical, plantation-style agriculture, which relies on supervision to motivate wage

Often the markets for the inputs or services needed in the production of non-traditional crops are thin or missing. This is particularly common in developing countries, where specialized planting, spraying and harvesting machinery, certain seeds, fertilizers, or pesticides, and sophisticated irrigation and soil-monitoring equipment are often unavailable. Firms that would like to locate a processing plant in a particular region to take advantage of that region's climate or labor must devise ways of transferring specialized technology to growers. Resource providing or production-management contracts and vertical integration are means by which the ®rm can relatively quickly initiate production in a new area (Austin, 1981). Once production has begun, ®rms can use vertical integration and contract farming to maintain monopoly power over the provision of specialized inputs (and monopsony power in the product market are discussed below). When factor markets are missing, the ®rm may have monopoly control over specialized knowledge (extension services), specialized equipment, or specialized agrochemicals and seeds. By rationing these inputs, ®rms can restrict cultivation to only those growers with whom the ®rm has a marketing agreement. Unless other ®rms enter the region to supply growers with inputs, the ®rm can extract rents through its exercise of market power (market power and bargaining costs are discussed below).

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There is no clear implication for scale resulting from missing or imperfect markets for specialized inputs. It is likely however, that ®rms will prefer to begin contracting with largescale producers if the technology they are promoting is better suited to large-scale operations. Often the farming systems that multinational agroindustrial ®rms transfer to developing countries re¯ect the relative prices of labor and capital prevailing in the countries where the technology was developed. Much of the machinery, and some agrochemicals such as herbicides, are labor saving and capital intensive, favoring wealthier growers. Technology appropriate to labor-abundant/capital-scarce developing economies is often slow to evolve, placing small-scale peasant agriculture at a competitive disadvantage relative to large-scale operations, at least initially. (ii) Factors controlled by farm households Ð family labor and land When markets for factors controlled by the household Ð such as family labor, land, managerial skill, or animal labor Ð are missing or imperfect, growers will attempt to compensate by trading in the markets that do exist. For example, family labor Ð especially female and child labor Ð often accounts for a signi®cant share of the total labor in production, yet for cultural and other reasons there is no market for this labor. When family labor is nontradable, households with larger endowments of family labor will attempt to compensate for the missing market by renting in more land, or by producing more labor intensive crops than would otherwise identical households with smaller endowments (Bell, 1989; de Janvry et al., 1991). In an environment of imperfect markets, households will be unable to adjust completely to missing factor markets. Households with large endowments of family labor that are unable to rent land, because of imperfect land markets or lack of ®nancial resources, will ``under-employ'' their family labor. Plantations operated by food processors, without access to family labor, would be at a production cost disadvantage relative to farms using family labor. The plantations would be unable to utilize the ``cheap'' family labor available to the individual growers9. Hence, there exists an incentive for ®rms to obtain product using spot markets or contracts, rather than by growing the crop itself.

Land is another important input for which markets are often imperfect, especially in Latin America. Only recently in Mexico, for example, have ejidatario farmers been able legally to rent or sell their land, and have foreign companies (but not foreign individuals) gained the right to own agricultural land. Without the ability to own land, agroindustrial ®rms were forced to contract or use spot markets. Mexico has also had a long history of government expropriation of land from large property owners. Poorly de®ned property rights are a signi®cant disincentive for ®rms to integrate vertically. Hence, in an environment of imperfect markets, ®rms have an incentive to contract with households with underutilized nontradable factors such as family labor or land. Family labor is likely to be underutilized in households with small land endowments that are constrained from renting in land because of imperfect land markets or lack of ®nancial resources. Consequently, for labor-intensive crops Ð and most crops that are contracted are labor intensive Ð the ®rm has an incentive to contract with households with small land endowments and large families. On the other hand, with land-intensive crops, where the cost of land is more important than the cost of labor, land will be under utilized on large farms, and ®rms will have an incentive to contract with larger landholders, ceteris paribus. (e) Product markets Many agroindustrial ®rms Ð and especially ®rms that are foreign owned Ð process or pack crops for which there is a thin or missing local market. Examples of such crops in Mexico include broccoli, basil, specialty melons, and Kabota squash. With undeveloped product markets, ®rms may not be able to obtain suf®cient quantity or timely delivery for their processing needs. Imperfect product markets create incentives for ®rms to produce the crop themselves or contract with growers to meet their crop supply needs. Missing product markets favor neither large nor small landholders. (f) Transaction costs associated with search, screening and the transfer of goods Transaction cost economics maintains that the organizational structures of ®rms are chosen, in part, to minimize the costs associated with business transactions (Williamson, 1975). Recent work has taken a transaction costs ap-

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA

proach to explain the organization of agricultural transactions (Masten, 1991; Ja€ee, 1991). Important costs for a ®rm associated with contract transactions include: (i) search for clients; (ii) screening of potential clients; (iii) negotiation of contracts; (iv) transfer of goods, services, or property rights; (v) monitoring behavior for breech of contract; and (vi) the enforcement of the contract terms. As Ja€ee summarizes: The tangible forms which transaction costs may take are numerous, including: personnel time, travel costs, communications costs, insurance costs, advertising and promotion costs, transport and storage costs, market research and consulting costs, arbitration, legal, and auditing costs, the costs of credit rating check and product inspection services, costs incurred in safeguarding property and in regulating trading practices, etc.

High transaction costs associated with contracting create an incentive for the ®rm to utilize markets or internalize the production process. A ®rm will choose its organizational strategy in part to minimize costs associated with its various business transactions. Transaction costs associated with distributing inputs, extension services, credit, etc., are often ®xed costs that do not depend on the size of the agent with whom the ®rm is contracting. For example, a visit by a processor's extension agent to a grower may require the same amount of time regardless of the farm's size. The processor can minimize these types of transaction costs by minimizing the number of agents with whom it contracts, or equivalently, by raising the average scale of the outgrowers with whom it contracts. The presence of ®xed contract-related transaction costs is a principal motive for ®rms to deal with larger growers. (g) Agency theory and contract bargaining and enforcement costs The ®rm will choose to contract if contracting is more pro®table than its organizational and crop supply alternatives. The pro®tability of contract farming for a ®rm will depend to a large extent on the ®rm's bargaining power relative to its suppliers and its contract enforcement costs. We draw on agency theory to explore the determinants of bargaining power and enforcement costs. The principal-agent literature has been used extensively to describe

389

land tenancy contracts, labor contracts, and credit contracts (Newberry and Stiglitz, 1979; Binswanger and Rosenzweig, 1984). In the principal agent game, the principal, in this case the ®rm, de®nes the terms of the contract anticipating how the agent, in this case the farmer, will respond to each strategy it proposes. The ®rm has imperfect information about the grower's behavior because production is costly to monitor and output has a random component. The ®rm does not observe with certainty whether low yields resulted from bad luck (e.g., weather, pests), poor management, or from a contract violation by the grower. The ®rm maximizes pro®ts subject to two constraints: that the grower will accept the contract Ð it must give him greater pro®ts than he can derive from his next best alternative, and that the grower will abide by the terms of the contract. (i) Contract bargaining transaction costs The ®rst constraint in the principal-agent game states that the grower will accept the contract if the contract o€ers him greater satisfaction than any alternative option available. When there is only one ®rm operating in an area, the ®rm may behave as a monopsonist, keeping grower pro®ts just above the point at which growers would switch to an alternative crop10. Eventually, successful contract farming arrangements may be mimicked by competing agroindustrial ®rms in the region, leading to oligopsonistic or competitive market structures. Hence, the ability of the ®rm to set pro®table terms will depend on the structure of the processing market. That is, in a more competitive environment, where there are multiple ®rms competing for clients or product supply, the reservation utility of the growers will be bid up, and the ®rm will have less bargaining power. As more ®rms enter a market, growers gain the ability to choose among contracts, and ®rms must compete to give the best contract ``package'' ± including inputs, credit, extension, and product price. Hence, contracts will be relatively less pro®table in a more competitive processing market. The pro®tability of contracting for the ®rm will also depend on the bargaining strength of the growers. With more potential crop suppliers, the weaker is the growers' bargaining power, which reduces the ®rm's bargaining and enforcement costs, and increases the pro®tability of contracting for the ®rm. Growers' bargaining power could increase if they nego-

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WORLD DEVELOPMENT

tiate contract terms collectively. A growers' union that can monopolize product supply could potentially extract pro®ts from ®rms up to the point where the ®rms would leave the market. This has occurred in several cases in the United States, including the fruit canning industry in California. The strength of a union's bargaining power will depend on the reservation utility of its members, the ability of the processing ®rms to circumvent the organization, and the market structure of the food processing industry. It is possible for both the ®rm and grower organizations to have market power, resulting in a bargaining game with an indeterminate outcome. The potential for collective action on the part of growers provides an incentive for ®rms to integrate vertically or to seek alternative sources of supply. The bargaining power of both the ®rm and grower will depend on the speci®city of their productive assets. Asset speci®city is the degree to which an asset is specialized for a particular product or trade. In agriculture, specialized assets include tree crops, livestock structures, crop processing facilities, and specialized machinery. Owners of specialized assets incur high bargaining and enforcement costs because they are ``tied'' into a particular activity, which reduces their opportunities for trade. High asset speci®city on the part of ®rms serves to discourage ®rms from contract farming, while high asset speci®city on the part of growers has the opposite e€ect. The bargaining power of growers will be greater when they have alternative production and income possibilities. Studies have noted a positive relationship between the availability of alternative production opportunities for growers Ð for example, keeping part of their land in food crops Ð and the bene®ts of contracting for growers (Glover and Kusterer, 1990; Porter and Phillips-Howard, 1997). The bargaining power of growers will also be strengthened to the extent that the growers control the means of production, especially land and water rights (Movaridi, 1995; Porter and Phillips-Howard, 1997). Ownership of productive assets increases the exit options for growers by increasing the availability of alternative income and production possibilities. In summary, the relative bargaining power of ®rms will be stronger when they are monopsonists in the processing market, when there are many disorganized producers, and when the asset speci®city is high for growers and low for the ®rms. Growers will have relatively stronger

bargaining power to the extent that they are better organized, have more alternative income opportunities, and own the means of production. In terms of scale of production, ®rms will generally have greater bargaining power when there is a large number of smaller growers, rather than a few large growers. A smaller number of larger growers can more easily organize themselves for collective action against the ®rm. Smaller groups are better able to organize because group members internalize a larger share of the bene®ts of their own actions; they are better able to observe the behaviors of other group members; communication among the group is easier; members are more likely to identify with the group; social sanctions may be more e€ective because of tighter social ties; and transaction costs associated with governance are smaller (Olson, 1965; Ellickson, 1991; Ostrom, Gardner and Walker 1994; Sethi and Somanathan, 1996).11 Firms will also favor smallholders because they are more likely to lack productive assets and have limited alternative income and production opportunities Ð which strengthens the ®rms' bargaining power. (ii) Contract enforcement transaction costs The second constraint in the principal agent game states that the utility that agents receive from abiding by the contract must be greater than what they would receive from any alternative behavior. A contract may specify that growers sell their crops only to the ®rm, repay their debts, or apply inputs in a particular manner. Firms can enforce the contract by rewarding good behavior or by threatening to punish bad behavior. The main threats available to ®rms are to withhold future business or to pursue legal action. The threat of legal action is often not credible in many developing countries due to a poorly functioning legal infrastructure. Firms with signi®cant monopsonistic market power are in a stronger position to enforce contract terms via the threat of withholding future contracts. Hence, contracts are more likely to be observed when enforcement costs are low, i.e., in areas where there is a functioning legal system or a monopsonistic processing market. (i) Summary Table 2 summarizes the major in¯uences on an agroprocessing ®rm's organizational strate-

Missing or shallow local product market High search, screening, transfer, and other costs associated with contracting transactions One or a few processors resulting in market power for processors (monopsony) Organized outgrowers have market (bargaining) power (monopoly) High asset speci®city for ®rm and low asset speci®city for growers ± high bargaining costs for ®rm Growers have few alternative income/production opportunities ± low bargaining costs for ®rm High contract enforcement costs (poorly functioning legal institutions)

(e) (f) + ) ) + )

) + + ) +

+ +

+

+ ) +

+

+

+ )

+

)

) )

+

+

+ )

CF +

SM )

Organizational strategy

+

)

+ +

)

+ )

)

+

)

+

+

+

)

VI +

a

Poor, with few productive assets Less likely to default on contract

Unorganized growers High asset speci®city

High levels of family labor relative to land endowment ? Large landholder minimizes number of transactions. ?

High ratio of total labour being self-supervised ?

Highly risk averse with poor ability to self insure Low risk aversion with good ability to self insure ?

High shadow value of liquidity Access to subsidized credit

Characteristic of outgrower favored under contract farming

?

S

S ?

?

? L

S

?

S

?

L

S

L

S

Scale

b

Organizational strategy: SM ± Spot Market; CF ± Contract Farming; VI ± Vertical Integration (Plantation). + favors the organizational strategy; ) does not favor the organizational strategy. b Scale: Scale of outgrower production likely to be associated with the favored characteristic under contract farming. L favors large scale outgrowers; S favors small scale outgrowers;? ambiguous e€ect on scale.

a

(g)

Imperfect market for specialized inputs (machinery, chemical inputs, seeds, etc.) Missing markets for family labor and land (labor-intensive crops)

Imperfect credit market resulting in high costs of credit to outgrowers ± ®rm acts as lender via resource providing contract Subsidized credit market resulting in low costs of credit to outgrowers ± not pro®table for ®rm to lend Imperfect insurance market and high crop price risk ± ®rm acts as insurer via forward contract Imperfect insurance market and high crop yield risk ± ®rm unable to insure due to moral hazard Imperfect market for production information ± technology, timing, and quality High labor supervision costs due to crop/technology requirements

(d)

(c)

(b)

(a)

Market imperfections and transaction costs: Letter refers to section in part 2

Table 2. In¯uence of market failures on processor organizational strategies and scale of contract farmers

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA 391

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WORLD DEVELOPMENT

gy and on the scale of outgrower production discussed in this section. The table indicates whether the presence of the market failure or transaction cost will tend to increase ( + ) or decrease ( ) ) the likelihood of observing that strategy. The table lists the characteristics of outgrowers that are favored under contract farming given the market imperfections or transaction costs. The table also indicates whether the favored characteristics are likely to be associated with large-scale outgrowers (L), small-scale outgrowers (S), or are indeterminate (?). In practice, many of the market conditions we discussed in this section will simultaneously in¯uence the ®rm's organizational strategy and the optimal contract. Consequently, even when many factors favor contracting with smallholders, other more important factors may cause a ®rm to contract with wealthier growers. In the next section we see how the theorized in¯uences on the type of institutional arrangement and scale of production discussed in Section 2 apply to the frozen vegetable processing industry in Mexico. Some frozen vegetable processors have found contracting with smallholders to be undesirable while others have contracted pro®tably with smallholders for many years, and we explore some of the reasons for this mixed success. 3. FROZEN VEGETABLE CONTRACTING IN MEXICO: A CASE STUDY The forces that in¯uence a ®rm's decision whether and with whom to contract, are manifold and may result in situations where no single type of organizational strategy, grower, or contract dominates the market. This is true in the Mexican frozen vegetable industry where all three types of organizational arrangements are observed Ð with contract farming and vertical integration being the most common. The industry is also characterized by a high degree of heterogeneity among outgrowers Ð ranging from large commercial operations cultivating several hundred hectares to small individually owned one-hectare ejido plots.12 In fact, it is common for the owners of processing facilities, who are themselves often large growers, to contract out for additional production with large and/or small scale producers. The terms of the contracts also vary signi®cantly across ®rms and growers, with a simple forward contract being more common

with the larger commercial outgrowers and a full resource-providing contract being preferred with smaller ejidatarios. Frozen vegetable contract farming in Mexico provides an interesting case for studying the factors that favor either small or large outgrowers and examining how these factors have in¯uenced contract design. We explore the reasons why some ®rms have pro®tably contracted with smallholders while others have found this unpro®table. The case study illustrates how small-scale producers can successfully compete with large growers, and highlights some of the reasons ®rms choose not to contract with smallholders. The case study also gives examples of how ®rms have reduced transaction costs associated with smallholders and designed contracts to meet the needs of di€erent types of growers. (a) Evolution of the industry and the incentives to contract The Mexican frozen vegetable industry was one of the most dynamic sectors of Mexican agriculture in the 1980s, with an annual average rate of growth of 34% during 1979±89 (Bivings and Runsten, 1992). The industry was initiated by Birdseye, a US ®rm, which converted a dehydrator on a farm north of Celaya, Guanajuato, into a frozen vegetable plant in 1967. A group of US processors (Del Monte, Heinz and Campbells) had earlier constructed canning plants in the same region, and when Birdseye initiated vegetable processing it contracted with many of the same farmers as the canneries (Morrissy, 1974; Rama and Vigorito, 1979). The industry is based in the Bajõo, primarily in the state of Guanajuato, in a region where smallholders control over one-half of the irrigated land. The frozen vegetable crops Ð primarily broccoli and cauli¯ower Ð are grown almost entirely for processing and export. As the industry has evolved, production and processing technologies have been transferred from larger international food processors to smaller domestically owned ®rms. Until the land reform law was amended in 1992, Birdseye and the other international ®rms were restricted from owning or renting land themselves and had to rely on local growers for product supply.13 With essentially no domestic spot market and unable to operate their own plantations, processors had to contract with independent growers. In contrast, large domestic farmers with the legal authority to con-

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA

trol large parcels of land could vertically integrate both production and processing.14 Beginning in 1975, the largest growers built their own freezing plants and integrated forward. The rapid growth of the industry has been due mostly to the construction of integrated freezing operations by large Mexican growers who used contract farming as an opportunity to develop their ability to produce vegetables for international markets. Initially, all contracts were resource-providing, which served to transfer specialized knowledge and inputs to producers. As the industry grew, input markets developed and many of the larger growers purchased the specialized machinery they had previously rented from the processors. Later, an incipient product market emerged allowing growers to sell their crops to processors without a contractual arrangement. The product market remains thin, however, and most product is supplied to the processing facilities via contracts. (b) Contracting with small and large-scale growers: An industry overview Bivings and Runsten (1992) and Runsten and Key (1996) present information on the 25 processing plants that comprised the Mexican frozen vegetable industry in 1992. The processing plants for which information was available obtained their supplies from an average of 56.6 growers. In contrast to contracting in Guatemala, where contracted growers often number in the thousands, 40% of all processing plants in the Mexican frozen vegetable industry had only a few (less than 10) large ``core'' suppliers, who were often partners in the ®rms. Only one of the plants surveyed Ð the Mexican Congelados plant in Zacatecas Ð obtained their product supplies from a large number of small growers (about 300). The large international ®rms have contracted with both large and small growers, and have increased contracting with groups of small producers during boom periods when high pro®ts created a high demand for the crops. When economic conditions became less favorable in the middle to late 1980s, these ®rms shifted production increasingly to larger growers. Pillsbury-Green Giant initiated production in Irapuato in 1983, and adopted an inclusive strategy in order to develop a sucient product supply Ð expanding production both in new regions and with new groups of ejidatarios. As late as 1986, Green Giant reported having dif-

393

®culty ®nding enough growers. But after 1987 the relative pro®tability of grain production declined due to changes in government policies, and a queue formed of growers willing to produce vegetables for the freezers. This allowed Green Giant to cut back on their dealings with small producers, trying instead to ``maximize production per grower'' to cut transaction costs. Birdseye also contracted with smallholders in Aguascalientes during the boom years of the 1980s, but abandoned contracting in Aguascalientes in favor of summer production with larger growers in new areas of northern Guanajuato by the end of the decade. The ®rm also abandoned subsequent contracts with smallholders in southern Guanajuato because its ``costs were too high.'' Campbells began contracting with small-scale ejidatarios in Valle de Santiago for production of pickling cucumbers. Campbells believed that the ejidos had the best access to the large amounts of labor the crop required (they needed to be picked every other day). This ejidal program was expanded to include other crops in the 1980s during the frozen vegetable boom, but the crash of the market led Campbells to get out of freezing vegetables in Mexico altogether by 1990. In contrast to the international ®rms discussed above, the Mexican family-owned ®rm Frigorizados La Huerta has successfully contracted with smallholders for an extended period. In the next section we discuss some of the most important factors favoring larger growers in the frozen vegetable market. We then discuss the case of Frigorizados La Huerta which illustrates some of the advantages of contracting with smaller growers, and how this ®rm was able to make contracting with smallholders viable. (c) Factors favoring large-scale producers Several factors have caused large-scale growers to dominate frozen vegetable production in Mexico. We begin by discussing how yield risk and a poorly functioning legal system have contributed to this phenomenon and we examine how ®rms have tried to cope with the higher levels of specialized inputs and services required by the small-scale producers. The case study experience illustrates the diculty ®rms have had designing contracts that internalize the higher transaction costs associated with contracting with smallholders. The frozen vegetable crops grown in the Bajõo are considered signi®cantly riskier than

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WORLD DEVELOPMENT

traditional grain crops. The frozen vegetables are more expensive to cultivate than traditional crops (Table 1) and they have greater yield variation, due to frost, hail, pests, and disease. There are several reports of new groups of producers losing their entire ®rst crop of cauli¯ower (personal interviews; DutreÂnit and Oliveira, 1991). In case of crop loss, ®rms would only forgive a small fraction of the total investment in the crop (usually the cost of the seedlings), so that a signi®cant portion of the yield risk is borne by the grower. As discussed above, larger growers are generally better able to bear the risk of crop loss. Related to the issue of yield risk is the fact that the contracts themselves are viewed as legally unenforceable. For ®rms operating in Mexico, the costs of legal action are high Ð both in terms of the ®nancial costs associated with notarization and prosecution, and in terms of damaged community relations. Foreign ®rms in particular have diculty taking legal action against local farmers, and the legal action is likely to be viewed negatively by community members. Without legal recourse, ®rms have to write o€ lost income. The director of the Birdseye plant in 1986 said his ®rm wrote o€ bad debts in the case of crop failure and nonpayment, or if a grower sold the product elsewhere.15 Birdseye's policy is to refuse to contract again with the delinquent growers. Because of the costs they incur from contract violations, ®rms have an incentive to deal with growers who are less likely to default (larger growers who can self-insure) and to screen applicants carefully. Since screening and enforcement costs are ®xed costs, ®rms can minimize total costs by minimizing the number of growers with whom they contract, i.e. maximizing the scale of the farmers with whom they contract. In order to pro®tably contract with smallholders, ®rms must set contracts that re¯ect the total costs associated with dealing with their clients Ð the variable costs associated with the inputs, capital, and technical assistance they provide, and the transaction costs associated with each of these exchanges. On average, smaller producers require more inputs and capital from the ®rm, per unit of product: they have to borrow or rent more specialized machinery (such as rototillers and high-pressure sprayers), they require more extension assistance, and they need to borrow more operating capital per unit of output. In interviews, executives of the processing ®rms indicated they

were well aware of the increased costs associated with dealing with large numbers of small producers. A greater number of producers means more trips by extension agents, more monitoring for pesticide violations, more deliveries of inputs, and smallholders also make more product deliveries of smaller volume. In terms of credit delivery, increasing the number of loans can signi®cantly increase the administrative costs for the ®rm.16 Communication with smallholders was dicult because the smallholders tended to be more geographically dispersed and did not own phones, nor were they organized in a way that facilitated communication. Firms had diculty designing contracts that accounted for the di€erent input needs of growers and which internalized di€erent transaction costs. Scale-invariant transaction costs make it more pro®table for the ®rm to provide services to one 10-hectare farm rather than 10 one-hectare farms.17 Since smaller growers require more services, ®rms can allow for additional transaction costs by in¯ating the price they charge for services. This type of contract overcharges larger growers and encourages them to seek other sources for their inputs. In theory, ®rms could charge di€erent rates for services to large and small growers but this has proven dicult to implement in practice and also creates public relations problems. Birdseye and Green Giant had only two contracts Ð one with a few services, and one with no services. Most of the growers for these ®rms were large and the only services they wanted were the provision of seedlings, some chemical inputs (that the ®rms purchased in bulk), and occasionally the use of specialized machinery. Because most smallholders could not produce without additional inputs, they were shut out of contracting. In the mid-1980s, Campbells offered seven di€erent types of contracts, which enabled them to o€er contracts based on the services the producers wanted. In 1986, they o€ered a contract with complete services (including all operating capital, use of specialized machinery, seedlings, inputs, regular technical assistance, and some risk-sharing in the event of crop loss) that had a base price of 6.5 cents per pound of broccoli. At the other end of the spectrum, they purchased spot-market broccoli at the plant door for 13.5 cents per pound. Evidently, the cost of all the services represents a substantial share of the ``plant-door,'' noservice price. The director of agriculture at Campbells said he was pressured by the other

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA

plants to maintain prices at a common level and not to price discriminate. The director claimed that even with the seven contracts he was unable to pay the no-service large growers a high enough price, nor the full-service small producers a low enough price, to account for all costs. While most of the ®rms interviewed expressed diculty in dealing with smallholders, there were exceptions. The next section discusses the case of La Huerta, which has successfully contracted with smallholders for over a decade.18 The case illustrates a contractual arrangement that takes advantage of the relative eciencies of smallholders while minimizing transaction costs for the ®rm. (d) Successful contracting with smallholders Frigorizados La Huerta is a frozen vegetable ®rm located just north of the city of Aguascalientes. Started in 1976, La Huerta was the ®rst vegetable freezer to be set up by a Mexican farm family, and it continues to be familyowned. The family's ranches supply most of the product to the plant, but the ®rm also contracts with approximately 10 private producers and 70 ejidatarios in seven ejidos in Aguascalientes and Zacatecas. The ejidatarios average one hectare of vegetable production for the ®rm apiece. The contracted growers produce mainly broccoli and cauli¯ower, with limited production of snow peas and carrots. The ®rm has contracted with some ejidos bordering the home ranch in Aguascalientes for over 12 years. La Huerta has had success in contracting with smallholders because it has been able to design and implement contracts that both the smallholders and the ®rm ®nd pro®table. Smallholders are able to compete with larger growers because they have several advantages in the land and labor markets that allow them to produce at low cost. At the same time, the ®rm is able to o€er contracts that provide smallholders with the necessary inputs, technical assistance, and credit in a way that minimizes the ®rm's contracting transaction costs. La Huerta estimated that the ejidatarios had per unit costs of producing broccoli that were 55% of the ®rm's own costs on vertically integrated land. Costs were lower in part because ejidatarios had access to unremunerated family labor for which markets are missing.19 Ejidatarios also had lower e€ective labor costs because they faced lower transactions costs Ð e.g. the cost of recruiting, supervising and trans-

395

porting labor ± and because they did not pay any government bene®ts ± e.g. social security. Imperfect land markets also created a cost advantage for the smallholders. Land rents were lower for ejidatarios than for the ®rm because most ejidatarios were willing to rent (using a sharecropping contract) to other ejidatarios, but were unwilling to rent to the ®rm. They would not rent to the ®rm because, at the time, renting land was nominally illegal, and renting to the ®rm was considered riskier. Hence, the ®rm could only rent from a limited number of non-ejido landholders, which resulted in higher costs. Ejidatarios also had lower pest control costs: they managed small acreages and could catch pest and disease problems sooner, thereby limiting their use of chemicals. Finally, La Huerta calculated that the ejidatarios had higher average yields than the ®rm's own ranches ± approximately 20% higher in broccoli and cauli¯ower. La Huerta attributed the higher yields to more ``conscientious'' work by the ejidatarios on smaller plots. As we discussed above, contract farmers may work more conscientiously than hired labor because they are the residual claimants of their labor. To take advantage of the relative eciency of the smallholders, the ®rm o€ered resourceproviding contracts that delivered credit, specialized inputs, and extension assistance. Credit was crucial for the ejidatarios who had little access to formal credit. Unlike the Mexican commercial banks and the rural development bank, La Huerta provided credit to the ejidatarios without collateral. La Huerta advanced seedlings, all pesticides, and fertilizers. The normal advances to the Zacatecas ejidos represented about 40% of variable cost, while the ejidatarios themselves provided the land, labor, and a portion of the costs of land preparation, water, and transportation. These in-kind credit contracts resulted in out-of-pocket costs for vegetable crops being in the same range as the costs for maize. In contrast to the foreign-owned companies discussed in the last section, La Huerta was able to make contracting with many smallholders pro®table in part by establishing a management strategy with low transaction costs. The ®rm restricted the number and location of the ejidatarios with whom it contracted Ð dealing only with ejidatarios located along the main highway. Chemical control decisions were made by an agronomist who visited growers once a week. The agronomist carried the pest control materials with him at all times, which allowed

396

WORLD DEVELOPMENT

him to make recommendations and distribute the materials in the same trip.20 In addition, the contracted growers had to obtain their transplants and fertilizers themselves from the ®rm's ranches, and had to deliver their harvest to the ®rm Ð both of which minimized transactions costs for the ®rm. 4. CONCLUSIONS Contract farming o€ers many bene®ts for growers, including access to new markets, technical assistance, specialized inputs, and ®nancial resources. Contracts can also reduce crop price variation, helping farmers bear the risk of nontraditional crop production. To the extent that ®rms contract with smallholders, contract farming has the potential to raise incomes of the poor and promote rural development. On the other hand, where smallholders are excluded from contracting, contract farming may serve to exacerbate income and asset inequalities. The case study of the Mexican frozen vegetable industry presented in this paper, and other studies of contract farming in Latin America, have noted many agroprocessors contracting primarily with large-scale growers, to the exclusion of smallholders. This paper has outlined the factors that in¯uence agroprocessing ®rms' decisions to contract-out, vertically integrate, or use spot markets to obtain raw product, and has identi®ed how these factors are likely to favor or disfavor contracting with smallholders. For agroindustrial ®rms, smallholders possess certain advantages over larger growers in terms of production costs: they have access to ``cheap'' family labor, and to the extent that the smallholders cultivate the crops themselves, their labor is self-supervising. On the other hand, larger and wealthier growers have better access to often-subsidized formal sector credit and insurance, they are better able to self-insure, and they can take advantage of economies of scale in production. Governments can reinforce the labor cost advantages of small family farms by enforcing labor laws, the minimum wage, and workplace health standards on large farms. The diseconomies of scale su€ered by small growers can be reduced by eliminating policy distortions and institutional biases that work against smallholders, and by promoting research into cropping technologies that re¯ect the relative prices of labor, capital and land faced by smallholders.

Paradoxically, some of the factors that cause smallholders to be at a disadvantage to large farmers in the market place Ð their lack of access to formal credit, their risk-aversion, and the high costs they face to smooth consumption Ð provide incentives for ®rms to contract with them. By acting as intermediaries, ®rms can pro®t from the willingness of smallholders to pay more for credit and insurance than would larger landholders. Hence, even if small-scale producers are not competitive in the open marketplace, they may be the most pro®table type of grower with whom the ®rms could contract. While agroprocessors may be able to earn the highest returns to their ®nancial and insurance services from smallholders, the higher risk of default and the higher transaction costs associated with providing these services to smallholders mitigate the bene®ts of contracting with them. Moreover, when competition from subsidized government credit or crop insurance programs, government regulations, or excessive transaction costs make lending or insuring unpro®table for the ®rm, only those (usually wealthier) growers able to ®nd their own sources of ®nance or insurance will be able to accept a contract. Likewise, when processors ®nd it dicult to monitor the behavior of growers, ®rms are more likely to refuse to extend input loans or to require loan collateral Ð actions that also favor wealthier growers. Poorer growers may be able to reduce transaction costs and default risk for a ®rm by contracting via a mutual insurance group. In a mutual insurance group, members are jointly liable to ful®ll all contracts signed by the members of the group. Since members have privileged access to information about the other members (which the ®rm does not have), they can avoid adverse selection (the incorporation of risky members into the group) and moral hazard (where members refuse to pay when they are able to). The challenge exists to transfer some of the lessons learned from successful group lending and mutual insurance programs into the realm of contract farming as a way of encouraging ®rms to contract with smallholders. The main disincentive for ®rms to contract with smallholders appears to be the transaction costs associated with providing inputs, credit, extension services, and product collection and grading. The case study described many of the diculties ®rms in the Mexican frozen vegetable industry have had in designing and imple-

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA

menting contracts that allow them to minimize the costs of working with large numbers of heterogeneous growers. While some ®rms have been able to structure the delivery of their services so as to reduce transaction costs ± as we describe in the case study Ð many ®rms have found it easier and more pro®table to deal with a few large growers. Producer organizations, such as marketing cooperatives, could serve to lower contracting transaction costs for ®rms and small-scale growers. By working with producer groups, a ®rm's extension agents could meet with many growers at a time rather than individually, and growers could bring soil or plant disease samples to extension meetings rather than have the extension agents visit the individual plots. A processor's input and service transaction costs would be lowered if growers picked up their inputs from a cooperative deposit point and delivered their product to a cooperative grading shed Ð as is the usual practice in Guatemala. In Mexico, many collective and cooperative rural organizations, including the ejido system, have a history of being used for political ends and subject to manipulation by corrupt leaders, or have failed because of interpersonal jealousies and mistrust (Girault, 1993). These experiences have created reluctance on the part of ejidatarios to work cooperatively, and cast doubt on the e€ectiveness of the ejido as a structure through which ®rms can interact with growers. Nevertheless, to increase smallholder participation in contract farming, a renewed e€ort on the part of growers to organize themselves, or to organize with the help of government agencies, nonpro®t organizations, or the agroprocessors themselves will be necessary.

397

An important reason why ®rms are reluctant to organize and interact with producer organizations is the possibility that these groups will be used for collective bargaining. State agencies and non government organizations (NGO's) have promoted producer organizations as a mechanism for enforcing contract terms and for lobbying for better contract conditions. Unfortunately, collective action by producer organizations may encourage ®rms to seek alternative non-organized growers (perhaps by relocating their operations to another region or country) or may encourage ®rms to integrate production vertically. The incentives and disincentives of ®rms to contract with smallholders should be considered in designing policies to regulate or in¯uence the terms of contract relations. Policies with laudable social or economic goals may, by restricting ®rms' control over the production technology or contract, inadvertently discourage contracting with smallholders. For example, a policy to promote food security by requiring ®rms to permit intercropping with contracted crops may create an incentive for ®rms to contract with larger commercial farms that do not intercrop. Similarly, a policy to promote gender equality within the household by requiring ®rms to contract directly with all the family members that grow the crop (when there are multiple such members in a household) will raise transactions costs for the ®rm ± encouraging ®rms to contract with fewer larger growers, or with growers that use hired rather than family labor. Hence, policy makers should be careful to weigh the bene®ts of a particular policy against the costs of discouraging contracting with smallholders.

NOTES 1. While some crops have been cultivated in units of less than one hectare (strawberries in central Mexico, snow peas in Guatemala, basil and tomatoes in the Del Cabo cooperative in Baja California Sur) ®xed cost of production and marketing often raise the minimum economically ecient scale of production to at least one hectare.

requires documentable land ownership ± something not yet available to most ejidatarios. While progress is being made in the land titling process initiated with the reform to article 17 of the constitution in 1991, the majority of ejidatarios do not yet have a land title, and no private banks have yet indicated a willingness to accept such ejidal titles as collateral.

2. In Mexico, banks usually require collateral valued at two to three times the loan principal. Assets that can be used as collateral are unevenly distributed among the population, and titles for these assets are often expensive or dicult to obtain. Land or land usufruct as collateral

3. While there has been an on-going debate as to the relative riskiness of high-yielding varieties versus traditional varieties of the same crop, cash crops will invariably present a greater risk than a traditional food crop.

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4. Production of such crops with current chemical pest and disease controls often leads to mounting problems that require integrated pest management techniques and site-speci®c research to control. The lack of such techniques and research support in many areas of Latin America has caused a wide variety of nontraditional cropping projects to fail or relocate (Glover and Kusterer, 1990; Murray and Rosset, 1996; Thrupp, 1995; Conroy, Murray and Rosset, 1996). 5. In Mexico, insurance for fruit and vegetable crops is not available, nor are there developed futures markets. While some insurance is available for ®eld crops, a survey of the ejido sector in Mexico revealed that only 2.9% of all producers had any crop insurance (SRA, 1994). 6. Numerous studies of contract farming in the United States have emphasized risk reduction as a principal incentive for producers to enter into contracts (e.g., Roy, 1972; Covey and Stennis, 1985; Dornbush and Boehlje, 1988; Herbert and Jacobs, 1988; Lawrence and Kaylen, 1990; Johnson and Foster, 1994; Knoeber and Thurman, 1995). 7. Attempts by processors in Mexico to leave the contract open to a higher market price at the time of harvest were often refused by smallholders who wanted a guaranteed ®xed price. The Del Cabo cooperative of ejidatarios in Baja California Sur ®xes the producer price of each product before the season to eliminate market risk to the grower. 8. A third method of overcoming the market failure would be for producers to hire a reputable independent agent to certify the quality of their crops. 9. In addition to potential salary savings, using family labor saves on a variety of transaction costs necessary in agricultural labor markets, such as the cost of bookkeeping, payroll, transport costs for the workers, etc. 10. While market power provides the ®rm with and opportunity to earn monopsony rents, monopsony power does not always imply monopsonistic behavior nor unreasonable pro®ts on the part of ®rms. Case study experience indicates that ®rms that initiate production in a region often lose money during the initial years, despite being the sole purchasers of a crop. The ®rms lose money because they have high start-up and learning costs and, at the same time, must pay a price to farmers suciently high to induce them to switch from growing their traditional crops to the riskier and less certain contract crop. Monopsonistic rents earned by agroin-

dustrial ®rms after several years of losses could be viewed, in this context, analogously to the royalties earned by a mineral extracting ®rm that ®rst invested in exploration. 11. Group heterogeneity will tend to increase the costs associated with collective action and group organizing (Libecap, 1989; Milgrom and Roberts, 1992). This factor will encourage ®rms to prefer to contract with a mix of small and large growers. 12. Ejidatarios are farmers of land that was redistributed after Mexico's social revolution. Ejidatarios are organized into rural communities called ejidos. Until the land reform of 1992, ejidatarios had usufruct rights but could neither sell nor rent the land. About half of all agricultural land in Mexico is in the ejido system. Ejidatarios are generally smallholders with average land assets of about ®ve hectares each (SRA, 1994). 13. The 1992 reform of Article 27 of the Constitution and the Agrarian Reform Laws permitted foreign corporations to own and lease land, and increased the permissible landholding limit. These changes have not yet led to agricultural land ownership by any of the foreign food processors. 14. The success of large-scale producers in the Mexico case is in contrast to the Guatemalan experience. In Guatemala, e€orts by US frozen vegetable ®rms to contract with large-scale producers initially failed, forcing them to expand supply systems with small-scale indigenous producers in the highlands (Glover and Kusterer, 1990). Over time it appears however that there has been a tendency toward larger acreages in Guatemala as well (Glover and Kusterer, 1990; Rosset, 1992; Conroy et al., 1996). 15. Contract violations resulting from opportunistic sales by growers to other buyers were not a severe problem in the Bajõo frozen vegetable industry, in part because the frozen vegetable crops (mainly broccoli) had limited alternative markets in Mexico. But, opportunistic sales have been a serious problem in other crops, such as strawberries in Zamora and Irapuato and processing tomatoes in Sinaloa and Sonora. Recently, with NAFTA's removal of tari€s on fresh broccoli exports, opportunistic sales to fresh broccoli brokers in the United States have become more common. 16. One director of a US ®rm expressed his exasperation with smallholders constantly asking for loans for machinery or other goods, saying that he felt like the patron of a hacienda.

CONTRACT FARMING, SMALLHOLDERS, AND RURAL DEVELOPMENT IN LATIN AMERICA 17. The attempt by ®rms to price transaction costs is one reason why the contract crop price is frequently correlated with size of the producer, which Rosset (1992) laments in reference to his data on melon production in Central America. Low crop prices result not only from the weaker bargaining power of small producers, but also from the higher real costs incurred by ®rms in dealing with these producers. 18. The information on La Huerta was collected in 1992. DutreÂnit and Oliveira (1991) describe other cases of successful (and unsuccessful) broccoli contracts between a Mexican processor and smallholders. Glover and Kusterer (1990) and von Braun, Hotch kiss and Immink. (1989) discuss similar issues in the Guatemalan frozen vegetable industry.

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19. Markets are missing primarily for the labor of women and children. Men generally have greater o€farm agricultural and nonagricultural labor alternatives, including migration to the United States. 20. The success of the La Huerta operation depends, to an extent, on the integrity and ability of the company agronomist. Many growers have abandoned frozen vegetable crops because of poor technical assistance which has led to crop losses or rejection of the crops by processors (see the discussion of poor technical assistance in Dutrenit and Oliveira 1991). For additional discussions of this industry, see Moulton and Runsten (1986), and Bivings and Runsten (1992).

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