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Contractual arrangements and enforcement in transition agriculture: Theory and evidence from China
Food Policy 33 (2008) 570–575
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Contractual arrangements and enforcement in transition agriculture: Theory and evidence from China Hongdong Guo a,*, Robert W. Jolly b a b
Center for Agricultural and Rural Development, Zhejiang University, Hangzhou, Zhejiang Province 310029, PR China Department of Economics, Iowa State University, Ames, IA 50011, USA
a r t i c l e
i n f o
Article history: Received 14 April 2006 Received in revised form 8 April 2008 Accepted 30 April 2008
Keywords: Contract enforcement Transition agriculture China
a b s t r a c t This paper empirically investigates the relationship between contractual arrangements and their enforcement in Chinese agriculture. Based on an analysis of a survey of 100 agribusiness firms engaged in contract farming in Zhejiang province of China, we find that private contract enforcement mechanisms play an important role in influencing smallholders’ decisions to breach or fulfill contracts. Contract arrangements such as floor pricing, or requiring smallholders to make specific investments facilitate self-enforcement and significantly improve the smallholder’s contract fulfillment rate. This is particularly important in Chinese agriculture since the business environment is characterized by an absence of effective public enforcement institutions. Crown Copyright Ó 2008 Published by Elsevier Ltd. All rights reserved.
Introduction The enforcement of contracts has long been recognized as an important pre-condition for efficient exchange and investment in market-guided economies in general and the agri-food sector in particular (Gow et al., 2000). Contracts can be enforced through a variety of public and private mechanisms, either separately or in combination. In developing countries and most significantly in transition economies such as China, public institutions such as the legal system are either absent or ineffective in ensuring contract enforcement. Under such conditions, private enforcement mechanisms may provide a suitable replacement for weak or missing public enforcement institutions (Greif and Kandel, 1995; Wooddruff, 1998; McMillan and Woodruff, 1999; Johnson et al., 2002; Gow et al., 2000; Gow and Swinnen, 2001; Beckmann and Boger, 2004; Tao and Zhu, 2001). Transitional economies typically do not have an effective legal system for contract enforcement. Given the ineffectiveness of public enforcement, one should expect that contracting parties would not rely on formal contracts, and if they do sign formal contracts, they would not rely on third parties for enforcement. China is no exception. In fact, the formal contract law of the PR China did not come into force until July 1, 1982, almost four years after the start of the economic reform in 1978. The law quickly became outdated. It was not until 1993 that the National People’s Congress passed a revision of the old contract law. However, the revised con-
* Corresponding author. Tel.: +86 571 86971756; fax: +86 571 86971646. E-mail address: [email protected] (H. Guo).
tract law still could not catch up with the ever-changing economic reality. In 1998, a unified, comprehensive draft contract law with more than 400 articles was put before the Congress’ legal affairs committee for study. It was eventually passed in March 1999 and took effect in October that year. The more serious shortcoming with China’s legal system, however, is not the lack of good laws but the lack of law enforcement. Administrative intervention, corruption, incompetence, shortage of professionals, and poor incentives have all hampered enforcement (Tao and Zhu, 2001). Despite the weakness of its legal system, contract farming in China has been able to sustain an impressive rate of growth over the past 15 years. As a component in the agricultural industrialization program in China since 1990, contract farming has been supported by the Chinese government in an effort to make agricultural production more profitable and competitive. The most recent data available shows the number of agribusiness firms involved in contract farming increased almost five times between 1996 and 2002 from 8377 to 46,060. The number of smallholders who signed contracts with firms is almost 72,650,000 in 2002. The proportion of total smallholders involved in contract farming went up correspondingly, from 10% to 30% between 1996 and 2002 (Niu, 2006). Two organizational models are used by agribusiness firms involved in contract farming. One is a centralized model in which a single processor and/or packer contracts directly with a large number of smallholders. In China this model is referred to as ‘‘firm + smallholder”. The second broadly used model involves an agribusiness firm contracting with smallholders through an intermediary such as a farmer cooperative, middleman, or a village council for example. This contracting model is referred to as ‘‘firm + intermediary + smallholder” in China.
0306-9192/$ - see front matter Crown Copyright Ó 2008 Published by Elsevier Ltd. All rights reserved. doi:10.1016/j.foodpol.2008.04.003
H. Guo, R.W. Jolly / Food Policy 33 (2008) 570–575
This study focuses on contract farming in Zhejiang province. Zhejiang province is located along the southeast coast of China. In the 1980s, the ‘‘People’s Commune” system was dismantled and replaced by individual family farms based on the ‘‘Household Responsibility System” (HRS) in Zhejing province. The HRS encouraged smallholders’ creativity, investment and efficiency. Agricultural output has increased significantly since its adoption. With the increase in agricultural production, China shifted from shortage to relative surplus since the 1990s. The more market-oriented economy has resulted in higher value crops replacing grain or cereal crops in Zhejiang province. Grain crop sown area in Zhejiang province was 1454.53 thousand hectare in 2004, down 57.5% compared with 1980. The area of vegetables was 661 thousand hectares in 2004, an increase of 5.11 times compared with 1980. The area share of cash crops increased from 26% of total sown acreage in 1980 to 48% in 2004. With changes in agricultural commercialization and market conditions, marketing of surplus agricultural products has become a more important task for the smallholders. Farm size is small and continues to decrease. From 1985 to 2004, the total number of rural households increased by nearly 33.8%, while total cultivated area decreased by 11.3%. The average area cultivated by each rural household in 2004 was 0.133 hectares, down 33.2% compared with 1985 (Zhejiang Statistical Yearbook, 2005). Moreover, smallholders are not well integrated into markets or with each other. Since the mid-1980s, the government has adopted many policies to help smallholders to access the market. One of the most important policies undertaken was to foster vertical coordination among stages in the supply chain to help the smallholders gain access to the market. Contract arrangements between smallholders and processing or distribution firms are the main types of vertical coordination in Zhejiang province. In the late 1990s, especially after China’s entry into WTO, the development of contract farming is remarkably accelerated. In our 2004 survey of agribusiness firms in Zhejiang province, China, 72% of agribusiness firms engaged in contract farming reported that more than 75% of the smallholders with whom they contracted fulfilled or met the provisions of their contracts – a surprisingly high performance level (Guo et al., 2007). Reasons for contract failure reported by responding firms included unacceptable delivery quality and contractees selling products to other parties for a higher price. The surveyed firms reported that resolution of contract disputes was difficult. As many as 53% of the firms report that there was no way to resolve conflicts. Legal action was pursued by only 7% of contracting firms. Another 7% reported that they rely on local government to resolve disputes. Generally speaking, the legal mechanism appears to be less important in improving contract performance than informal approaches. China’s success with contract farming in the absence of effective formal contract enforcement mechanisms appears to contradict well-accepted doctrine (Chow, 1997). This paper attempts to explain why the default rate on contracts with the smallholders appears to be relatively low in China despite the inefficiencies of its legal system. Because we only have access to information about contract breach by smallholders, this paper’s main objective is to identify contract arrangements that influence smallholder’s decisions to breach or fulfill contracts. This paper draws on Beckmann and Boger (2004), but extends the work to a game theoretic setting. The paper is organized as follows: The literature on contract performance is reviewed in the Literature Review. In Conceptual Framework, we develop a simple contract enforcement model to specify testable hypotheses about the relationship between contract arrangements and the smallholders’ contract fulfillment rate. In Data and Methods, we describe the survey and the data. In Result and Discussion, we present our results and discussion. Finally, we offer conclusion.
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Literature review The design, acceptance and adherence to a contractual arrangement is a multi-criterion decision problem. Bogetoft and Olesen (2002) identify three main objectives for a contract. First, a contract aims to ensure that the right products are produced at the right time and place. Second, a contract ensures that the parties have individual incentives to make coordinated decisions. Third, a contract attempts to ensure that coordination and motivation incentives are provided at the lowest possible cost. There are many specific means and instruments in the contract arrangement to realize these objectives. In practice, contracts vary significantly in terms of type, form and specifications. For example, a contract can be informal (oral) or formal (written). With an informal contract the provisions and incentives reflect the norms that have been established by repeated interaction between parties or within society. Even formal contracts are naturally incomplete. Contracting parties will find it difficult and expensive to foresee all possible contingencies and to enforce these contracts, especially when outcomes are unobservable or non-verifiable by a third party (Hart, 1995). Because even formal contracts are incomplete both parties expose themselves to ex post costs related to performance and enforcement. The economic literature on contract enforcement identifies two mechanisms to reduce the likelihood of a holdup – public (legal) enforcement and private enforcement (self-enforcement). Public (legal) enforcement means that agreements and contracts can be effectively and almost costlessly enforced within the legal system. Private self-enforcement implicitly or explicitly means that contracts between two parties can be enforced by private sanctions not by courts (Telser, 1980; Klein and Leffler, 1981; Klein, 1996). Private sanctions include the losses that result from termination or non-renewal of the contract or relationships and the damage of the reputation in business or social networks (Ellickson, 1991, 1994). In particular, Williamson (1979, 1985, 1991, and 1996) emphasized that specific investments, which create valuable relationships, make both court and self-enforcement costly. Traditional contract theory usually considers court enforcement and private enforcement as alternatives. Klein (1996) emphasizes fundamental complementarities between court enforcement and private enforcement. In fact, empirical evidence shows that legal enforcement is often possible, but obviously costly. This is particularly true in many transition countries, where the legal and judicial system is in an embryonic stage of development and court decisions may be highly uncertain and non-transparent. Recent experience in post-communist countries offers new evidence on the relative importance of courts and relationships in enforcing contracts. A pervasive belief in the effectiveness of the courts may have a significant positive impact on the level of trust shown in new relationships between firms and their customers (Johnson et al., 2002). It is sometimes not viable to use legal dispute mechanisms due to litigation costs, ineffective contract law, or poor third party verifiability (Gow et al., 2000). Where contract law is inadequate, informal social and economic relationships can substitute for the courts (McMillan and Woodruff, 1999). Therefore, when two agents choose an enforcement mechanism, they must first consider the cost and benefits resulting from contract breach including the magnitude of damages and the enforceability of claims resulting from contract breach (Beckmann and Boger 2004). Conceptual framework The contracting process begins with the smallholder and the agribusiness agreeing on a set of duties and conditions – quantity delivered quality, paying price, discounts, delivery time and the like. At the time of delivery or contract fulfillment, market prices,
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yields, product quality, production costs, and other factors are known, asymmetrically in many cases, to the contracting parties. Contract default or breach may be initiated by either party. The determining factor influencing default will be whether or not the long run benefits outweigh the costs (Gow et al., 2000). Since most contract defaults in China appear to be associated with price or quality issues (Chen, 2004), the default process can be modelled as a simple sequential game in which the agribusiness and the smallholders have the option to fulfill or breach the contract. If the contract is breached by either party, the other party can choose to accept the default, self-enforce or take legal action. Consider the following simplified game following, Beckmann and Boger (2004) in which market price at the time of delivery is the only factor that would result in breach. In other words, we ignore the possibility of default due to inadequate yields, quality or other factors that may induce opportunistic behavior. Further, we limit attention to contract default by smallholders, not the contracting firm. When the agribusiness firm buys the product from the smallholders according to the signed contract, the actual market price, P, may deviate from the contracted price Pfixed. If P P Pfixed, then the contract provides unanticipated rents to the agribusiness firm and the benefits of contract breach increase for the smallholder since they could get a higher price by selling the product on the market. The smallholder’s benefits of contract breach depend on the wedge between the actual market price and the contracted price times the contracted quantity Q. The cost to the smallholder of breaching the contract is determined by different enforcement mechanisms. When the smallholder breaches the contract, the agribusiness firm can apply two enforcement mechanisms: (1) self-enforcement (termination), and (2) court enforcement. Each enforcement will result in different default cost for the smallholder. Under self-enforcement if the smallholder breaches the contract, then the agribusiness firm will accept the default and the financial loss. Let’s assume that the agribusiness firm will not trade with a smallholder over some period of time. The default cost to the smallholder includes both the value of losses that result from termination or non-renewal of the contract or relationship and the damage of the smallholder’s reputation in local business or social networks. We can represent these default costs as Pn i W h ¼ i whi =ð1 þ dÞ , where whi is the value of smallholder losses in the future i year, for the period, n, over which the agribusiness will not do business with the smallholder and d is the discount rate. Note in this specification, that the default costs are implicitly a function of contract size or value. Under a court enforcement mechanism, if the smallholder breaches the contract, the agribusiness firm would immediately take legal action to force the smallholder to compensate for agribusiness firm losses resulting from contract breach. The smallholder costs depend on the value of compensation D for agribusiness firm losses resulting from contract breach and the probability q that the courts will adequately determine the magnitude of damages and enforce the claim resulting from contract breach. Again, both D and q are functions of contract size. The probability q that the smallholder is forced to pay compensation for losses resulting from contract breach is determined the cost of contract enforcement for the agribusiness firm and the adequacy of the legal system. The costs of contract enforcement are time, effort and money that must be spent to take legal action (Beckmann and Boger, 2004). These are affected by: (1) efficiency of the legal system, (2) contract provisions and design, and (3) characteristics of the firm or smallholder. Following the above discussion, we can specify the smallholder’s contract enforcement strategy. If P P Pfixed, the smallholder will weigh the costs and benefits of contract breach. The smallholder will breach the contract only when the benefits
Q(P Pfixed) are greater than the costs (Wh + qD). The decision rule for the smallholder would be to default if Q ðP P fixed Þ P W h þ qD. On the other hand, if P 6 Pfixed, then the dominant strategy for smallholder is to fulfill the contract. This decision rule would hold independently of the type of contractual arrangement – direct with the smallholder or indirect through an intermediary. From the above discussion, we can infer that the value of q, Wh, D, Q and the wedge between the actual market price P and the contracted price Pfixed will affect smallholders’ contract fulfillment rate. Given the state of the legal system and market conditions these values are determined by contract provisions, such as contract form, contract type, or contracted price. To analyze the relationship between contract arrangement and smallholders’ contract fulfillment rate, a straightforward reduced form model was developed. The smallholders’ contract fulfillment rate was regressed against various characteristics of contract arrangements that are believed to influence smallholders’ contract fulfillment rate. Eq. (1) represents this reduced form equation,
CEi ¼ FðCT i ; CF i ; CPi ; CDi ; CSi ; CBi ; bÞ þ ei
ð1Þ
The dependent variable, CE measures the level of smallholders contract fulfillment experienced by the contracting firms and the independent variables CT, CF, CP, CD, CS, CB measure the impact of contract provisions on smallholders’ contract fulfillment rate. The variables are defined as follows: The dependent variable, CE, is binary and is derived from contracting firms’ response to a survey question. The firms were asked to select the level of smallholder contract fulfillment that most closely represents their recent experience. The choices were:
less than 25%; between 25% and 50%; between 50% and 75%; greater than 75%.
Note that the question addresses smallholder fulfillment rates, not contract fulfillment. If the firm contracts directly with farmers, then the interpretation of this question is straightforward. On the other hand, if the firm contracts through an intermediary, the firm would know how many smallholders had been contracted through the intermediary. Therefore, the firm’s ability to assess contract performance is independent of the contracting arrangements. In our specification, satisfactory contract performance is measured by a smallholder fulfillment rate greater than 75% smallholders. Variable CT is defined as the organizational model used between agribusiness firms and smallholders. CT is binary and takes on the value of the 1 if the ‘‘firm + smallholder model” is used and 0 if an intermediary model is employed. In China the smallholders are numerous, dispersed and small scale. The legal system is inefficient and most of the agricultural product markets are competitive auction markets. If the agribusiness firms sign contracts directly with smallholders then enforcement can be very costly when smallholders breach the contract. The cost of court enforcement for the agribusiness firms is very high, the value of the compensation D for losses of breach contract and the possibility q of acquiring indemnification for losses from the smallholders could be very low. In this case, the value Wh of smallholder losses that result from termination is not particularly high. In contrast, if an intermediary contracting model is used, the costs of underwriting, monitoring and enforcing the contract would be borne by the intermediary. We hypothesize that if an agribusiness firm signs a contract with smallholders directly, the contract is more likely to be breached by the smallholders due to higher enforcement costs. The variable CF measures the form of contract – oral or written between the agribusiness firm and the smallholder. The existing literature suggests that agribusiness firms will experience lower
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levels of contract fulfillment with oral compared to written contracts. The written contract is explicit and closely details the conditions and obligations of each party. An oral contract, in contrast, may leave the responsibilities of both parties and the delivery specifications open to interpretation. Confusion and misunderstanding can easily occur, if the agreements are not stated and agreed to by the agribusiness and the smallholders. If a smallholder has an oral contract it can be very difficult for the court to determine a responsibility for the default. As Lyons (1996, p. 27) states: ‘‘the arrangement need not be written, but it is obviously difficult to enforce, it if it is not written or witnessed by a third party”. CF is binary and takes on a value of 1 if the contract is oral. We hypothesize if an agribusiness firm completes an oral contract with smallholders, the contract is more likely to be breached. The variable CP measures the pricing model specified in the contract. CP is binary and takes on the value 1, if a floor pricing provision is stated in the contract and 0 otherwise. Relative to other pricing models, CP is expected to increase smallholders’ contract fulfillment. From the conceptual model, we know that the gap between the contracted price and the actual market price will affect the smallholders’ contract fulfillment rate. A floor price provision offers smallholders a minimum price at the beginning of each season. If the local market price is higher than the minimum price, the agribusiness will use the market price. If the market price is lower than the minimum price, the agribusiness will use the minimum price. Such an arrangement provides income guarantees for smallholders. Because the agribusiness has higher risk tolerance than does the smallholder, it is more able to accept the risk of market price fluctuations. Relative to other pricing methods, we hypothesize rates of contract breach will be reduced with floor pricing. Variable CD is defined as the length of the contract between the agribusiness firm and smallholder. CD is expected to be positively related to higher levels of contract fulfillment. As our model suggests smallholders will compare the short term gains they can achieve by defaulting on the contract with the discounted expected future profit stream, Wh, that they will lose from termination or non-renewal of the contract or relationship and the damage of the smallholder’s reputation in business or social networks. The value Wh of losses is affected by the contract length, as well as, duration of the contracting relationship. The longer the duration of contract, the greater the losses from default. We hypothesize CD will be positively related to contract fulfillment. Finally, the variable CS measures the level of smallholders’ specific investment required by the agribusiness firm. CS is expected to be positively related to contract fulfillment. If the agribusiness firm requires the smallholder to make a specific investment in a production facility, such as a new chicken house that meets the exact specifications of the processor, the smallholder will be more likely to fulfill the contract. If the smallholder breaches the contract, their specific investments will have less value outside the relationship. From the theoretical model, the value Wh will increase and make default more costly to the smallholders. Contract fulfillment levels will consequently increase. The variable CB takes on the value of 1 if a bonus clause is included in the contract. CB is expected to encourage higher levels of contract fulfillment. If the agribusiness firm offers a bonus to the smallholders who perform well on the contract, the value Wh will increase and discourage contract default.
firm managers, government officials and smallholders to understand fully the context in which contract farming operated. Second, a questionnaire was designed to obtain information from agribusiness on contract arrangements and the smallholders’ contract fulfillment. Third, we created a list of agribusinesses believed to be engaged in contract farming. In China, most agribusiness firms are classified into four categories based on their economic strength, operational scale, level of technology, management and their potential to improve farm incomes. The categories national, provincial, municipal and county reflect the scope of the firm’s economy impact. For example, a national agribusiness firm must meet the scale and management criteria drafted by the National Agricultural Industrialization Development Joint Committee. Other rankings are specified by committees at corresponding levels. County level agribusiness firms are the lowest level with the smallest size and impact within this ranking system. These firms agree to develop production or marketing systems that include market access, technology, technical assistance, credit and other inputs for local farmers. The provincial government administration office provided access to a database containing the names and addresses of national and provincial agribusiness firms. The provincial government office helped send questionnaires to 116 firms in return for a small administrative fee. A total of 80 usable questionnaires were returned. During the same period, we conducted face-to-face interviews with an additional 36 municipal and county level agribusiness firms in Zhejang province for a total of 116 valid responses. Among the 116 surveyed firms, 100 reported they were involved in contract farming. The sample may not be representative of all agribusiness firms in China, since firms identified by the government are likely to be more successful than average. Table 1 summarizes data obtained from the 100 firms involved in contract farming. The majority of the firms, 70% of the firms are privately owned and only 6% are state owned. Approximately 29% of the firms were involved in vegetable processing, and 14% of the firms were involved in food oil processing. Aquaculture and meat processing firms made up the next highest category at 10% each. Most of the firms were active in the domestic market. About 33% of the firms were active in foreign markets. Experience with contract farming varies across firms. Out of the total, 65% have experience in contracting for more than 3 years, 31% between 1 and 3 years and only 4% reported less than 1 year of experience. Methods In order to examine the relationships between contract provisions and smallholders’ contract fulfillment rate, we estimated a binominal logit model using a maximum likelihood estimator, (MLE). The dependent variable is the smallholders’ contract fulfillment rate (CE). The independent variables are contract provisions (CT, CF, CP, CD, CS, CB). The estimating equation is defined as:
PrðCEi ¼ 1Þ ¼ f ðpi Þ ¼
expðb0 xi Þ 1 þ expðb0 xi Þ
ð2Þ
where f(pi) is the probability of satisfactory performance and xi represents the hypothesized explanatory variables. The individual likelihood for observation i becomes:
Data and methods
pðCEi Þ ¼ f ðpi ÞCEi ½1 f ðpi Þð1CEi Þ
Data
Further assuming independence across individuals we are able to obtain the likelihood function for all observations:
Agribusiness data from Zhejiang province were collected in three phases over the period February to August 2004. First, exploratory interviews were undertaken with some agribusiness
L¼
n Y i¼1
PðCEi Þ ¼
n Y i¼1
f ðPi ÞCEi ½1 f ðPi Þð1CEi Þ
ð3Þ
ð4Þ
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Table 1 Summary of survey data
Table 3 Estimated logit coefficients: contract arrangement and enforcement
Category
Percent
Ownership of firms Privately owned Collectively-owned State-owned Joint-venture Other
70.0 3.0 6.0 10.0 11.0
Rank of firm National Provincial Municipal County
9.0 66.0 16.0 9.0
Main activities of firms Vegetable processing Meat processing Food oil processing Fruit processing Aquaculture processing Diary processing Tea processing Silk processing Edible mushroom processing Bee honey processing Others
29.0 10.0 14.0 3.0 14.0 3.0 9.0 2.0 4.0 2.0 10.0
Product target market Domestic Foreign
67.00 37.00
Experience with Contract farming (years) Less than 1 year 1–2 years Over 3 years
4.0 31.0 65.0
We used SPSS 11.5 software to estimate the binominal logit regression using backward selection. Table 2 provides description of variables along with sample means. Results and discussion Table 3 presents the results of the binominal logit model. The regression results show contract organizational model, CT, has no significant impact on the smallholders’ contract fulfillment rate. In addition the variable CF shows a significant positive rather than the expected negative impact on the smallholders’ contract fulfillment rate in all model specifications at the 1% level. Both results seem contrary to the stated hypothesis. The reason might lie with the fact that social capital plays an important role in contract enforcement in China. Social capital can help economize on trans-
Dependent variable P(CE = 1) Constant CT: Firm + smallholder CF: Oral contract CP: Floor pricing CD: Length of contract CS: Specific investment CB: Bonus 2 Log likelihood Cox and Snell R square Nagelkerke R square Sample size ***
Model 1 ***
5.917 1.167 5.134*** 3.688*** 0.334 4.360*** 3.346*** 46.678 0.513 0.738 100
Model 2 ***
Model 3
5.072 1.065 4.778*** 3.454***
5.487***
4.223*** 3.365*** 47.476 0.509 0.733 100
4.217*** 3.211*** 49.402 0.499 0.719 100
4.519*** 3.408***
Significant at 1% level (p < 0.01).
action costs by speeding up search, increase trust and facilitating the flow of information (Fafchamps and Minten, 2001; Knack and Keefer, 1997). The firm level survey reveals that 100% of the ‘‘Firm + Smallholder” have written contracts with smallholders, but only about 85.7% of the ‘‘Firm + Cooperative + Smallholder” and ‘‘Firm + Middleman + Smallholder” have written contracts. Oral contracts tend to be used by the cooperatives and middleman. Because most of the cooperatives are organized by the smallholders themselves, underwriting and enforcement may rely on the network and norms of smallholders. This smallholders’ network, based on family ties provides both information about smallholders’ reliability and serves as a means of sanctioning smallholders who renege or default on contracts. Most of the middleman in China live in rural areas, and belong to the same rural social networks as smallholders, and are able to assess smallholders’ reliability. The variable CP is significantly positive at the 1% level in all specifications. This result supports the theoretical hypothesis about floor pricing. When price flooring is used, smallholders are more likely to fulfill the contract. The variable CD shows no significant negative impact on the smallholders’ contract fulfillment rate. This result does not support theoretical hypothesis about length of contract. The variable CS, shows a significant (1% level) positive relationship in all model specifications. This result supports the stated hypothesis that requiring specific investments as a contract provision improves the contract fulfillment rate. The variable, CB, also shows a significant positive impact on the likelihood of a contract fulfillment. This clearly supports the stated theoretical hypothesis that a bonus clause will improve smallholders’ contract fulfillment rate. Conclusions The aim of the paper is to identify contract arrangements that influence smallholders’ contract fulfillment rate. The most important result from this study is that contract performance or fulfill-
Table 2 Definition and descriptive statistics of variables Variable
Unit
Description
Sample means
Dependent variable CE: Contract fulfillment rate
Binary
If agribusiness firm states that the smallholder contract fulfillment rate exceeded 75% = 1, else = 0
0.72
Independent variables CT: Firm + smallholder CF: Oral contract CP: Floor pricing CD: Length of contract CS: Specific investment CB: Bonus
Binary Binary Binary Ordinal Binary Binary
If If If If If If
0.72 0.15 0.53 2.12 0.74 0.73
‘‘ Firm + smallholder” model is used = 1, else = 0 oral contract is used = 1, else = 0 contract offers a floor price = 1, else = 0 length of the contract Less 1 year=1, 1–2 years = 2, 2–3 years = 3, over 3 years = 4 agribusiness firm required smallholder to make specific investments = 1, else = 0 agribusiness offers a bonus to smallholder who complies with the contract = 1, else = 0
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ment is significantly affected by the design of the contract. In China, mechanism design is an alternative to legal mechanisms. The combination of litigation costs, ineffective contract law, poor third party verifiability make formal means of enforcement costly or ineffective. The implication is that private contract enforcement is not just a transitory issue, but will likely continue to play an important role in China and in other transition economies, even as public institutions become more effective (Gow and Swinnen, 2001). The role of private contract enforcement mechanisms in improving smallholders’ contract fulfillment rate depends on introducing innovations in contract design with smallholders. Contract provisions such as floor pricing, specific investment requirements and bonuses among others will reduce the likelihood of contract default by smallholders. A number of shortcomings remain with our research. In this study, we only have had access to information about contract default by smallholders – not by agribusinesses. Our study is limited to identifying factors that influence smallholder’s decisions to breach or fulfill contracts. In fact, there are many other factors such as the structure of the market and level of competition that will affect the smallholders’ contract performance. These factors should be taken into account in future empirical research. References Beckmann, V., Boger, S., 2004. Courts and contract enforcement in transition agriculture: theory and evidence from Poland. Agricultural Economics 31, 251– 263. Bogetoft, P., Olesen, H.B., 2002. Ten rules of thumb in contract design: lessons from Danish agriculture. European Review of Agricultural Economics 29, 185– 204. Chen, J.B., 2004. The role of agribusiness firms in agricultural industrialization program in China. Rural Economic Literature 11, 31–45. Chow, G., 1997. Challenges of China’s economic system for economic theory. American Economic Review, Papers and Proceedings 87, 321–327. Ellickson, R.C., 1991. Order Without Law: How Neighbors Settle Disputes. Harvard University Press, Cambridge.
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Contractual arrangements and enforcement in transition agriculture: Theory and evidence from China Hongdong Guo a,*, Robert W. Jolly b a b
Center for Agricultural and Rural Development, Zhejiang University, Hangzhou, Zhejiang Province 310029, PR China Department of Economics, Iowa State University, Ames, IA 50011, USA
a r t i c l e
i n f o
Article history: Received 14 April 2006 Received in revised form 8 April 2008 Accepted 30 April 2008
Keywords: Contract enforcement Transition agriculture China
a b s t r a c t This paper empirically investigates the relationship between contractual arrangements and their enforcement in Chinese agriculture. Based on an analysis of a survey of 100 agribusiness firms engaged in contract farming in Zhejiang province of China, we find that private contract enforcement mechanisms play an important role in influencing smallholders’ decisions to breach or fulfill contracts. Contract arrangements such as floor pricing, or requiring smallholders to make specific investments facilitate self-enforcement and significantly improve the smallholder’s contract fulfillment rate. This is particularly important in Chinese agriculture since the business environment is characterized by an absence of effective public enforcement institutions. Crown Copyright Ó 2008 Published by Elsevier Ltd. All rights reserved.
Introduction The enforcement of contracts has long been recognized as an important pre-condition for efficient exchange and investment in market-guided economies in general and the agri-food sector in particular (Gow et al., 2000). Contracts can be enforced through a variety of public and private mechanisms, either separately or in combination. In developing countries and most significantly in transition economies such as China, public institutions such as the legal system are either absent or ineffective in ensuring contract enforcement. Under such conditions, private enforcement mechanisms may provide a suitable replacement for weak or missing public enforcement institutions (Greif and Kandel, 1995; Wooddruff, 1998; McMillan and Woodruff, 1999; Johnson et al., 2002; Gow et al., 2000; Gow and Swinnen, 2001; Beckmann and Boger, 2004; Tao and Zhu, 2001). Transitional economies typically do not have an effective legal system for contract enforcement. Given the ineffectiveness of public enforcement, one should expect that contracting parties would not rely on formal contracts, and if they do sign formal contracts, they would not rely on third parties for enforcement. China is no exception. In fact, the formal contract law of the PR China did not come into force until July 1, 1982, almost four years after the start of the economic reform in 1978. The law quickly became outdated. It was not until 1993 that the National People’s Congress passed a revision of the old contract law. However, the revised con-
* Corresponding author. Tel.: +86 571 86971756; fax: +86 571 86971646. E-mail address: [email protected] (H. Guo).
tract law still could not catch up with the ever-changing economic reality. In 1998, a unified, comprehensive draft contract law with more than 400 articles was put before the Congress’ legal affairs committee for study. It was eventually passed in March 1999 and took effect in October that year. The more serious shortcoming with China’s legal system, however, is not the lack of good laws but the lack of law enforcement. Administrative intervention, corruption, incompetence, shortage of professionals, and poor incentives have all hampered enforcement (Tao and Zhu, 2001). Despite the weakness of its legal system, contract farming in China has been able to sustain an impressive rate of growth over the past 15 years. As a component in the agricultural industrialization program in China since 1990, contract farming has been supported by the Chinese government in an effort to make agricultural production more profitable and competitive. The most recent data available shows the number of agribusiness firms involved in contract farming increased almost five times between 1996 and 2002 from 8377 to 46,060. The number of smallholders who signed contracts with firms is almost 72,650,000 in 2002. The proportion of total smallholders involved in contract farming went up correspondingly, from 10% to 30% between 1996 and 2002 (Niu, 2006). Two organizational models are used by agribusiness firms involved in contract farming. One is a centralized model in which a single processor and/or packer contracts directly with a large number of smallholders. In China this model is referred to as ‘‘firm + smallholder”. The second broadly used model involves an agribusiness firm contracting with smallholders through an intermediary such as a farmer cooperative, middleman, or a village council for example. This contracting model is referred to as ‘‘firm + intermediary + smallholder” in China.
0306-9192/$ - see front matter Crown Copyright Ó 2008 Published by Elsevier Ltd. All rights reserved. doi:10.1016/j.foodpol.2008.04.003
H. Guo, R.W. Jolly / Food Policy 33 (2008) 570–575
This study focuses on contract farming in Zhejiang province. Zhejiang province is located along the southeast coast of China. In the 1980s, the ‘‘People’s Commune” system was dismantled and replaced by individual family farms based on the ‘‘Household Responsibility System” (HRS) in Zhejing province. The HRS encouraged smallholders’ creativity, investment and efficiency. Agricultural output has increased significantly since its adoption. With the increase in agricultural production, China shifted from shortage to relative surplus since the 1990s. The more market-oriented economy has resulted in higher value crops replacing grain or cereal crops in Zhejiang province. Grain crop sown area in Zhejiang province was 1454.53 thousand hectare in 2004, down 57.5% compared with 1980. The area of vegetables was 661 thousand hectares in 2004, an increase of 5.11 times compared with 1980. The area share of cash crops increased from 26% of total sown acreage in 1980 to 48% in 2004. With changes in agricultural commercialization and market conditions, marketing of surplus agricultural products has become a more important task for the smallholders. Farm size is small and continues to decrease. From 1985 to 2004, the total number of rural households increased by nearly 33.8%, while total cultivated area decreased by 11.3%. The average area cultivated by each rural household in 2004 was 0.133 hectares, down 33.2% compared with 1985 (Zhejiang Statistical Yearbook, 2005). Moreover, smallholders are not well integrated into markets or with each other. Since the mid-1980s, the government has adopted many policies to help smallholders to access the market. One of the most important policies undertaken was to foster vertical coordination among stages in the supply chain to help the smallholders gain access to the market. Contract arrangements between smallholders and processing or distribution firms are the main types of vertical coordination in Zhejiang province. In the late 1990s, especially after China’s entry into WTO, the development of contract farming is remarkably accelerated. In our 2004 survey of agribusiness firms in Zhejiang province, China, 72% of agribusiness firms engaged in contract farming reported that more than 75% of the smallholders with whom they contracted fulfilled or met the provisions of their contracts – a surprisingly high performance level (Guo et al., 2007). Reasons for contract failure reported by responding firms included unacceptable delivery quality and contractees selling products to other parties for a higher price. The surveyed firms reported that resolution of contract disputes was difficult. As many as 53% of the firms report that there was no way to resolve conflicts. Legal action was pursued by only 7% of contracting firms. Another 7% reported that they rely on local government to resolve disputes. Generally speaking, the legal mechanism appears to be less important in improving contract performance than informal approaches. China’s success with contract farming in the absence of effective formal contract enforcement mechanisms appears to contradict well-accepted doctrine (Chow, 1997). This paper attempts to explain why the default rate on contracts with the smallholders appears to be relatively low in China despite the inefficiencies of its legal system. Because we only have access to information about contract breach by smallholders, this paper’s main objective is to identify contract arrangements that influence smallholder’s decisions to breach or fulfill contracts. This paper draws on Beckmann and Boger (2004), but extends the work to a game theoretic setting. The paper is organized as follows: The literature on contract performance is reviewed in the Literature Review. In Conceptual Framework, we develop a simple contract enforcement model to specify testable hypotheses about the relationship between contract arrangements and the smallholders’ contract fulfillment rate. In Data and Methods, we describe the survey and the data. In Result and Discussion, we present our results and discussion. Finally, we offer conclusion.
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Literature review The design, acceptance and adherence to a contractual arrangement is a multi-criterion decision problem. Bogetoft and Olesen (2002) identify three main objectives for a contract. First, a contract aims to ensure that the right products are produced at the right time and place. Second, a contract ensures that the parties have individual incentives to make coordinated decisions. Third, a contract attempts to ensure that coordination and motivation incentives are provided at the lowest possible cost. There are many specific means and instruments in the contract arrangement to realize these objectives. In practice, contracts vary significantly in terms of type, form and specifications. For example, a contract can be informal (oral) or formal (written). With an informal contract the provisions and incentives reflect the norms that have been established by repeated interaction between parties or within society. Even formal contracts are naturally incomplete. Contracting parties will find it difficult and expensive to foresee all possible contingencies and to enforce these contracts, especially when outcomes are unobservable or non-verifiable by a third party (Hart, 1995). Because even formal contracts are incomplete both parties expose themselves to ex post costs related to performance and enforcement. The economic literature on contract enforcement identifies two mechanisms to reduce the likelihood of a holdup – public (legal) enforcement and private enforcement (self-enforcement). Public (legal) enforcement means that agreements and contracts can be effectively and almost costlessly enforced within the legal system. Private self-enforcement implicitly or explicitly means that contracts between two parties can be enforced by private sanctions not by courts (Telser, 1980; Klein and Leffler, 1981; Klein, 1996). Private sanctions include the losses that result from termination or non-renewal of the contract or relationships and the damage of the reputation in business or social networks (Ellickson, 1991, 1994). In particular, Williamson (1979, 1985, 1991, and 1996) emphasized that specific investments, which create valuable relationships, make both court and self-enforcement costly. Traditional contract theory usually considers court enforcement and private enforcement as alternatives. Klein (1996) emphasizes fundamental complementarities between court enforcement and private enforcement. In fact, empirical evidence shows that legal enforcement is often possible, but obviously costly. This is particularly true in many transition countries, where the legal and judicial system is in an embryonic stage of development and court decisions may be highly uncertain and non-transparent. Recent experience in post-communist countries offers new evidence on the relative importance of courts and relationships in enforcing contracts. A pervasive belief in the effectiveness of the courts may have a significant positive impact on the level of trust shown in new relationships between firms and their customers (Johnson et al., 2002). It is sometimes not viable to use legal dispute mechanisms due to litigation costs, ineffective contract law, or poor third party verifiability (Gow et al., 2000). Where contract law is inadequate, informal social and economic relationships can substitute for the courts (McMillan and Woodruff, 1999). Therefore, when two agents choose an enforcement mechanism, they must first consider the cost and benefits resulting from contract breach including the magnitude of damages and the enforceability of claims resulting from contract breach (Beckmann and Boger 2004). Conceptual framework The contracting process begins with the smallholder and the agribusiness agreeing on a set of duties and conditions – quantity delivered quality, paying price, discounts, delivery time and the like. At the time of delivery or contract fulfillment, market prices,
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yields, product quality, production costs, and other factors are known, asymmetrically in many cases, to the contracting parties. Contract default or breach may be initiated by either party. The determining factor influencing default will be whether or not the long run benefits outweigh the costs (Gow et al., 2000). Since most contract defaults in China appear to be associated with price or quality issues (Chen, 2004), the default process can be modelled as a simple sequential game in which the agribusiness and the smallholders have the option to fulfill or breach the contract. If the contract is breached by either party, the other party can choose to accept the default, self-enforce or take legal action. Consider the following simplified game following, Beckmann and Boger (2004) in which market price at the time of delivery is the only factor that would result in breach. In other words, we ignore the possibility of default due to inadequate yields, quality or other factors that may induce opportunistic behavior. Further, we limit attention to contract default by smallholders, not the contracting firm. When the agribusiness firm buys the product from the smallholders according to the signed contract, the actual market price, P, may deviate from the contracted price Pfixed. If P P Pfixed, then the contract provides unanticipated rents to the agribusiness firm and the benefits of contract breach increase for the smallholder since they could get a higher price by selling the product on the market. The smallholder’s benefits of contract breach depend on the wedge between the actual market price and the contracted price times the contracted quantity Q. The cost to the smallholder of breaching the contract is determined by different enforcement mechanisms. When the smallholder breaches the contract, the agribusiness firm can apply two enforcement mechanisms: (1) self-enforcement (termination), and (2) court enforcement. Each enforcement will result in different default cost for the smallholder. Under self-enforcement if the smallholder breaches the contract, then the agribusiness firm will accept the default and the financial loss. Let’s assume that the agribusiness firm will not trade with a smallholder over some period of time. The default cost to the smallholder includes both the value of losses that result from termination or non-renewal of the contract or relationship and the damage of the smallholder’s reputation in local business or social networks. We can represent these default costs as Pn i W h ¼ i whi =ð1 þ dÞ , where whi is the value of smallholder losses in the future i year, for the period, n, over which the agribusiness will not do business with the smallholder and d is the discount rate. Note in this specification, that the default costs are implicitly a function of contract size or value. Under a court enforcement mechanism, if the smallholder breaches the contract, the agribusiness firm would immediately take legal action to force the smallholder to compensate for agribusiness firm losses resulting from contract breach. The smallholder costs depend on the value of compensation D for agribusiness firm losses resulting from contract breach and the probability q that the courts will adequately determine the magnitude of damages and enforce the claim resulting from contract breach. Again, both D and q are functions of contract size. The probability q that the smallholder is forced to pay compensation for losses resulting from contract breach is determined the cost of contract enforcement for the agribusiness firm and the adequacy of the legal system. The costs of contract enforcement are time, effort and money that must be spent to take legal action (Beckmann and Boger, 2004). These are affected by: (1) efficiency of the legal system, (2) contract provisions and design, and (3) characteristics of the firm or smallholder. Following the above discussion, we can specify the smallholder’s contract enforcement strategy. If P P Pfixed, the smallholder will weigh the costs and benefits of contract breach. The smallholder will breach the contract only when the benefits
Q(P Pfixed) are greater than the costs (Wh + qD). The decision rule for the smallholder would be to default if Q ðP P fixed Þ P W h þ qD. On the other hand, if P 6 Pfixed, then the dominant strategy for smallholder is to fulfill the contract. This decision rule would hold independently of the type of contractual arrangement – direct with the smallholder or indirect through an intermediary. From the above discussion, we can infer that the value of q, Wh, D, Q and the wedge between the actual market price P and the contracted price Pfixed will affect smallholders’ contract fulfillment rate. Given the state of the legal system and market conditions these values are determined by contract provisions, such as contract form, contract type, or contracted price. To analyze the relationship between contract arrangement and smallholders’ contract fulfillment rate, a straightforward reduced form model was developed. The smallholders’ contract fulfillment rate was regressed against various characteristics of contract arrangements that are believed to influence smallholders’ contract fulfillment rate. Eq. (1) represents this reduced form equation,
CEi ¼ FðCT i ; CF i ; CPi ; CDi ; CSi ; CBi ; bÞ þ ei
ð1Þ
The dependent variable, CE measures the level of smallholders contract fulfillment experienced by the contracting firms and the independent variables CT, CF, CP, CD, CS, CB measure the impact of contract provisions on smallholders’ contract fulfillment rate. The variables are defined as follows: The dependent variable, CE, is binary and is derived from contracting firms’ response to a survey question. The firms were asked to select the level of smallholder contract fulfillment that most closely represents their recent experience. The choices were:
less than 25%; between 25% and 50%; between 50% and 75%; greater than 75%.
Note that the question addresses smallholder fulfillment rates, not contract fulfillment. If the firm contracts directly with farmers, then the interpretation of this question is straightforward. On the other hand, if the firm contracts through an intermediary, the firm would know how many smallholders had been contracted through the intermediary. Therefore, the firm’s ability to assess contract performance is independent of the contracting arrangements. In our specification, satisfactory contract performance is measured by a smallholder fulfillment rate greater than 75% smallholders. Variable CT is defined as the organizational model used between agribusiness firms and smallholders. CT is binary and takes on the value of the 1 if the ‘‘firm + smallholder model” is used and 0 if an intermediary model is employed. In China the smallholders are numerous, dispersed and small scale. The legal system is inefficient and most of the agricultural product markets are competitive auction markets. If the agribusiness firms sign contracts directly with smallholders then enforcement can be very costly when smallholders breach the contract. The cost of court enforcement for the agribusiness firms is very high, the value of the compensation D for losses of breach contract and the possibility q of acquiring indemnification for losses from the smallholders could be very low. In this case, the value Wh of smallholder losses that result from termination is not particularly high. In contrast, if an intermediary contracting model is used, the costs of underwriting, monitoring and enforcing the contract would be borne by the intermediary. We hypothesize that if an agribusiness firm signs a contract with smallholders directly, the contract is more likely to be breached by the smallholders due to higher enforcement costs. The variable CF measures the form of contract – oral or written between the agribusiness firm and the smallholder. The existing literature suggests that agribusiness firms will experience lower
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levels of contract fulfillment with oral compared to written contracts. The written contract is explicit and closely details the conditions and obligations of each party. An oral contract, in contrast, may leave the responsibilities of both parties and the delivery specifications open to interpretation. Confusion and misunderstanding can easily occur, if the agreements are not stated and agreed to by the agribusiness and the smallholders. If a smallholder has an oral contract it can be very difficult for the court to determine a responsibility for the default. As Lyons (1996, p. 27) states: ‘‘the arrangement need not be written, but it is obviously difficult to enforce, it if it is not written or witnessed by a third party”. CF is binary and takes on a value of 1 if the contract is oral. We hypothesize if an agribusiness firm completes an oral contract with smallholders, the contract is more likely to be breached. The variable CP measures the pricing model specified in the contract. CP is binary and takes on the value 1, if a floor pricing provision is stated in the contract and 0 otherwise. Relative to other pricing models, CP is expected to increase smallholders’ contract fulfillment. From the conceptual model, we know that the gap between the contracted price and the actual market price will affect the smallholders’ contract fulfillment rate. A floor price provision offers smallholders a minimum price at the beginning of each season. If the local market price is higher than the minimum price, the agribusiness will use the market price. If the market price is lower than the minimum price, the agribusiness will use the minimum price. Such an arrangement provides income guarantees for smallholders. Because the agribusiness has higher risk tolerance than does the smallholder, it is more able to accept the risk of market price fluctuations. Relative to other pricing methods, we hypothesize rates of contract breach will be reduced with floor pricing. Variable CD is defined as the length of the contract between the agribusiness firm and smallholder. CD is expected to be positively related to higher levels of contract fulfillment. As our model suggests smallholders will compare the short term gains they can achieve by defaulting on the contract with the discounted expected future profit stream, Wh, that they will lose from termination or non-renewal of the contract or relationship and the damage of the smallholder’s reputation in business or social networks. The value Wh of losses is affected by the contract length, as well as, duration of the contracting relationship. The longer the duration of contract, the greater the losses from default. We hypothesize CD will be positively related to contract fulfillment. Finally, the variable CS measures the level of smallholders’ specific investment required by the agribusiness firm. CS is expected to be positively related to contract fulfillment. If the agribusiness firm requires the smallholder to make a specific investment in a production facility, such as a new chicken house that meets the exact specifications of the processor, the smallholder will be more likely to fulfill the contract. If the smallholder breaches the contract, their specific investments will have less value outside the relationship. From the theoretical model, the value Wh will increase and make default more costly to the smallholders. Contract fulfillment levels will consequently increase. The variable CB takes on the value of 1 if a bonus clause is included in the contract. CB is expected to encourage higher levels of contract fulfillment. If the agribusiness firm offers a bonus to the smallholders who perform well on the contract, the value Wh will increase and discourage contract default.
firm managers, government officials and smallholders to understand fully the context in which contract farming operated. Second, a questionnaire was designed to obtain information from agribusiness on contract arrangements and the smallholders’ contract fulfillment. Third, we created a list of agribusinesses believed to be engaged in contract farming. In China, most agribusiness firms are classified into four categories based on their economic strength, operational scale, level of technology, management and their potential to improve farm incomes. The categories national, provincial, municipal and county reflect the scope of the firm’s economy impact. For example, a national agribusiness firm must meet the scale and management criteria drafted by the National Agricultural Industrialization Development Joint Committee. Other rankings are specified by committees at corresponding levels. County level agribusiness firms are the lowest level with the smallest size and impact within this ranking system. These firms agree to develop production or marketing systems that include market access, technology, technical assistance, credit and other inputs for local farmers. The provincial government administration office provided access to a database containing the names and addresses of national and provincial agribusiness firms. The provincial government office helped send questionnaires to 116 firms in return for a small administrative fee. A total of 80 usable questionnaires were returned. During the same period, we conducted face-to-face interviews with an additional 36 municipal and county level agribusiness firms in Zhejang province for a total of 116 valid responses. Among the 116 surveyed firms, 100 reported they were involved in contract farming. The sample may not be representative of all agribusiness firms in China, since firms identified by the government are likely to be more successful than average. Table 1 summarizes data obtained from the 100 firms involved in contract farming. The majority of the firms, 70% of the firms are privately owned and only 6% are state owned. Approximately 29% of the firms were involved in vegetable processing, and 14% of the firms were involved in food oil processing. Aquaculture and meat processing firms made up the next highest category at 10% each. Most of the firms were active in the domestic market. About 33% of the firms were active in foreign markets. Experience with contract farming varies across firms. Out of the total, 65% have experience in contracting for more than 3 years, 31% between 1 and 3 years and only 4% reported less than 1 year of experience. Methods In order to examine the relationships between contract provisions and smallholders’ contract fulfillment rate, we estimated a binominal logit model using a maximum likelihood estimator, (MLE). The dependent variable is the smallholders’ contract fulfillment rate (CE). The independent variables are contract provisions (CT, CF, CP, CD, CS, CB). The estimating equation is defined as:
PrðCEi ¼ 1Þ ¼ f ðpi Þ ¼
expðb0 xi Þ 1 þ expðb0 xi Þ
ð2Þ
where f(pi) is the probability of satisfactory performance and xi represents the hypothesized explanatory variables. The individual likelihood for observation i becomes:
Data and methods
pðCEi Þ ¼ f ðpi ÞCEi ½1 f ðpi Þð1CEi Þ
Data
Further assuming independence across individuals we are able to obtain the likelihood function for all observations:
Agribusiness data from Zhejiang province were collected in three phases over the period February to August 2004. First, exploratory interviews were undertaken with some agribusiness
L¼
n Y i¼1
PðCEi Þ ¼
n Y i¼1
f ðPi ÞCEi ½1 f ðPi Þð1CEi Þ
ð3Þ
ð4Þ
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Table 1 Summary of survey data
Table 3 Estimated logit coefficients: contract arrangement and enforcement
Category
Percent
Ownership of firms Privately owned Collectively-owned State-owned Joint-venture Other
70.0 3.0 6.0 10.0 11.0
Rank of firm National Provincial Municipal County
9.0 66.0 16.0 9.0
Main activities of firms Vegetable processing Meat processing Food oil processing Fruit processing Aquaculture processing Diary processing Tea processing Silk processing Edible mushroom processing Bee honey processing Others
29.0 10.0 14.0 3.0 14.0 3.0 9.0 2.0 4.0 2.0 10.0
Product target market Domestic Foreign
67.00 37.00
Experience with Contract farming (years) Less than 1 year 1–2 years Over 3 years
4.0 31.0 65.0
We used SPSS 11.5 software to estimate the binominal logit regression using backward selection. Table 2 provides description of variables along with sample means. Results and discussion Table 3 presents the results of the binominal logit model. The regression results show contract organizational model, CT, has no significant impact on the smallholders’ contract fulfillment rate. In addition the variable CF shows a significant positive rather than the expected negative impact on the smallholders’ contract fulfillment rate in all model specifications at the 1% level. Both results seem contrary to the stated hypothesis. The reason might lie with the fact that social capital plays an important role in contract enforcement in China. Social capital can help economize on trans-
Dependent variable P(CE = 1) Constant CT: Firm + smallholder CF: Oral contract CP: Floor pricing CD: Length of contract CS: Specific investment CB: Bonus 2 Log likelihood Cox and Snell R square Nagelkerke R square Sample size ***
Model 1 ***
5.917 1.167 5.134*** 3.688*** 0.334 4.360*** 3.346*** 46.678 0.513 0.738 100
Model 2 ***
Model 3
5.072 1.065 4.778*** 3.454***
5.487***
4.223*** 3.365*** 47.476 0.509 0.733 100
4.217*** 3.211*** 49.402 0.499 0.719 100
4.519*** 3.408***
Significant at 1% level (p < 0.01).
action costs by speeding up search, increase trust and facilitating the flow of information (Fafchamps and Minten, 2001; Knack and Keefer, 1997). The firm level survey reveals that 100% of the ‘‘Firm + Smallholder” have written contracts with smallholders, but only about 85.7% of the ‘‘Firm + Cooperative + Smallholder” and ‘‘Firm + Middleman + Smallholder” have written contracts. Oral contracts tend to be used by the cooperatives and middleman. Because most of the cooperatives are organized by the smallholders themselves, underwriting and enforcement may rely on the network and norms of smallholders. This smallholders’ network, based on family ties provides both information about smallholders’ reliability and serves as a means of sanctioning smallholders who renege or default on contracts. Most of the middleman in China live in rural areas, and belong to the same rural social networks as smallholders, and are able to assess smallholders’ reliability. The variable CP is significantly positive at the 1% level in all specifications. This result supports the theoretical hypothesis about floor pricing. When price flooring is used, smallholders are more likely to fulfill the contract. The variable CD shows no significant negative impact on the smallholders’ contract fulfillment rate. This result does not support theoretical hypothesis about length of contract. The variable CS, shows a significant (1% level) positive relationship in all model specifications. This result supports the stated hypothesis that requiring specific investments as a contract provision improves the contract fulfillment rate. The variable, CB, also shows a significant positive impact on the likelihood of a contract fulfillment. This clearly supports the stated theoretical hypothesis that a bonus clause will improve smallholders’ contract fulfillment rate. Conclusions The aim of the paper is to identify contract arrangements that influence smallholders’ contract fulfillment rate. The most important result from this study is that contract performance or fulfill-
Table 2 Definition and descriptive statistics of variables Variable
Unit
Description
Sample means
Dependent variable CE: Contract fulfillment rate
Binary
If agribusiness firm states that the smallholder contract fulfillment rate exceeded 75% = 1, else = 0
0.72
Independent variables CT: Firm + smallholder CF: Oral contract CP: Floor pricing CD: Length of contract CS: Specific investment CB: Bonus
Binary Binary Binary Ordinal Binary Binary
If If If If If If
0.72 0.15 0.53 2.12 0.74 0.73
‘‘ Firm + smallholder” model is used = 1, else = 0 oral contract is used = 1, else = 0 contract offers a floor price = 1, else = 0 length of the contract Less 1 year=1, 1–2 years = 2, 2–3 years = 3, over 3 years = 4 agribusiness firm required smallholder to make specific investments = 1, else = 0 agribusiness offers a bonus to smallholder who complies with the contract = 1, else = 0
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