A Financial Contracting Approach to the Role of Supermarkets in Farmers' Credit Access
ABSTRACT Replaced with revised version of paper 10/17/08.
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ABSTRACT: This paper highlights the strategic role that private quality standards play in food supply chains. Considering two symmetric retailers that are exclusively supplied by a finite number of producers and endogenizing the producers' delivery choice, we show that there exist two asymmetric equilibria in the retailers' quality requirements. The asymmetry is driven by both the retailers' incentive to raise their buyer power and the retailers' competition for suppliers. We find that the use of private quality standards is detrimental to social welfare. A public minimum quality standard can remedy this unfavorable welfare outcome.04/2011;
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ABSTRACT: Standards are increasingly important in the global market system. Consumers rely progressively more on public standards (set by governments) as well as private standards (set by firms) to make their consumption decisions. Similarly producers rely heavily on standards to gear their production systems to one another and to increase transparency and traceability throughout the supply chain. Standards address a large variety of issues in consumption and production such as nutritional (e.g. low fat, vitamin-rich), safety (e.g. pesticide residues, small toy parts), quality (e.g. minimum size requirements, life span guarantees), environmental (e.g. low carbon dioxide emissions, waste management), and social concerns (e.g. no child labor, fair trade). While the above examples illustrate some of the potential benefits of standards, their implementation also entails costs and affects prices. The second chapter of this dissertation illustrates that standards may therefore have different positive or negative welfare impacts on different actors in the market. Additionally, standards may increase or decrease social welfare. These potentially different impacts on various groups in society have caused suspicion that standards may be captured by lobby groups to serve their individual interests instead of the public. Despite standards potential benefits, fears have arisen (a) that these public regulations may be used as strategic trade-protectionist tools to shelter domestic producers; (b) that private standards may be introduced by retailers as devices to extract rents from other agents in the supply chain; and (c) that certain (groups of) producers in developing countries may be excluded from these production systems governed by high standards and high quality. Each chapter in this dissertation addresses one of these concerns. To analyze the first concern that standards may serve as protectionist instruments, the third chapter develops a political economy model of public standards in which both consumers and producers try to influence the governments standard-setting behavior through lobbying. The model shows that public standards nearly always affect imports and can be either catalysts or barriers to trade, even if standards are optimal from a social welfare perspective. Hence a public standards impact on trade cannot be directly linked to protectionism since the change in imports may be optimal from a (domestic) social welfare perspective. Additionally, even if public standards deviate from the social optimum, this does not necessarily amount to producer protectionism as producers may be hurt by suboptimal public standards as well. Importantly, the model does not refute the possibility that public standards may serve protectionist intentions, but it nuances the argument that all standards are pure protectionism. Hence an important implication of this chapter is that one should be careful in categorizing standards as protectionist instruments or not, and that standards may be welfare optimal while negatively affectingtrade. Additionally, this model contributes to explaining the observed positive correlation between standards and development, and demonstrates that this relation not necessarily implies that protectionism through standards rises with development as well. The fourth chapter addresses the same concern of standards-as-protectionism but from a strategic and dynamic perspective. The chapter advances a dynamic political economy model of technology regulation in which two countries governments strategically decide which of two technologies to allow by setting a public standard. We show that a temporary difference in consumer preferences between those countries may trigger differences in initial technology regulations, and thus different investments by producers. Due to these technology-specific investments, producer interests in both countries shift in favor of maintaining the regulatory status quo which excludes foreign imports, although producers were initially indifferent towards the technology choice. Consequently, if governments are responsive to domestic producers pressures, regulatory differences may be long-lasting even if consumer preferences are identical between countries in the long run. Hence producer lobbying may create hysteresis in (differences in) technology regulation. These results fit well the differences in biotechnology regulation between the EU and the US, and illustrate that both consumer preferences and protectionist motives play a crucial role in explaining these differences. The main factor that causes producer lobbying and thus regulatory persistence is the cost related to switching between different technologies. If producers could adjust their production technology without losing profits to foreign producers, their incentives to lobby in favor of a regulatory status quo would disappear and hence the hysteresis in technology regulation as well. This holds the important policy implication that to overcome the status quo bias, adjustment costs need to be reduced. This would effectively reduce the capture of public standards and technology regulation by interest groups that aim at protecting their home markets from foreign imports. The fifth chapter tackles the second issue, namely that retailers may employ private standards to extract rents from other agents in the supply chain. The model shows that several factors may cause retailers to set their private standards at more stringent levels than public standards. Retailers are more likely to set relatively more stringent and rent-extracting private standards if (a) the rent transfer from the retailer to producers is smaller such that producers bear a larger share of the standards implementation cost; (b) the producers interest group has a larger political power when producers interests are opposite to those of the retailer; (c) the standard creates a smaller efficiency gain for consumers; and (d) the standard entails larger implementation costs for producers. We also show that retailers market power is crucial in this argument: if retailers have no market power, private standards are never set at higher levels than public standards. Hence when producers use their political power to obtain lower public standards, retailers may apply their market power to set higher private standards. In combination these factors may contribute to explaining why industry-wide private standards may be more stringent than their public counterparts. Importantly, the model also demonstrates that, in general, the optimal private standard differs from the socially optimal one. This sub-optimality generates additional profits for retailers at the expense of consumer and/or producer welfare. Therefore government intervention that regulates the use of private standards could be warranted. However, doubts might be cast on the optimality of government intervention in the domain of private standards because, as demonstrated in the third chapter, also politically optimal public standards may differ from their social optimum due to interest group lobbying. Finally, the sixth chapter addresses the issue that certain (groups of) producers may be excluded from a high-quality economy (HQE) and supply chains governed by high standards. The partial equilibrium model developed in the sixth chapter shows that the initial production structure (in terms of productivity heterogeneity) affects who is able to participate in the HQE and who is not. The most productive producers switch first to the HQE, and in countries with a more heterogeneous production structure this process is more likely to lead to an initial exclusion of producers, although the emergence of the HQE occurs faster in terms of rising incomes. In countries with a more uniform production structure, the emergence of the HQE, although delayed, can be expected to be more inclusive. We also demonstrate that, depending on their nature, transaction costs may or may not reinforce the disadvantaged position of less productive producers. Additionally, our model shows that contracting between producers and processors i.e. processors supplying credit to producers may induce the HQE to be more inclusive towards less efficient producers. The model thus lays out three different mechanisms by which a HQE can be made more inclusive towards different groups of producers, namely (a) by reducing heterogeneity in the initial production structure through raising productivity of the least productive producers; (b) by reducing transaction costs in general and especially those transaction costs that reinforce productivity disadvantages; and (c) by creating an institutional environment that is favorable to contracting between producers and processors or that facilitates producers access to credit.01/2011;
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ABSTRACT: This paper develops a formal theory of the endogenous process of the introduction of high quality production in developing countries. Initial differences in income and capital and transaction costs are shown to affect the emergence of and the size of the high quality economy. Initial differences in the production structure and the nature of transaction costs—as well as the possibility of contracting between producers and processors—are shown to determine which producers are included in the high quality economy, and which not.Review of Development Economics 01/2012; · 0.69 Impact Factor
A Financial Contracting Approach to the Role of Supermarkets in
Farmers’ Credit Access
Philippe Marcoul∗and Luc Veyssiere†
September 7, 2007
Over the last decade, supermarkets have spread to developing countries and have become major actors
in the food marketing system in these countries. Their involvement in farmer’s production is wellkown.
In this paper, we construct a simple financial contracting model to analyze this activity and especially
its impact on farmers’ credit access.
In our framework, the supermarket is modeled as a procurement organization, not only able to
advise contracting farmers on their production practices, but also to partly finance their activity; i.e. to
substitute for conventional lenders. We show that by bundling advising and moneylending activities the
supermarket reduces the agency cost incurred to insure proper incentives in the procurement process.
This reduction in agency costs can extend financing to smaller farmers who would otherwise remain
credit constrained. We also point out to reasons as to why supermarket sometimes prefer small farmers.
Finally, supermarkets usually set higher food standards. By examining the impact of the introduction
of higher food standards, the paper shows that the coexistence of the market for domestic retailers and
supermarket products may broaden the credit access of farmers.
Keywords: Financial Contracting, Development, Financial Intermediation, Food Standards, Organiza-
tion of Production, Supermarket
JEL classification: O17, O33, O50, Q12, Q13
∗Corresponding author: Philippe Marcoul, Department of Economics, Iowa State University, Ames, IA 50011-1070. Phone:
(515) 294-6311, Fax: (515) 294-0221; E-mail: firstname.lastname@example.org.
†Veyssiere Luc, Department of Economics, Iowa State University, Ames, IA 50011-1070. Phone: (515) 294-4611, Fax: (515)
294-0221; E-mail: email@example.com.
In the last two decades, we have witnessed an impressive development of supermarket chains in developing
countries. Saturation and intense competition in retail markets of developed countries, together with sub-
stantial margins offered by investing in developing markets, have largely contributed to the emergence of
supermarket chains.1In countries where a substantial portion of the population lives in rural areas, the rise
of supermarkets, that arguably affect the livelihood of farmers, is a sensitive issue. Although they represent
a source of investment in local economies, their real welfare impacts are hard to assess and remain contro-
versial. On the one hand, many empirical studies have found that supermarkets tend to leave behind or
exploit small growers, preferring to concentrate their procurement of fresh agricultural products on larger
scale operations (Dolan and Humphrey 2000; Dolan, Humphrey and Harris-Pascal 2001, Trail 2006).2On
the other hand, although many growers successfully work with supermarkets, it is not clear whether growers
who fail to enter a business relationship with them are worse off relative to the period preceding their entry.
In addition, other recent case studies have somewhat challenged the view that supermarkets have only a
negative impact on small growers. In particular, these studies show that in niche markets small growers per-
form remarkably well and remain an attractive supply source for supermarket chains (Boselie, Henson and
Weatherspoon 2003, Henson, Masakure and Boselie 2005 and Minten, Randrianarison and Swinnen 2007).
However, while arguments on both sides are compelling, it is somewhat difficult, in light of these (rather)
contradictory observations, to forge a clear understanding of the impact of supermarkets on grower activity.
The objective of this paper is to contribute to this debate by providing a theoretical framework to analyze
the impact that supermarkets have on growers’ credit access.
There exists an important descriptive literature on supermarkets in developing countries. This literature
describes and discusses what these retail chains are trying to accomplish and how they achieve their goals.
First, it must be noted that besides the growing (local) demand for fresh food products that they try to meet,
supermarkets or their affiliated grocers demand a substantially higher quality in the products they procure.
Thus, supermarkets not only need to sell more in local markets, but they need to offer safer and higher quality
products, as well. Therefore, the natural response of supermarkets has been to develop their own standards in
countries where public food quality standards are often inadequate and lack proper enforcement. However,
the quest for higher quality and safer food products cannot be achieved without innovative procurement
practices. These practices revolve around the creation of vertical relationships with growers through the
1For instance, Carrefour, a French-based supermarket chain, earned on average three times higher margins in its Argentine
operations than in those located France (Reardon et al., 2003).
2While the local demand for food is globally increasing, supermarket chains established in developing countries also export
a substantial portion of their production to developed countries (Dolan and Humphrey 2000). Thus, supermarket production
will only exclude a portion of the growers that remain uninvolved with the supermarket.
establishment of tighter procurement contracts. Although the specific form of the contractual relationship
between the grower and the supermarket can vary greatly depending on the context, there is arguably a
Typically, supermarkets require their growers to make a substantial up-front investment into their oper-
ations. This investment ranges from new equipment purchases to the establishment of quality control and
coordination systems. The literature analyzing supermarket procurement practices also reports that super-
markets are playing new roles in the production process. These roles essentially consist of a combination of
intense production monitoring and advising, sometimes using the support of public partners (Boselie, Henson
and Weatherspoon 2003). In practice, the advising is performed on the spot, when supermarket employees
visit producers and discuss with them problems encountered during the growing cycle. The typical advice
ranges from the proper way to apply fertilizers to the safe handling of pesticides. In addition, supermarkets
also take on a monitoring role that essentially protects their investment in the growers’ operations. Indeed,
the relationship between farmers and supermarkets features a strong moral hazard component. For instance,
to certify that product standards are met, but also that procured quantities are sufficient, supermarkets must
make sure growers follow specific procedures and do not cheat or misrepresent their efforts and/or actions.3
Finally, although supermarkets rarely provide cash credit to farmers, they extend loans in the form of
input advances that are reimbursed later when the crop is sold.4These input loans, which range from seeds
to fertilizers and pesticides, cover most of the necessary inputs and their amount can be substantial relative
to expected crop payments.5Supermarkets also attempt to absorb some of the growers’ risks related to
market conditions. This is usually achieved by committing to input and output prices prior to planting.
Such commitments arguably result in lower liquidity needs for growers and are, in that sense, equivalent
to additional loans. Overall, supermarkets’ objectives seem to ensure that the financial and production
risks faced by their grower base are sustainable and compatible with a long-term dedication to safe and
high-quality products (Henson, Masakure and Boselie 2005).
The organization of production by supermarkets, nevertheless, raises several questions. For instance, it
is not clear from a theoretical standpoint why supermarkets should provide such a bundle of services. It is
conceivable that advising services could be provided independently of input loans. Farmers could finance,
possibly using moneylending services, the purchase of the inputs necessary to carry over the production
Supermarkets would then purchase the crop, provided that it met a certain quality threshold.
3The most common form of cheating faced by supermarkets is one in which farmers sell part of their crop (for a higher
price) to other grocers or local markets and, therefore, do not deliver the quantity that was agreed upon (Gow and Swinnen
2001 and Minten, Randrianarison, and Swinnen 2007).
4Cash advances are, in fact, widespread in transition countries (Gow and Swinnen 2001).
5For instance, Boselie, Henson and Weatherspoon (2003) reports that it takes a number of plantings for producers to achieve
a net overall profit.
6In developing countries, credit loans extended by traditional moneylenders use growers’ crops as collateral. To make sure
The mere fact that such organization of production does not prevail in practice suggests that substantial
benefits exist in bundling these tasks. In particular, to the extent that supermarkets are keen to have a large
grower base, it is possible that this organization of production will allow more farmers to access credit. More
generally, we wonder how the emergence of supermarkets will modify credit access for small growers.
In this paper, we analyze the market for growers’ loans using a simple model of financial intermediation.
In our framework, growers need to make a financial investment before they can produce for the supermarket.
An organization in which supermarkets advise, extend a loan and monitor growers is preferred by the
supermarket. In other words, bundling these tasks in the financial contract results in an organization in
which motivation costs or agency rents are reduced. Allocating the two tasks to the supermarket implies
that, as a monitor, the value of a high quality crop is increased when the probability of success increases as
well; thus the supermarket also has an incentive to advise diligently. We show that rent contraction results
in more poor growers obtaining loans.
Our definition of the supermarket procurement process is very much similar to that of contract farming.
Production finance by contract farming usually involve technical advising and monitoring. As described
by Conning (2000), contract farming, apart from the advising part, is not different from traditional money
lending. In particular, it possesses all the informal aspects of moneylending. However, this type of lending
has become prevalent in many developing countries. For instance, Conning (2000) reports that, during the
last 20 years, that production finance has become dominant in Chile. Our multitask approach to this type of
contract can explain their relative superiority with respect to banking finance or traditional moneylending.
We also analyze the implications of our model for the grower’s effort. We show that the organization
of the production by the supermarket has some motivational consequences for growers. In particular, in
our framework, poorer farmers tend to exert higher levels of effort and consequently produce higher quality
products. Many recent empirical contributions tend to echoe our finding that smaller farmers maybe prefered
by supermarkets (Boselie, Henson and Weatherspoon 2003, Henson, Masakure and Boselie 2005 and Minten,
Randrianarison and Swinnen 2007).
Finally, we explore the implication of higher standards set by supermarkets on the final market. In this
variant of our model, loan access is endogenized and ultimately determined by the competitive outcome on
the final market. We show that stronger standards can benefit growers, as they obtain loans more often.
In what follows, we briefly present the existing literature on lending in developing countries that is relevant
to our work. We also relate our paper to the corporate finance literature on advising and venture capital.
that the grower repays his loan, the moneylenders closely monitor him during the crop cycle to make sure that he does not
secretly side-sell and then default on their loan by pretending to have a bad harvest (See Aleem 1990 and Hoff and Stiglitz
1998). Unlike the advising part, the monitoring exerted by the supermarket is very similar to that of traditional moneylending
(See Conning 2000 and Minten, Randrianarison and Swinnen 2007 for the case of supermarket monitoring.)
The model developed in the main section formalizes the basic idea of bundling advising and monitoring
tasks in the same financial contract. We then study growers’ incentives in this setup. Finally, we study how
standards affect competition in the final market, and thereby influence growers’ access to loans.
2 Relation to the literature
The literature on moneylending in developing countries starts from the premise that borrowers in developing
countries usually have weak balance sheets, and therefore have difficulty accessing financing. Most of the
contributions in this field describe mechanisms by which borrowers are able to commit to repay their loans.7
One of the main mechanisms to facilitate access to financing in the absence of adequate collateral is group
lending. In Beasley and Coate (1995), a lender extends a loan to a group of persons jointly responsible for
its repayment. Each borrower can be diligent and decide to repay his loan. When he or she is tempted
to default, the rest of the group will subject him to intense social pressure, so that shirking incentives are
weakened. Thus, this mechanism essentially makes use of the ability of the agents to monitor each other’s
actions (Barnerjee, Besley, and Guinnane 1994).
Group lending also uses the fact that members of the group are well-informed agents. Ghatak (1999)
shows that a group that is jointly liable can act as a screening device when agents have superior information
about each other’s project profitability.8
As investigated by Aleem (1990) and Hoff and Stiglitz (1998),
the informal lending activity in developing countries is usually performed by local agents who can easily
monitor borrowers. Hoff and Stiglitz (1998), especially emphasize the fact that the moneylending activity is
an informationally intensive activity characterized by monopolistic competition.
Similarly, our work assumes that supermarkets are especially well-informed local agents as, in practice,
they employ well-informed local agents to perform the monitoring activity.9In addition, the monitoring
activity of supermarket employees is very close in nature to that of moneylenders.10
7A comprehensive review of this literature is out of the scope of this paper and we only allude to key contributions. For a
good review of this literature, we refer the reader to Armendáriz de Aghion and Morduch (2005).
8Interestingly, without appealing to adverse selection, Armendariz de Aghion and Gollier (2000) show that group joint
liability also has the property of making cross pledging possible and therefore can enhance lending activity. The idea is to
mutualize risks in such a way that a person’s loan success can serve to repay another person’s loan failure.
9For instance, Minten, Randrianarison and Swinnen (2007) describe the organization of the procurement activity by retail
chains in Madagascar. They write (p. 11):
Every extension agent, the chef de culture, is responsible for about thirty farmers. To supervise these, (s)he
coordinates five or six extension assistants (assistant de culture) that live in the village itself. The chef de culture
has a permanent salary paid by the firm.
10Minten, Randrianarison and Swinnen (2007) also describes the frequency and the purpose of the monitoring (p 12):
During the cultivation period of the vegetables under contract, the contractor is visited on average more than
once (1.3 times) a week. This intensive monitoring is to ensure correct production management as well as to avoid