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Development Southern Africa Vol. 19, No. 4, October 2002
Linking agribusiness and
small-scale farmers in developing
countries: is there a new role for
contract farming?1
Johann Kirsten & Kurt Sartorius2
This article examines a new role for contract farming in developing countries in the light of the
industrialisation of agriculture and the globalisation of world markets. A theoretical rationale
for contracting in developing countries is developed on the basis of adopting new institutional
economic theory for the purpose of matching governance forms to market failure problems and
transaction character istics. The history of contract farming is reviewed, together with the
advantages and disadvantage s to the various players, for the purpose of developing a list of key
success factors, problems and some possible solutions.
1. INTRODUCTION
Efforts to develop the agricultural sector in developing countries are now taking place
against the background of major structural change in the world agricultural industry. In
many developed countries, agricultural production is changing from an industry
dominated by family-based, small-scale farms or rms to one of larger rms that are
more tightly aligned across the production and distribution value chain (Boehlje, 2000).
In addition, the trend of market-orientated reforms, following multilateral trade liberal-
isation and especially structural adjustment programmes in developing countries, has
led to the increased integration of world markets (Reardon & Barrett, 2000). This has
meant that farmers in the developing world are now, more than ever, linked to
consumers and corporations of the rich nations. Although most of the changes in
agricultural and food markets are taking place in developed countries, they have
far-reaching implications for agricultural development efforts in developing countries.
The changes in food and agricultural markets (the so-called industrialisation of
agriculture) have in uenced the need for higher levels of managed coordination. This
has resulted in the introduction of different forms of vertical integration and alliances,
which have become a dominant feature of agricultural supply chains. Allied to these
changes is a worldwide increase in consumer demand for differentiated agricultural
products that are relatively labour intensive (Rhodes, 1993; Royer, 1995; Pasour,
1998).
These consumer demands, combined with the reality that food safety issues are more
likely to be a concern in the case of fresh food products , have led to major concerns
1Research for this article was funded partly through a BP Agricultural Research Scholarship and
a Fullbright Scholarship awarded to the rst author.
2Respectively, Professor, Department of Agricultural Economics, Extension and Rural Develop-
ment, University of Pretoria, Pretoria, South Africa; and Senior Lecturer, Department of
Accountancy, University of Witwatersrand, Johannesburg, South Africa (as well as PhD student,
Department of Agricultural Economics, Extension and Rural Development, University of Pretoria,
Pretoria).
ISSN 0376-835X print/ISSN 1470-3637 online/02/040503-27 ÓDevelopment Bank of Southern Africa
DOI: 10.1080/037683502200001942 8
504 J Kirsten & K Sartorius
for developing countries. Fresh food products , which include fresh meat, seafood,
vegetables and fruits, account for half the value of total food and agricultural exports
from developing countrie s (Unneveher, 2000). The need to control for high perishabil-
ity and safe handling involves specialised production, packing techniques and refriger-
ated transport, all of which require large capital investments and also investment in
research, development and marketing, which small and medium-sized enterprises
cannot easily afford.
However, it is often only the well-endowed and skilled that have the ability to be part
of these coordinated marketing chains and alliances. There is, therefore, a danger that
the requirements, quality standards and food safety rules of the consumers and
corporations (supermarkets ) in the developed countries can act as effective barriers to
participation in the high-valu e chains by small exporters and, to some extent, small
producers. Only a small number of farmers in developing countries have the ability and
luxury to be part of these lucrative markets and for them the reward is substantial.
Recent studies of the managerial economics of industrialised agriculture have revealed
crucial new insights into the economic rationale for higher levels of managed coordi-
nation as a choice of governance structure. In conjunction with this, the history of
vertical coordination projects in developing countries has provided many lessons and
a reference framework against which future development can be evaluated. All of these
could pioneer a new approach to improve our understanding of problems of market
access facing farmers in developing countries. This new approach, based on the new
institutional economic theory, argues, among other things, that we now have economic
actors engaging in transactions rather than a large number of atomistic rms constitut-
ing a ‘market’.
There are serious concerns about the ability of small farms and also small agribusiness
rms to survive in the medium term under these changing circumstances. However,
there still remain opportunitie s for smaller rms and farms to exploit. This role could
relate to product differentiation linked to products from region of origin, or organic
products and other niche markets. The major route for continued survival would,
however, be through exploiting other factors. One such factor is a reliance on external
rather than internal economies of scale through networking or clustering and other
forms of alliances. This could be among small rms or through establishing links
between small rms or growers and larger enterprises that have already overcome the
major barriers to market entry. These links are usually formalised through some form
of contract similar to contract farming schemes implemented in the developing world.
Contract farming has over the years been considered as one system that has consider-
able potential for providing a way to integrate small-scale farmers in developing
countries into export and processing markets and into the modern economy. In Africa,
contract farming is believed to help farmers by providing new technology, ready
markets and secured inputs and prices. Further, contract farming offers a mechanism
that ensures self-sustained development (Glover, 1987; Weatherspoon et al, 2001).
Contract farming has also been a component of the most successful income-generating
projects for smallholders, as well as an important earner of foreign exchange in
developing countries. This is despite strong criticism that contract farming is just
another form of exploitation with limited equity impact, increasing socio-economic
differences and evidence of some unsuccessful schemes and problems for many
outgrowers exists (cf. Glover, 1987).
Linking agribusiness and small-scale farmers in developing countries 505
In this article we argue that the changing nature of world agriculture provides a new
set of reasons and objectives why contract farming could become an important
institution for empowering poor small-scale farmers in developing countries, as well as
a ‘vehicle’ for providing access to more lucrative markets. Other reasons for the
renewed attention to contract farming are related to the many economic reforms in
developing countries that have reduced public expenditur e on credit programmes, staple
crop price supports, input subsidies and government research and extension pro-
grammes (Key & Runsten, 1999).
The article starts by reviewing the changing nature of agriculture and why it has paved
the way for a ‘re-emergence’ of contract farming or contractual relations in developing
country agriculture. In the developed countries, contracts have almost become a
standard feature of agriculture. For a variety of reasons, as explained above, contract
farming is now once more a feature in developing countries. The article also highlights
the theoretical arguments for the introduction and growth of contract farming in
developing countries since the early 1960s, and brie y summarises the experience with
contract farming. In Section 5 we discuss the bene ts and disadvantages for the various
players of such contractual relations and, nally, the aspects of contractual relations
that would require attention to ensure the success of future ventures between agribusi-
ness (private or state sponsored) and smaller growers are discussed. The article ends
with some conclusions and recommendations.
2. INDUSTRIALISATIO N OF AGRICULTURE AND THE NEED FOR MORE
VERTICAL COORDINATION
This section describes how the forces of change, i.e. globalisation, agricultural market
reforms in developing countries plus the so-called ‘industrialisation’ of world agricul-
ture, pave the way for an increased use of contract farming as one form of institutional
organisation to bring about greater coordination in the agrifood supply chain. The
industrialisation of agriculture in developing countries is often shaped by a different set
of constraints and forces than those faced by the developed world, and as a result, one
can see a diversity of institutional arrangements emerging in developing countries,
different to those in developed countries. As a response to the industrialisation of
agriculture, contracting arrangements are increasingly coordinating modern agricultural
supply chains. The exact form of this governance structure, however, can vary widely
according to situation-speci c variables.
Accepting the diversity in the nature of the agricultural transformation process between
countries, the concept of agricultural industrialisation describes the signi cant struc-
tural changes in the food and bre system. It refers to the ‘increasing consolidation of
farms and vertical coordination (contracting and integration) among the stages of the
food and bre system’ (C-FARE, 1994: 1). It also implies larger-scale production units
linked to processors, distributors and retailers through formal or informal arrangements
(Boehlje & Doering, 2000). Although the term is a nomenclature for a whole range of
changes, two changes stand out (Drabenstott, 1995):
·A shift from food commodities to food products
·A shift from spot markets to more direct market channels, such as production
contracts
Boehlje (2000) argues that the most dramatic changes in agriculture are taking place
506 J Kirsten & K Sartorius
in terms of changes in the fundamental business proposition and the ways of doing
business:
·The development of differentiated products
·The implementation of biological manufacturing
·The formation of food supply chains
The increased industrialised nature of agriculture in both developed and developing
countries is largely the result of biological and information technologies (Schrader,
1986), economic growth, mechanisation, the increasing scale of organisation and the
modernisation of production, processing and distribution systems (Sofranko et al,
2000). Drabenstott (1995: 14) argues that there are two powerful forces driving this
process of industrialisation: a new consumer and a new producer. The new consumers
are a highly demanding sort, while the new producers are equipped with new
technology and management tools that enable them to engineer food from farm to table.
Although this sounds like an ideal situation, traditional markets do not handle these
circumstances well.
The new lifestyles of consumers in the wealthy countries of the north, shifting
demographics and a growing appreciation for the link between diet and health have
contributed to different eating patterns and in uenced the foods consumers in these
countries buy. The concern about food safety and the recent food scares also in uence
consumer behaviour heavily. The speci c needs of consumers have led to the
splintering of the mass food market into a large number of niche markets. As a result,
food companies have to market customised products , each aimed at a separate market
niche (cf. Boehlje, 2000; Drabenstott, 1995; Davis & Langham, 1995). This argument
also applies to developing countries as a result of increased urbanisation.
Present-day consumers are demanding much more than choice –they also want quality,
consistency and value. Much of agriculture therefore has to shift from a philosophy
from ‘here’s what we produce’ to a situation where farmers take note of what the
consumers want. New technology, which includes bio- and information technology,
makes it possible to ensure that agricultural and food products do have the character-
istics consumers want (Drabenstott, 1995; Boehlje, 2000).
Apart from the pressures from consumers and end-use markets, other major drivers of
and contributors to these changes in agriculture include the following:
·Increasing competition from global market participants
·Economies of size and scope in production and distribution
·Risk mitigation and management strategies of buyers and suppliers
·Strategic positioning and market power/control strategies of individual businesses
Increased levels of processing, improved productivity, new technology and market
forces have expanded the range of products (Von Braun & Kennedy, 1994; Royer,
1995) and food production has become an industrialised, capital-intensive business that
operates in a highly competitive and unpredictable global market, is relatively inelastic
and is faced with increased supply by competing countries (Huffman & Just, 1994;
Meliczek, 2000). The result of these forces is that the industry has evolved to optimise
ef ciency and minimise transaction costs, and this has resulted in fewer larger farms,
the concentration of farming, and specialisation (Schrader, 1986; Frank & Henderson,
1992; Rhodes, 1993; Ling & Liebrand, 1995; Pasour, 1998). Agriculture has therefore
seen a move away from open market productio n and has become increasingly vertically
Linking agribusiness and small-scale farmers in developing countries 507
coordinated with agribusiness in order to produce a greater range of high-quality
differentiated products (Babb, 1992; Sporleder, 1992; Royer, 1995; Peterson &
Wysocki, 1998; Pasour, 1998; Pritchett & Liu, 1998; Goodhue, 1999; Sofranko et al,
2000).
The need for increased coordination can also be attributed to the failure of traditional
(spot) agricultural markets to deal with this new scenario. Usually, bulk commodities
ow through commodity markets to food processors, which in turn market standardised
products to consumers. Consumers now demand tailored foods and to ensure that they
get them, food companies want more speci c farm products. In addition, food safety
is also a concern, especially regarding fresh food products, thus bringing about
increased scrutiny and regulation in developed countries. As a result, processors and
marketers have avoided traditional spot markets and have engaged in more direct
market channels such as market and production contracts, full ownership or vertical
integration.
Apart from the process of industrialisation, the increasing liberalisation in world
agricultural markets, as well as the range of domestic market reforms in developing
countries, has a non-desirable impact on small-scale producers worldwide. The liberal-
isation efforts, the harmonisation of standards and the encouragemen t of foreign direct
investment might make it very dif cult for small-scale producers to participate in new
marketing opportunities presented under the reforms (Stanton, 2000). This stems from
the typical problems of limited access to capital and technical assistance, and compet-
itive buyers. Domestic market reforms in developing countries have boosted agricul-
tural exports in general and provided opportunitie s for global and regional companies
to invest in agribusiness in these countries. The rapid increase in multinational rms in
the agri-food sectors has also led to increased concentration in the downstrea m
enterprises in the agri-food chain and contributed to signi cant changes in the
organisation of the agri-food system.
The process of industrialisation has created opportunities for smallholders in develop-
ing countries to produce horticultural commodities under contract according to certain
speci cs (Kandiwa, 1999), but has the danger that small farmers will be marginalised
and excluded from high-value markets (Reardon & Barrett, 2000). The challenge is
therefore to prevent this from happening and to nd ways to link small growers in
developing countries to these high-value markets. The question remains whether an
arrangement such as contract farming provides the solution to this challenge. This
article suggests that contracting, modi ed to suit country-speci c conditions, can be
used as a vehicle to overcome transaction cost barriers, technology, competition, low
prices, the inelasticity of demand and the inherent instability of agriculture, as
suggested by Bonnen & Schweikhardt (1998). The danger exists that the intrinsic
monopsonistic nature of large agribusiness (often multinationals) could result in the
total marginalisation of many farming communities if the introduction of this ‘new
agriculture’ and relationships in developing areas are not well managed.
3. THE EARLIER EXPERIENCE WITH CONTRACT FARMING
Contract farming, as an institution in agriculture, has a long history. Various forms of
this institutional arrangement were employed by United States multinationals in Central
America at the beginning of the 20th century, and by the Japanese to secure sugar
production in Taiwan from 1885 (Runsten & Key, 1996; Rehber, 1998). In the period
508 J Kirsten & K Sartorius
1930–50, contracting was used increasingly in many food and bre sectors. The fruit
and vegetable canning sectors expanded in the United States and Europe (Little &
Watts, 1994; Clapp, 1994) and merchants in Europe and North America entered into
seed production contracts with growers in Australia, Britain, Canada, France, Holland,
Hungary and the United States (Watts, 1994). From the late 1950s, Mexican growers
increasingly supplied the American markets with fruit and vegetables under contract
(Watts, 1994), and in the period 1960–80 there was a signi cant increase in contracting
for vegetables, fruit, nuts and seed crops (Kilmer, 1986). By the late 20th century,
contract farming was widespread across Western Europe, the United States and Japan
(Rehber, 1998). Contract farming is now a common organisational structure in many
developed countries.
Contract farming has also spread rapidly in Asia, Latin America and Africa owing to
the higher returns earned by high-value export crops and the impact of new technolo-
gies (Clapp, 1994; Eicher & Staatz, 1998). Contract farming in Latin America has been
extensively promoted since 1945 in a series of import substitution programmes, and has
a much longer history than in Africa (Clapp, 1994; Little & Watts, 1994; Daddieh,
1994; Runsten & Key, 1996). In the period 1930–50, contracting expanded in the fruit
and vegetable canning sectors of colonial Africa (Little & Watts, 1994) and was
followed by a rapid increase in the period 1975–85, with some 60 schemes operating
in 16 countries (Carney, 1988; Watts, 1994; Little, 1994; Eicher & Staatz, 1998). South
Africa has a long history of farming under contract, which includes a wide range of
sharecropping arrangements dating back to the early 20th century (Bundy, 1979).
Vertical coordination arrangements currently exist in the tea, fruit, sugar, ower,
cotton, vegetable, timber, shing and tobacco sectors (Levin, 1988; Porter & Phillips-
Howard, 1997; Van Rooyen, 1999; Karaan, 1999).
Contract farming often involves a great number of variations and multiple objectives,
which include welfare, political, social and economic criteria. Usually, this institution
takes the form of a central processing or exporting unit purchasing harvests of
independent farmers, but also includes multipartite, nucleus estate and informal models
(Eaton & Shepherd, 2001). The terms of the purchase are arranged through contracts
that vary from case to case but are usually signed at planting time. Often the
agribusiness provides credit, inputs, farm machinery and technical advice to the farmers
in exchange for the commodity they produce (Glover, 1994; Grosh, 1994; Eaton &
Shepherd, 2001).
Contract farming can include a number of options in terms of how the contract between
the producer and the integrator is structured, where some forms of contracting are
dependent on speci c institutions such as marketing orders, bargaining cooperatives
and marketing cooperatives (Sporleder, 1992). The contract could specify the price,
quantity, quality, the provision of agribusiness inputs, the provision of credit facilities,
the conditions of production and the delivery and grading requirements (Sporleder,
1992; Runsten & Key, 1996). The price set in all these alternative arrangements could
be a xed price or a differential price (Sporleder, 1992). The various types of contract
could include a marketing contract, a contract specifying some measure of company
control, or a contract specifying the provision of company inputs, as well as full
company control of production (Wolz & Kirsch, 1999):
·In the case of the marketing contract, sometimes called a market speci cation
contract, the producer sells the raw commodity to the processor at a speci ed price,
Linking agribusiness and small-scale farmers in developing countries 509
quality and time. In this type of contract, the produce r has full autonomy regarding
production decisions (Rehber, 1998).
·In the second type of contract, certain company resources could be supplied and
there is a measure of company control. In this context, the producer agrees to
produce the raw commodity under some degree of company control and
speci cation, as well as to sell the commodity to the processor at an agreed price,
quality and time (Rehber, 1998; Wolz & Kirsch, 1999).
·Finally, the third type of contract includes full company control as well as the
provision of company inputs. In this regard, complete control of the production
process passes to the integrator, who will supervise production, provide the necess-
ary inputs and services and remunerate the producer for the raw commodity at an
agreed price (Rehber, 1998; Wolz & Kirsch, 1999).
Furthermore, in certain cases of contracting, the structure of the contract is based on
the farmer’s access to key resources such as water (Morvaridi, 1995), while in others
the producer does not even own the intermediate product, which remains the property
of the agribusiness. In a contract such as these, the agribusiness uses the facilities and
labour of the farmer, who is paid a fee to provide such facilities and services. This type
of contract can ensure that the technology incorporated in the intermediate product
supplied by the farmer is retained exclusively by the agribusiness (Martin, 1999;
Goodhue, 1999). In addition, many contracts incorporate some credit arrangement
(Wolz & Kirsch, 1999).
Given the poor performance of agriculture in many developing countries, especially in
Africa, many donors and governments hoped that contract farming and its variants
(outgrower schemes, nucleus estates, satellite farming) would bring about improved
incentives, increased income for farmers and positive multiplier effects for impover-
ished rural economies. As a result, there was considerable growth in the number of
contract farming schemes during the 1970s and 1980s . Most of these contract farming
or outgrower schemes were multipartite arrangements involving private rms (often
foreign), the government of the host country, non-governmenta l organisations, paras-
tatal bodies and international aid or lending agencies, such as the United States Agency
for International Development, the World Bank and the Commonwealth Development
Corporation (Glover, 1994; Little & Watts, 1994).
Contract farming in developing countries has experienced a mixed fortune, yielding
some successes and many failures (cf. Little & Watts, 1994; Jaffee, 1994; Glover,
1984; Runsten & Key, 1996). Jaffee (1994), for example, talks of the ‘rocky road of
contract farming in Kenya’. Several studies (cf. Minot, 1986; Glover, 1984, 1987,
1994; Glover & Kusterer, 1990; Jaffee, 1994; Little & Watts, 1994; Porter &
Phillips-Howard, 1997; Runsten & Key, 1996; Eaton & Shepherd, 2001) have analysed
the nature and performanc e of contract farming schemes in developing countries. These
studies contain useful reviews of the rich case study literature on contract farming
schemes in the developing world. A large number of studies on contract farming also
came from anthropologists , political economists, sociologists and geographers (Grosh,
1994). This literature is largely dominated by questions related to the dependency and
world systems approach, and criticises contract farming as an institution leading to an
increase in the marginalisation of farmers and communities that do not participate in
contracting (Korovkin, 1992; Watts, 1994; Little, 1994). In this respect, it is argued that
technological advances are passed on to the minority, resulting in uneven bene ts that
do not necessarily suit the needs of the developing country concerned (Meliczek,
510 J Kirsten & K Sartorius
2000). Furthermore, there is evidence of an increase in landlessness as a result of
contract farming expanding land requirements (Little, 1994). In the African context,
contract farming has been observed to disrupt power relations within farm households;
to exploit an unequal power relationship with growers; and to lead to growers
becoming overly dependent on their contracts (Key & Runsten, 1999).
The main lessons from the experience with contract farming emerging from the
literature reveal a number of factors that determine the success of contract farming
ventures. In general, it can be argued that the chances of success will be enhanced if
the following measures are taken:
·The farmer partners should be properly screened.
·The country-speci c historical and institutional legacies that have shaped local
conditions should be taken into account in project design.
·Commodities requiring more labour-intensive production techniques should be
selected. A crop that requires low levels of mechanisation and high labour inputs
may not be suited to large producers, who could have the same labour and
supervision problems as plantations. The production of a commodity that is delicate,
highly perishable, involves a high level of labour inputs and a low level of
mechanisation, and that needs a high degree of coordination, technology inputs and
tight quality speci city is better suited to contract farming involving small farmers.
(As discussed in Section 5, the danger still exists that agribusiness could prefer
contract arrangements with large-scale farmers.)
·Crops displaying a high value per hectare, as well as requiring post-harvest facilities
that are not feasible for the farmer, should be selected. Commodities with high
transaction costs in marketing and processing and economies of scale higher in the
marketing chain are the crops ideally suited for some form of vertical integration,
such as contract farming.
·Mutual asset speci city between the contracting partners should be incorporated,
thus raising the exit costs for both partners and ensuring a much more stable and
sustainable relationship.
·The location and concentration of growers in relationship to the location of the
agribusiness rm and other logistical factors should be optimised.
·If a competitive local market is present, contracted farmers may choose to sell to the
fresh market instead of the contracting rm, who is often unable to legally enforce
contractual obligations. Serious disruption to input supplies to farmers can result in
such a situation.
·The legal system should be well-developed, strong and respected, ensuring contract
enforcement at minimal costs.
·Contractual relations should be well managed and based on mutual trust. The
perceived high levels of contract manipulation by agribusiness rms, distrust by
farmers of the contractual relationship, and a perception of loss of autonomy have
characterised contract farming in developing countries. Removing all elements of
mistrust and establishing trustworthy relationships are important measures for
success.
·Farmer interests should be well represented in contract negotiations. In this respect,
the formation of farmer cooperatives in a contract farming arrangement is seen as the
most cost-effective way to represent the interests of the contracted farmer, as well
as for the integrator to deliver inputs and services to the individual farms.
·Agribusiness should play a key role in coordinating farmers’ access to a range of
inputs, services and facilities. These could include promoting literacy, improving
Linking agribusiness and small-scale farmers in developing countries 511
business skills, fostering farmer links with agribusiness and banks, establishing a
facility for resolving con icts, infrastructure development, etc.
4. A NEW INSTITUTIONAL PERSPECTIVE ON CONTRACT FARMING
This section uses the principles of the New Institutional Economics (NIE) to explain
the rationale for contract farming as an institutional arrangement, and provides an
additional motivation for the increased vertical integration discussed in Section 2.
Contract farming, as viewed from an NIE perspective, can be seen as one of the
governance forms in a vertical coordination continuum that can be utilised to effect the
requirements of higher levels of managed coordination. Contract farming is an
intermediate form of industrial organisation in agriculture, standing between spot
markets and full vertical integration. At the one end of the continuum, we have spot
market transactions, with coordination of the activities in the supply chain coordinated
by the price mechanism. This form of industrial organisation is usually applicable when
conditions approach that of the perfect market, i.e. many buyers and sellers, homoge-
neous goods, and goods that have little quality variation and are less perishable. At the
other end of the continuum we have fully integrated operations, with one company
controlling all stages of the market chain (Williamson, 1979; Barney & Ouchi, 1988;
Peterson & Wysocki, 1998). Spot markets in general show de ciencies in transferring
production information and marketing information regarding quality, timing and future
demand, and in overcoming problems resulting from imperfect input markets. Firms
consequently use contracts (including contract farming) to overcome these problems.
The NIE provides a useful theoretical framework for explaining the existence of and
theoretical rationale for contract farming, as many of the problems of market failure
and missing markets are typically caused by asymmetric information and a range of
other factors that impact on transaction costs. A full set of reasons for market failure,
in addition to the suggeste d optimal coordination form for each case, have been
developed by a number of authors (cf. Minot, 1986; Grosh, 1994; Key & Runsten,
1999). Minot’s (1986) application is illustrated in Table 1. A variant of this framework
is provided by Key & Runsten (1999) and is summarised in Table 2.
Both the rst and second part of Minot’s table relate speci cally to the characteristics
of agricultural produce, namely perishability, quality and production variability in
terms of quantity and quality. Agricultural produce typically also varies in terms of
moisture and sugar content, size, shape, colour, avour, timing of delivery, and so
forth. The issue is that consumers have particular preferences with respect to each of
these characteristics and are prepared to pay premia for produce that has the desired
qualities. Often, the problem with spot markets and the traditional price mechanism is
that these preferences and characteristics are not well communicated through these
markets (Key & Runsten, 1999; Grosh, 1994; Minot, 1986). When there is asymmetric
information between the buyer and the seller regarding the quality of the product,
product markets might break down all together –presenting a need for coordination
through contracting. Analyses also refer to the need for information on production
technology required for ef cient production and optimum quality and the desired
characteristics of the product. When markets for this type of information do not exist
producers nd it hard to adjust to the changing demands of consumers, which creates
the need for forms of vertical coordination and integration. This section of Minot’s
table thus con rms in many ways why contract farming could exist in the context of
the new developments in food and agricultural markets discussed in Section 2.
512 J Kirsten & K Sartorius
Table 1: Market failure and mechanisms of vertical coordination
Method by which institutions improve
coordination
Type of market failure and Circumstances under
coordination problems that result which failure occurs Contracting Vertical integration
Production information The crop needs
asymmetry: the buyer knows complex technology
signi cantly more than the or is new to the
grower about the production grower
technology
1. Quality improvements could Quality varies, affects Management-providing Production information
increase pro tability for growers demand, and is contract that speci es is transferred within the
but growers lack technical controllable practices to achieve rm through the
expertise quality, timing and company
least-cost production. communication system
The company recovers
the cost of extension
from the proceeds of
marketing the product
2. Better timing of supply could Timing of supply
raise pro tability but the growers affects demand, and is
cannot change the timing controllable
3. Improved practices would be Improved practices
pro table but the growers are not exist and are known
familiar with them to the buyer
Marketing information The crop has a
asymmetry: the buyer knows specialised or distant
signi cantly more about markets market and demand,
than the grower, e.g. future, and is relatively new
seasonal patterns, quality needs
1. Quality improvements could Complex quality Market-speci cation Market information is
increase pro tability for growers requirements, exists, contract, which allows transferred within the
Linking agribusiness and small-scale farmers in developing countries 513
but they are not aware of the especially for exports greater exchange of integrated rm down
premium on quality information regarding to the eld level
demand, quality, timing
and price
2. Better timing of supply could Perishable goods are
raise pro tability but the growers supplied for
are not aware of timing processing or export
requirements
3. Although greater production is It is a volatile or new
pro table, the growers not sure market; the grower
of future prices does not trust the
monopsonist
Imperfections exist in markets Use of large amounts
for credit, inputs and agricultural of inputs, particularly
services. Transaction costs are specialised inputs, is
high; growers are unsure of the pro table for the
pro tability of inputs and commodity
services; lenders are unsure of
the reliability of borrowers;
policy-induced distortions reduce
input and credit availability
1. Quality is suboptimal owing to Crop for which quality Resource-providing Credit and inputs are
limited use of inputs and services depends on inputs contract supplying provided internally
inputs and credit. within the rm
Repayment is assured
by the contract to
market the product
2. Timing of supply is Crop for which timing
inappropriate or uncoordinated depends on inputs
without inputs and services.
3. Output is suboptimal and there Crop for which input
is excessive use of inputs and use reduces
services production costs
Source: Minot (1986).
514 J Kirsten & K Sartorius
Table 2: In uence of market failures on agribusiness organisational strategies
Organisational
Market imperfections and transactio n costs strategy*
Imperfect credit market resulting in high costs of credit to growers –agribusiness acts CF/VI
as lender via t he contract
Imperfect insurance market and high price risk –the r m acts as insurer via the CF/ VI
forward contract
Imperfect insurance market and high yield risk –the rm is unable to insure due to VI
moral hazard problems
Imperfect market for production information –technology, timing CF/VI
High labour supervision cost s due to crop requirements CF/SM
Imperfect market for specialised i nputs (machinery, seeds, etc.) CF/VI
Missing markets for family labour and land CF/SM
Missing or thin local product markets CF/VI
Notes: *CF 5contract farming ; VI 5vertical integration; SM 5spot market.
Source: Adapted from Key & Runsten (1999).
Another central part of the theory of contract farming refers speci cally to the failures
of the major factor markets, land, credit, inputs and services (re ected in the last
section of Table 1). These market failures, especially the unavailability of production
credit, limit the adoption of new crops and also restrict the access to inputs, technology
and information that is necessary to produce a timely and good quality product. Many
farmers are therefore unable to produce a particular commodity, without supply of
credit and inputs by the agribusiness rm or estate.
Many of the commodities grown traditionally under contract farming in developing
countries have long gestation periods requiring substantial capital investment. In the
light of the failure of capital markets in developing economies, contract farming acts
as an institution overcoming capital market failures –it is thus a form of interlocking
factor market contract. The contracting rm supplies production material and inputs on
credit and uses the future delivery of the crop as collateral. In this way many farmers
have obtained the opportunit y to produce something they would not have done
otherwise. This relationship between producers and the rm can, however, be endan-
gered if there are other opportunities for producers to sell their product. Owing to weak
legal institutions not guaranteeing contract enforcement in many countries, chances of
opportunistic behaviou r of growers do exist, providing an important risk element to the
contracting rm. However, Key & Runsten (1999) stress the point that agribusiness
rms are often in a much better position to provide production loans to growers owing
to the limited alternative markets and low monitoring, enforcement and other trans-
action costs.
One option to eliminate most of the problems discussed earlier is for agribusiness rms
to opt for vertical integration whereby all stages of the marketing chain –from
production to consumption –take place within one rm. However, due to typical
problems in the labour market (shirking, supervision costs, etc.), vertical integration is
seen as inferior to the contracting option. In commodities where labour input is fairly
high, the plantation or vertical integrated models will clearly provide diseconomies of
scale and inef cient outcomes, thus opening the way for small-scale family farms.
Linking agribusiness and small-scale farmers in developing countries 515
This is con rmed by the analysis of Delgado (1999), who applied a similar review of
the speci c factors in rural Africa most likely to be associated with transaction costs,
and the way in which they shape the type of producer organisation most suited to
dealing with them. His analysis provides an added dimension of the commodity
characteristics to the theoretical explanation for the existence of contract farming and
other forms of vertical integration. These include some of the aspects discussed in
greater detail in Section 2. To a large extent, however, Delgado (1999) also con rms
the points made by the other authors referenced in this section.
It is important to recognise that individual commodities have both production and
marketing characteristics that will determine the most optimal form of production
organisation for that speci c commodity (Hobbs & Young, 1999). As shown earlier,
high labour intensity favours smallholder organisation, whereas both economies of
scale and heavy investment requirements in production produce the opposite effect.
Delgado (1999) argues that most commodity-speci c transaction costs arise in market-
ing and processing. Contract farming reduces the need for labour supervision while
increasing the access of producers to needed inputs and skills. High perishability also
tends to discourage independent small-scale operators, because of the high risks
involved in not having an assured processor market.
A high value-to-weight ratio tends to be associated with greater risks in marketing and
a more specialised clientele, leading to contractual or vertically integrated forms of
organisation. Similarly, the absence of domestic markets for export items makes it risky
to produce outside a marketing structure that can handle these items. Finally, items
such as cut owers and vegetables that are exported tend to be characterised by
economies of scale in marketing, as are other perishables that require a cold chain for
handling. Such economies of scale tend to lock out independent small operators
(Delgado, 1999).
5. ADVANTAGES AND DISADVANTAGE S OF CONTRACTING IN AGRI-
CULTURE
5.1 Advantages to the producer
The enthusiasm of donors about the bene ts of contracting in developing countries has
resulted in in ated expectations of the potential of this institution (Little, 1994).
Nevertheless, there are bene ts to the farmer, as discussed below.
Contracting allows farmers to overcome the barriers of entry into crop- and animal-
speci c sectors, as explained earlier in Section 2. Farmers usually enter into contract
production in order to reduce cost and gain access to information, technology,
marketing channels, managerial skills, technical expertise, access to plant and equip-
ment and patented production procedures (Carney, 1988; Rhodes, 1993; Glover, 1994;
Clapp, 1994; Jackson & Cheater, 1994; Little, 1994; Royer, 1995; Pasour, 1998;
Delgado, 1999; Vellema, 2000). Contracting could also improve access to capital and
credit (Hudson, 2000). This is a major concern for most farmers and especially so in
developing countries. Farmers are prepared to relinquish their autonomy for the sake
of being able to produce.
Contracting farmers can reduce production costs and increase production and income
as a result of their use of new technology and their access to company inputs (Watts,
1994; Clapp, 1994). The reduction in cost is due to better technology, better collective
decisions and reduced transport and marketing costs (Hennessy, 1996; Pasour, 1998),
516 J Kirsten & K Sartorius
cheap inputs from the integrator and, as a result of this, the ability to increase
economies of scale (Royer, 1995), or technology developed by the integrator that can
reduce cost (Pasour, 1998).
Contracting farmers can reduce marketing risk and stabilise income and, in this sense,
the integrator provides a form of insurance (Featherstone & Sherrick, 1992; Watts,
1994; Jackson & Cheater, 1994; Runsten & Key, 1996; Wolz & Kirsch, 1999;
Flaskerud & Klenow, 1999; Martin, 1999; Colchao, 1999; Sofranko et al, 2000). At the
same time, contracts may simplify production and marketing decisions, thus improving
the farmer’s effectiveness (Hudson, 2000). The reduction of marketing risk through the
demand assurance embodied in a contract is also appealing to farmers, especially those
producing products for which the markets are thin.
Contracting farmers can increase pro t opportunities through a greater product range
and differentiated products (Pasour, 1998), or by diversifying out of traditional crops
in developing countries in order to grow high-value crops and thereby increase their
income (Williams, 1985; Levin, 1988; Korovkin, 1992; Glover, 1994; Von Braun &
Immink, 1994; Kennedy, 1994; Delgado, 1999; Coulter et al, 1999). There is wide-
spread evidence of an improvement in farmer income in developing countries as a
result of contracting (Levin, 1988; Clapp, 1994), although the effect of an increase in
production costs is sometimes not considered when evaluating the incidence of
increased income (Little, 1994). In addition, the distribution impacts of this increased
income is not assessed.
In conclusion, the educational experience of interacting with an agribusiness partner
can provide a platform for farmers in developing countries who are attempting to
convert from subsistence to commercial farming (Glover, 1984, 1994; Sofranko et al,
2000).
5.2 Disadvantages to producers
Most of the critique against contract farming schemes makes reference to the disadvan-
tages to the farmers embedded in the contractual arrangements. These disadvantages
include farmers’ loss of autonomy, increased production risk, increased market power
of agribusiness, increased concentration of production and, insuring instances reduced
producer income.
There is a universal loss of autonomy as farmers operate under a centralised control
system (Schrader, 1986; Currie & Ray, 1986; Levin, 1988; Korovkin, 1992; Morvaridi,
1995; Pasour, 1998; Rehber, 1998; Wolz & Kirsch, 1999; Colchao, 1999; Sofranko et
al, 2000) and the contracted farmer is sometimes reduced to little more than a hired
hand (Clapp, 1994). Conversely, it can be argued that the independent farmer who is
heavily indebted has much the same status (Watts, 1994). It is also said that producers
are disadvantaged by the high level of manipulation of the contract, in terms of both
the legal and tacit arrangements (Glover, 1984, 1987; Porter & Phillips-Howard, 1997),
and by the fact that contracting undermines traditional structures and support systems
(Korovkin, 1992). Moreover, contracting is often associated with higher levels of
family con ict (Watts, 1994).
A further source of criticism is related to increased production risk due to the need to
meet the contractual obligations of the integrator (Royer, 1995). In this sense, risk can
also increase in that the farmer invests in highly speci c xed production assets,
combined with the non-assurance of a permanent contract or the chance that the
Linking agribusiness and small-scale farmers in developing countries 517
integrator may default (Featherstone & Sherrick, 1992; Royer, 1995; Rehber, 1998).
Production risk is increased especially when farmers in developing countries diversify
out of traditional crops into non-traditional crops where the technology has not been
developed locally (Runsten & Key, 1996).
Contracting universally increases land-use intensity and can lead to higher levels of
pollution (Runsten & Key, 1996). Contract farming in developing countries can result
in decreased food production and increased food security problems as a result of the
concentration on contract crops (Glover, 1994; Clapp, 1994; Morvaridi , 1995; Rehber,
1998).
It is accepted that prices paid to the contractor will be less than spot market prices
because of the reduction in marketing risk to the farmer and the increased market
power of the contracting rm. The result of this is reduced income (Pasour, 1998). This
situation might especially penalise a contracted farmer with high levels of capitalisation
and managerial skills where an open market exists for the same crop (Runsten & Key,
1996; Rehber, 1998). Moreover, contract production often involves a high-cost package
of inputs that require nancing facilities. The change in cost structure is especially
marked in developing countries when farmers diversify out of traditional crops, and can
negate the effect of increased revenue (Von Braun & Immink, 1994; Little, 1994).
Farmers incur additional cost because of the need to coordinate their production to suit
the integrator, as well as to liaise for the use of company inputs and services (Glover,
1987).
5.3 Bene ts to agribusiness rms
The bene ts to the agribusiness rm from a contract-farming venture revolve mainly
around cost reduction, quality control and reduced uncertainty with regard to the supply
of raw material. Cost is reduced as a result of a more synchronised input–output
processing function (Kilmer, 1986; Azzam, 1996) and the cost and nancing of
production are passed on to the farmer (Schrader, 1986) without the loss of control
(Rhodes, 1993). The company can ensure that the quality of large volumes of the raw
commodity is better controlled (King, 1992; Featherstone & Sherrick, 1992; Goodhue,
1999) and that the company’s technology is adopted properly by the producer
(Leathers, 1999). Further advantages to the company are the ability to reduce the cost
of the raw commodity supplied by the contracted farmer through assuming the
marketing risk of the farmer and thus reducing related farmer marketing and transport
costs (Glover, 1984; Kumar, 1995). Owing to a relatively stronger bargaining position
in the contractual arrangement, the agribusiness is also able to in uence favourable
farmer commodity prices (Delgado, 1999). Contracting thus removes the production
risk to the farmer and eliminates the uncertainty of large volumes of input (raw
material) supply (Levin, 1988; Korovkin, 1992). Because the quality of inputs is more
consistent, the risk of dissatis ed consumers is reduced (Pasour, 1998; Rehber, 1998;
Wolz & Kirsch, 1999).
Advantages that are speci c to agribusiness rms in developing countries are the
substantial political economy gains as a result of involvement in national development
projects, or because the governmen t is a party to the contracting arrangement (Hayami,
1990; Binswanger et al., 1993; Watts, 1994; Little, 1994), where this can translate into
more tangible economic bene ts resulting from government intervention or cheap
credit (Clapp, 1994; Morvaridi, 1995). In conclusion, agribusiness rms in developing
518 J Kirsten & K Sartorius
countries that are not allowed to own land can use contract farming with local farmers
to overcome this constraint. This happened in many parts of Latin America where
multinational agribusiness rms used contract farming to secure a constant ow of
commodities for their processing and export ventures (Runsten & Key, 1996).
5.4 Disadvantages for agribusiness rms
A principal disadvantage frequently associated with contract farming in developing
countries is the high level of transaction costs. Transaction costs are often excessive in
projects involving large numbers of small farmers who are spatially dispersed, require
high levels of inputs and support and who make smaller, more frequent deliveries to
the agribusiness (Key & Runsten, 1999).
Excessive transaction costs are generated as a result of the structuring, administering
and enforcing of the large number of contracts (Barry et al, 1992). Moreover, the
integrator incurs additional supervision and monitoring costs in conjunction with the
non-cost-effective delivery of services and inputs to farms that are small and spatially
dispersed. In this regard, it is estimated that dealing with larger farmers, who make less
use of inputs and deliver in greater volumes, results in lower levels of transaction cost.
Coulter et al (1999) refers to an example of horticultural exporters in Zimbabwe who
pay their smallholder suppliers 30 per cent of the price per kilogram paid to the
large-scale farmers in order to break even. Contracting rms could easily (and usually
do) prefer to deal with larger growers, which makes the relationship much more
pro table but contributes to many smallholders being shut out from production.
Evidence is already emerging that agribusiness rms prefer to deal with larger farmers
in order to reduce transaction costs and achieve greater consistency of quality and
supply. In the United States, for example, contract farms are signi cantly bigger than
non-contract farms (Sofranko et al, 2000) and, if the raw commodity offers economies
of scale and is not labour intensive, large farmers have a production advantage (Glover,
1984; Runsten & Key, 1996). Further, larger producers who are located closer to
highways have often been quicker to respond to contracting opportunities (Von Braun
& Immink, 1994). Processors often prefer to deal with this type of producer because
they are more geographically concentrated than small farmers and because of the
reduced cost of procurement (Pasour, 1998). Large farmers, with higher levels of
capitalisation and management skills, reduce the risk related to supply (Coulter et al,
1999) and have a better chance of success (Little & Watts, 1994). Larger farmers tend
to be better educated and better able to adopt technology, are able to acquire specialised
capital inputs more easily, require less inputs from the integrator and less monitoring,
and the larger volumes supplied reduce the cost of interaction. Furthermore, agribusi-
ness dealings with small farmers in developing countries have often resulted in
increased cost per capita in respect of administration, services rendered, transportation
and communication. Moreover, small farmers borrow more, require the use of spe-
cialised equipment more frequently, require more intensive monitoring and make more
frequent deliveries of smaller quantities to the integrator, resulting in increased cost per
unit of raw commodity supplied. In a situation where contracting is not legally
enforceable, the costs of screening potential contract farmers is a function of the
number of farmers screened and, in this respect, larger farms cost proportionally less
(Runsten & Key, 1996).
This reality presents a great danger for small-scale farmers in developing countries, and
Linking agribusiness and small-scale farmers in developing countries 519
may lead to their exclusion from contract opportunities. How this can be prevented is
discussed in the next section.
6. CONTRACT FARMING IN DEVELOPING COUNTRIES: QUO VADIS?
The forces of globalisation and industrialisation in world agriculture have prompted
new ways of organising the agri-food sector. At the end of the 1980s, the agricultural
and food sector was characterised by rms operating highly autonomously . Nowadays,
because of the need for a year-round supply, product assortment and developments in
information technology, the agricultural sector is changing into a sector of international
networks of rms (Overboom, 2000). Vertical coordination of food supply chains has
gained a great deal of attention. Of particular concern is the effect of all these
developments on the future of small-scale agriculture in developing countries. Reardon
& Barrett (2000) show how these changes have caused small rms and farms to go out
of business under the new competitive pressures. The new competitive environment
leads to industrial concentration, with practices that result in the exclusion of domestic
rms and small farmers from the bene ts and rewards of the high-value markets.
The key issue is therefore to establish the types of institutions that can help ensure that
the poor bene t from globalisation and industrialisation. For example, what is the role
of cooperatives, contracting arrangements, market regulation and food and safety
standards in facilitating smallholder farmers’ access to expanding markets for higher-
value products?
Contract farming has been implemented widely in developing countries as a means to
reduce risk and ensure throughput volumes of known quality and price. In a similar
fashion, in most countries there has been a rapid increase in the use of different forms
of contract (market and production contracts) in agriculture as a way to ensure quality,
coordination and desired product attributes. Many people see contracts as a means to
reduce coordination costs within the food supply chain. Most of these contracts are
with large national and multinational food corporations. As the dominance and market
power of these rms often create an unfair playing eld, people may question the
appropriateness of contracts in ensuring that small farmers in developing countries are
part of the ‘new agriculture’.
The danger with most contract farming types is that it displaces decision-making
authority from the farmer to the downstream processor or distributor, thus turning the
farmers into quasi-employees. This happens when the contractor supplies all inputs as
well as production guidelines and instructions, and then subtracts all these costs from
the producer payment at the time of delivery.
Other problems relate to the high per unit costs of contracting with small-scale farmers,
as discussed in Section 5.4. In addition, because these farmers are perceived to have
greater problems in meeting stringent quality and safety requirements, agribusiness
rms favour contracts with medium- to large-scale farmers (Key & Runsten, 1999).
Add to this the problem of enforcing contracts in most developing countries due to
poorly developed judicial systems. These factors could contribute to smallholders not
being preferred as parties to contracting arrangements.
A review of the literature on agricultural contracts in general and contract farming in
developing countries in particular, provides a good platform for assessing the future of
contract farming in developing countries as one form of vertical organisation and
520 J Kirsten & K Sartorius
coordination in agricultural supply chains. If we accept the premise that contract
farming remains an important vehicle to keep small farmers involved in markets for
high-value crops and animal products, it is now important to take the lessons from the
experience with contract farming and use them to improve the workings of this
institution. With the evolution and increasing prevalence of vertical coordination in
agriculture, the theoretical framework for evaluating these developments has also
evolved. Several aspects of the New Institutional Economics, such as contract theory,
agency relationships (principle agent problems, incomplete contracts), transaction costs
and the boundaries of the rm, have become key focus areas (Barry et al, 1992). This
theoretical framework is useful in analysing the relationships between the farmer
(agent) and the agribusiness (the principal), where decisions about the extent of vertical
coordination and related contract speci cations can in uence the nancial position and
performance of both parties. In the context of contract farming, this framework can be
used to analyse and address the problems that could typically constrain or lead to the
breakdown of contractual relations in developing country agriculture.
The problems and disadvantages of contract farming that could contribute to the
exclusion of smallholders from contractual relationships, as discussed earlier, can be
summarised as follows:
·Enforcement of contracts
·High transaction costs of dealing with many smallholders
·Strict demands for consistency (no variation), quality, food safety, due diligence, etc.
·Business attitudes and ethics referring to non-payment, delayed payments or even
reduced payments
·High rate of product rejection by agribusiness rms and traders (Kherallah, 2000)
·Weak bargaining position of farmers vis-a`-vis a limited number of traders (Kheral-
lah, 2000)
Despite the vital role contract farming can play in providing services and market access
to smallholders, these problems result in high costs and often undermine the viability
and sustainability of contract farming in developing countries. The two main problems
relate to contract default and enforcement and the scale of farming operations leading
to high per unit transaction costs. Solutions to these various constraints could go a long
way in improving the viability of contract farming. Possible solutions are discussed in
some detail below.
6.1 Contract enforcement
Although contract farming involves a written agreement between farmers and the
agribusiness rm or integrator, these contracts are seldom legally enforceable in
practice (Grosh, 1994). The poorly developed legal institutions in developing countries
contribute to high transaction costs in suing individual smallholders for contract breach.
Enforcing a contract also leads to souring the relationship between the farmers and the
rm, as well as between the agribusiness and the community. Adding to these high
costs in terms of nancial and community relations is the fact that in many countries
the contracts are often viewed as legally unenforceable. Thus, the only real threat at the
disposal of the contracting rm is to discontinue the contract with those farmers not
complying with its terms and then to write off lost income. Because of these costs,
rms deal only with growers who are less likely to default (often larger growers) and
are required to screen applicants. These screening and enforcement costs are xed costs
Linking agribusiness and small-scale farmers in developing countries 521
and can be minimised by reducing the number of contract farmers, thus favouring
larger growers (Key & Runsten, 1999).
Farmers sometimes break contract either on account of production failure or because
they have sold the produce to competing buyers or to the local spot market. When there
is a good market at harvest, many farmers are lured by higher spot prices where they
can sell their produce for cash. In this way they avoid the repayment of credit, which
is usually subtracted at the time of delivery. The farmer often claims production failure
for the lack of compliance with the contract. The absence of effective legal systems and
lack of collateral held by smallholders, as well as the weak insurance markets, create
considerable risk for companies engaging in contract farming with smallholders
(Coulter et al, 1999). Because of the risk of default, many agribusinesses or traders
have discontinued the process of supplying inputs to farmers (Kherallah, 2000), again
creating barriers preventing entry to agricultural markets by some smallholders.
How does one resolve the problem of farmer default? Agribusiness has developed a
number of innovative mechanisms to deal with this problem , mainly in the case of
high-value crops. These mechanisms, which are discussed in more detail in Coulter et
al (1999), are the following:
·Lending through groups. Providing inputs and services through groups of smallhold-
ers reduces per unit transaction costs and risk of default.
·Good communication and close monitoring. This helps foster good company–farmer
relations and a sense of trust, which can contribute to minimising strategic default.
·Range and quality of services offered. The better and broader the range of services
offered, the closer the relationship between the farmer and business and the more the
farmer stands to lose by breaking the relationship. Delivering timely services
according to farmers’ needs will foster trust and reduce the risk of default.
·Incentives. There should be incentives for repayment and strict management of
defaulters.
·Cooperation between buyers. Agreements between agribusines s rms not to pur-
chase from farmers under contract from other buyers, or through a joint operation of
contract farming schemes, can also reduce the risk of default.
In the absence of public mechanisms for contract enforcement, private enforcement
mechanisms can be of help. A study by Gow et al (2000) has shown that the use of
internal private mechanisms for contract enforcement through contractual arrangements
between two parties in an exchange can make contracts ‘self-enforcing’. The introduc-
tion of contract innovations and associated support programme s in this case study
induced output and productivity growth in both the agribusiness and the farmers. An
input provision and investment facilitation programme was introduced for farms that
signed long-term contracts with the company. The investment facilitation programme
consisted of a guarantee at the state agricultural bank plus an interest rate subsidy. This
investment ensured that the agribusiness was less likely to breach its part of the
contract due to the increase of its costs of contract breach. At the same time, it reduced
the costs for contract hold-up for these producers and contributed to increased
investment in the particular commodity by the farmers. This programme therefore
increased the private enforcement capital to the contract and improved incentives for
the contracted farms to make contract-speci c investments.
In other parts of the developing world, one nds that legal institutions do not play an
important role in the enforcement of contracts. An analysis by Fafchamps & Minten
522 J Kirsten & K Sartorius
(1999) suggests that trust-based relationships are the dominant contract enforcement
mechanism under these circumstances. Trust is established primarily through the
repeated transactions of the contracted parties. Trust and social networks are usually the
mechanisms by which transactions and contractual arrangements in developing coun-
tries are enforced and thus provide another alternative to be considered in reducing
contract default. With many agribusiness rms controlled by multinational interests and
often from a different ethnic group usually related to previous colonial regimes, one
would expect that trustworthy relationships would be hard to come by. Striving towards
establishing trustworthy relationships would, however, still be important.
6.2 High transaction costs
When agribusiness rms contract with a number of smallholders they incur high
transaction costs, as shown in the discussion earlier. A greater number of producers
means more trips to them by extension agents, more monitoring of pesticide violations,
more deliveries of inputs and also more deliveries by smallholders. Smallholders are
often dispersed and dif cult to reach, which adds to the costs of service delivery and
monitoring. Smallholders also require more inputs and capital from the rm per unit of
production, as well as specialised machinery and much more extension assistance (Key
& Runsten, 1999). Despite the inherent ef ciency of small-scale farmers and the fact
that it is sometimes politically attractive to deal with them, the high costs of
supervision and other related per unit transaction costs are often prohibitive. Contract-
ing rms therefore usually prefer to deal with larger growers, which makes the
relationship much more pro table but tends to shut many smallholders out from
production opportunities and markets.
Key & Runsten (1999) cite a case study in Mexico where a local frozen vegetable rm
managed to engage in successful contracting with smallholders despite the inherent
problems listed above. The company designed contracts that both parties found
pro table. The rm offered resource-providin g contracts that delivered credit, spe-
cialised inputs and extension advice. The credit to the farmers was advanced against no
collateral in the form of seedlings, all pesticides and fertilisers. The value of these
advances was equal to about 40 per cent of total production costs, with the farmers
being responsible for land, labour and the costs of land preparation. The out-of-pocket
costs for the farmers were thus in the same range as the costs for maize. In addition,
the company introduced a management strategy that further reduced transaction costs.
Participation by smallholders was restricted to a certain location and chemical control
decisions were taken by an agronomist who visited growers once a week, carrying all
material with him at all times. Farmers were responsibl e for obtaining their seedlings
and fertilisers from the rm’s ranches and for delivering their harvests. This strategy
has reduced transaction costs tremendously, making the contract arrangement with the
smallholders pro table.
One approach suggested by Coulter et al (1999) to counter the problem of high
transaction costs of dealing with smallholders is to consider the promotion of farmer
groups or farmer-controlled enterprises (commonly also referred to as cooperatives) in
conjunction with a contract-farming venture. The cooperative could bargain and
negotiate prices and the terms of the contract on behalf of the farmers. It can also be
instrumental in providing information, inputs, technical and quality assistance to the
growers. The agribusiness as such will have a stake in strengthening such institutions
since it will contribute to considerably lower transaction costs. These cooperatives
Linking agribusiness and small-scale farmers in developing countries 523
should be assisted by the agribusiness through training in literacy and numeracy and
also improving their ability to bargain effectively (despite this not being in the direct
interest of the agribusiness). This would help the farmers’ group or cooperative not to
become excessively linkage dependent. Owing to the poor record of agricultural
cooperatives in developing countries, it is important that such cooperatives be estab-
lished on sound principles that will ensure their sustainability. The recent work by
Cook & Chaddad (2000) provides an indication of the aspects that should be taken into
account to ensure that cooperatives (or ‘new generation cooperatives’, as these authors
call them) provide the necessary bene ts to producers in any contractual or marketing
arrangement.
Both Kherallah (2000) and Coulter et al (1999) use the activities of the Fresh Produce
Exporters’ Association of Kenya (FPEAK) as an example to illustrate the value of
grass-roots activity in promoting linkages of smallholders with agribusiness (exporters).
FPEAK supports small farmer groups through technical assistance and training, small
grants to invest in infrastructure such as grading sheds and charcoal coolers, and loans
to purchase inputs. It also provides services such as market intelligence and market
promotion. The technical and nancial support has made it possible for many farmers
to meet the strict requirements and standards of the UK supermarkets –the largest
buyers of Kenyan fresh produce. By assigning groups of farmers to different exporters
it was now more pro table for exporters to contract with small-scale farmers (Kheral-
lah, 2000). This organisation has thus addressed not only the issue of high transaction
costs in dealing with smallholders, but also the problem of product quality and
standards, which is a major concern for most traders.
Although the rapid growth of contract farming in the last couple of years can be
ascribed to the importance of grades and standards in the fresh food industry, as
established by multinational rms and consortia (Reardon & Barrett, 2000), the above
discussion illustrates the dif culty in enforcing such measures when dealing with a
large number of smallholders. Additional support from farmer or grass-roots organisa-
tions or the government will be needed to ensure that this does not lead to the exclusion
of smallholders from contracting opportunities due to their non-complianc e with food
safety and quality standards.
Dorward et al (1998) list the conditions for successful interlocking contracts between
smallholders and agribusiness, and in a certain sense they address all the problems
related to contract farming raised at the beginning of this section. The conditions are
the following:
·Increased competition among traders or rms to prevent monopsonistic control (this,
however, creates opportunities for side-selling, leading to problems of contract
enforcement)
·A guaranteed outlet for the nal product
·An effective repayment mechanism through loan groups of farmers
·Access to market information by farmers to prevent exploitation and to strengthen
bargaining power
·Volume of transactions that are large enough to reduce transaction costs (this can be
achieved through farmer cooperatives or farmer groups)
·A well-established formal or informal network of traders to control rogue traders
·Little alternative sources of raw material to prevent the trader or agribusiness from
buying from other farmers
524 J Kirsten & K Sartorius
7. CONCLUSION
In view of the changing nature of world agriculture and food markets and the resulting
need for vertical coordination along the agri-food supply chains, this article considers
the role of contract farming as an institution to ensure the continued participation of
small-scale producers in developing countries in the markets for high-value and animal
products. The article rst discusses the theoretical rationale for contract farming and
illustrates how the New Institutional Economics can be used to show how contract
farming as institutional arrangement overcomes input market failures and asymmetric
information problems in the output market. Contract farming has been a feature of the
agricultural sector in many developing countries since the 1960s and a large body of
literature has documented the experience with contract farming. This article brie y
reviews this literature and highlights the main problems normally associated with
contract farming ventures, which lead to many failures and mistrust between agribusi-
ness and smallholder families. These problems are:
·Poor enforcement of contracts
·High transaction costs in dealing with many smallholders
·Strict demands for consistency (no variation), quality, food safety, due diligence, etc.
·Business attitudes and ethics referring to non-payment, delayed payments or even
reduced payments
·High rate of product rejection by agribusiness rms and traders
·Weak bargaining position of farmers vis-a`-vis a limited number of traders
The two main problems relate to contract default and enforcement and the scale of
farming operations leading to high per unit transaction costs, and are discussed at some
length. Some solutions to these problems are provided and could go a long way in
improving the viability of contract farming. However, it is suggested that much more
research within the context of the New Institutional Economics framework is needed
to study contractual relations in developing country agriculture, and to nd appropriate
solutions to prevent future failures of contracting ventures and further exclusion of
smallholders from high-value markets. In this context, we are of the opinion that
research into contract enforcement mechanisms, principle-agent problems, governance
of supply chains and farmer cooperatives could provide valuable information to secure
an important role for contract farming to link smallholders and the agribusiness rms
in the high-value markets.
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