With the constant pressure to meet consumer demands and the need to be competitive,
the question of quality is becoming a central point in agro-food chains organization. It is
well known that quality is dependent upon the characteristics on inputs obtained from
growers. But the action of the grower in producing a quality product is rarely observed
by the processor, which generates moral hazard problems. Consequently, once a
processor decides to acquire his input needs, a difficult question must be resolved.
Should his input be acquired via contract with growers, or is it more efficient to buy it
on the spot market?
The study of vertical relationships has come to be dominated by the principal-agent
framework in agriculture (Otsuka, Chuma and Hayami, 1992). From this theory, it is
well known that when measuring grower’s effort is expensive, an incentive share
contract can be appropriate second best in addressing underlying moral hazard problems
(Stiglitz, 1974): it provides incentive but only by imposing risk on the grower. Thus,
trading off the loss from too little incentive against that from too great risk bearing
defines the optimal share contract (Bell and Zusman, 1976; Stiglitz, 1988).
In this approach, protecting input quality has been suggested to be a possible
motivation for the use of contracts over the spot market alternative, especially in the
presence of imperfect quality measurement (Hueth and Ligon, 1999a,b, 2001, 2002). In
particular, Wolf, Hueth and Ligon. (2001) conclude that “contracting can be thought of
as an organizational response to an increased demand for quality among increasingly
discerning consumers”.
Many studies of incentive contracts testing principal-agent framework have found
support for this effect of incentive contracts on quality. Among the existing studies,
Curtis and McCluskey (2003) analyze a sample of production contracts between potato
processors and growers in the Columbia Basin area of Washington and Oregon. The