Vertical Coordination and Contract Farming
Rehber
2.2. Theories of the Vertical Coordination
The food system from farm to the consumer table
has been traditionally operated in an open market system
relaying on the price signals. However, considerable
close cooperation-coordination has been observed in
food systems as they move from arm’s-length or open
market transaction toward pure vertical integration.
There are several theories that are used to study
vertical coordination and no conclusive theory yet
exists(Azzam and Pagaulatos 1999). Each theory focuses
on different aspects, applies different explanation
mechanisms and reaches different outcomes and
managerial implications.
Traditional microeconomic theory provides limited
help because it assumes open markets and independent
firms react to determined market prices. Concepts of
industrial organization are only partially helpful in that
they assist in understanding the relationships between
structure and performance but do little to explain
dynamics of firm behavior and interactions between or
amongst firms. Behavioral science may provide rather
comprehensive framework to study vertical coordination
involving the theories of transaction cost and principal-
agent, strategic management, negotiating power, and
performance incentives.
Some of the more reliable considerations on theory
of vertical coordination, in general, are summarized
below. The issues of vertical coordination and contract
farming can be easily understood and analyzed in the
light of a combination of different and sometimes
overlapping approaches and understandings of these
theories. In other words, the theories presented here
reflect different facets of the vertical coordination and
can be thought of as complementary.
2.2.1. Theory of Life Cycle
Stigler’s life-cycle theory of vertical integration was
based on Adam Smith’s theorem: “the division of labor
is limited by the extent of market.” Life-cycle theory
shows that an industry is more vertically integrated in its
early stage of development. When the industry is small,
it does not pay for a firm to specialize in an activity that
yield increasing return to scale. As the industry grows,
some existing or incoming firms may specialize in one
of the processes. That is, as the industry expands, it
becomes profitable for a firm to specialize. Thus, in this
second stage, a disintegration occurs. During the third
stage, as the markets shrinks, firms tend to reintegrate
and undertake more processes than in the first stage.
Stigler’s life cycle approach has been criticized but also
extended to explain the evolution of agricultural
industries (Berkama and Drabenstott1995; Gillespie et
al. 1997).
2.2.2. Transaction Cost and Principal-Agent Theory
The history of transaction cost economics starts with
Coase’s famous article in 1937 explaining why firm
exists (Coase 1988). Coase argued the existence of costs
of using the price mechanism. These costs later termed
transaction costs, included the costs of writing,
executing, and enforcing contracts. Firms are established
to minimize these transaction costs of exchange. If it is
more expensive for a firm to acquire an input in the
market place than to produce it itself, the firm will
vertically integrate into production of the input. After
Coase’s study, the literature on transaction cost approach
to vertical coordination did not substantially develop
until the late 1970s (Barry et al. 1992). Williamson
expanded Coase’s idea of transaction cost including
behavioral assumptions of opportunity2 and bounded
rationality3 of economic agents. This theory is based on
the idea that “institutions of economic organization have
a transaction cost origin“(Williamson 1973).
Williamson considered the main purpose of vertical
integration to be economizing of transaction costs. He
identified two types of transaction costs; Ex-ante and ex-
post. Ex ante costs include the cost of drafting,
negotiating, and safeguarding an agreement. Ex- post
costs are those costs incurred when agreements become
a source of disputes.
In each case these costs may include the cost of
acquiring and processing information, legal costs,
organization costs and costs of inefficient pricing and
production behavior (Joskow 1990). The concept of
transaction cost and principal-agent theory as conceived
by Coase and expanded by Williamson and others
indicates that the form of vertical linkages or
coordination in an economic system depends not only on
economies of size and scope as suggested by
conventional theory but also on costs incurred in
completing transactions using various coordination
mechanisms.
Furthermore, these costs and the performance of
various coordination mechanism depend in part on the
incentives and relationship between transacting parties in
the system, the principal and the agent. Under various
conditions, the principle and/or agent may exhibit
2 Opportunism is the wayward tendencies of supplier to
mislead, cheat and generally underperform. An integrated firm
minimizes these hazards by owning and directly controlling its
own suppliers.
3 Bounded rationality is the limits of reducing transaction
costs. By owning and directly controlling their own
operations, an integrator firm can avoid the cost of searching
for the best and the cheapest suppliers.
Food Marketing Policy Center Research Report #52