Vertical Coordination and Contract Farming
Rehber
shirking behavior or moral hazard behavior4 (Boehlje
and Schrader 1998).
Transaction costs can be separated into two
categories: coordination and motivation costs (Milgrom
and Roberts 1992).
i. Coordinating costs are the costs of monitoring
the environment, planning and bargaining to decide what
needs to be done (pre-contractual costs; ex-ante).
ii. Motivation costs are the cost of measuring
performance, providing incentives, and enforcing
agreements to ensure that people follow instructions,
honor commitments, and keep agreements (post-
contractual costs; ex-post)
In transaction cost theory, each type of vertical
governance structure will stem from the characteristic of
transactions. Under the assumption of economic
efficiency and competition, the chosen governance
structure will minimize total transaction costs (Sauvee
1998).
Agency theory deals with the relationship between
two parties. In an agency relationship, the agent (e.g., the
farmer) is expected to behave in accordance with the
goals of the principles (e.g., lenders, wholesalers,
processors).
The theory focuses on the contract between these
two parties and seeks to determine the optimal contract,
i.e., the contract with the most efficient organization of
information and the lowest cost.
Agency theory suggests two main strategies of
control, behavior based and outcome based (Eisenhardt
1985). When the behavior of the agent is observed, a
behavior-based contract is optimal. In the case of
complete information the agent is aware of his/her
behavior, but the principal is not. In the case of
incomplete information, if the agent is rewarded based
upon his/her behavior, the agent may shirk. In both these
cases, the principal has two options; either the principle
can purchase information about the behavior of the agent
and rewards good behavior or the principal can reward
the agent based on outcomes. The optimal choice occurs
between the two alternatives based on the trade-off
between the cost of measuring behavior and the cost of
measuring outcomes and transferring risk to the agent
(Eisenhardt 1985).
In an agency relationship, because of the different
reasons such as information asymmetries, it is
impossible to write a complete and comprehensive
contract to cover all possible future events. Therefore,
contracts generally are incomplete and the objectives and
4 The possibility of self-interested misbehavior before and/or
after agreement (pre- and/or post negotiation.
activities of the principal and agent will not completely
coincide (Barry et al. 1992).
The set of institutional arrangements within a
transaction is called a governance structure. Mohaney
(1992) recognizes a continuum of governance structures
including spot markets, short term contracts, franchising,
joint ventures, and vertical financial ownership.
Mohaney suggests that the form of coordination or
business linkages will be a function of three
characteristics of the transactions and the industry :
i. Asset specificity refers to the specialized nature
of the human or physical assets that are required to
complete the transaction. The more idiosyncratic the
asset, the stronger the linkage or bound required for the
transacting parties to invest in that asset.
ii. Task programmability: Indicates that a
transaction is well understood by all parties and often
repeated, thus not requiring intense discussions or
negotiations and easily accomplished by impersonal
coordination mechanisms.
iii. Task separability: Refers to the ability to
determine and measure the value of the contribution and
thus the reward that should be given to each participant
in the transaction. If it can be accomplished easily (and
thus transaction is separable), coordination systems that
are less personal are relatively more efficient and
effective than separability does not exist.
Transactions have been classified in terms of
frequency, uncertainty, and asset specificity5. The
transaction cost approach provide insight into the key
role of asset specificity but neglects the interactive effect
of the measurement problems that have been highlighted
by the agency theory.
On the other hand, positive agency theory
emphasizes measurement costs but neglects asset
specificity (Mahoney 1992). The integration of the
transaction costs and agency approaches yields five
determinants of organizational form: task
programmability, task separability, demand uncertainty,
5 Williamson (1989, p.143) identifies four different types of
transaction specific investment; i. Site specificity: Buyer and
seller are in a relation with one another, reflecting ex ante
decisions to minimize inventory and transportation expense. ii.
Physical asset specificity: When one or both parties make
investments in equipment and machinery that involves design
characteristic specific to the transaction and which have lower
values in alternative uses. iii. Human-capital specificity:
Arising as a consequence of learning-by doing, investment and
transfer skills (specific human capital). iv. Dedicated assets:
General investments that would not take place but for the
prospects of selling a significant amount of products to a
particular customer. If the contract is terminated, it would
leave the supplier with significant excess capacity.
Food Marketing Policy Center Research Report #52