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Vertical Coordination and Contract Farming

Rehber


specialized assets increase the potential loss under
unexpected market outcomes. Thus, uncertainty (price,
quantity, quality and time) is an important factor
favoring internal coordination along with the availability
of asset specificity.

Market imperfection that may produce incentives for
vertical integration include imperfect competition in
addition to imperfections caused by externalities and
imperfect or asymmetric information (Rogers 1998).

Uncertainty and reducing risk have significant
coordination implications. One of the main risks is that
of prices of inputs and outputs. Coordination through
contracting or integration will reduce price risk to some
extent. A second source of risk is related to quantity and
quality features. In a open market structure, it is almost
impossible to provide the required quantity of
commodity in a certain quality. A third source of risk is
food safety issues that can be analyzed into two
dimensions. The risks for human life and for
environment pollution. Both require rather personal and
coordinated market relationships.

Another main important force behind the integration
and contract farming is the changes in the market
structure. Well-trained buyers in the market and the
necessity to supply produce with a certain quality and
quantity over time are the main reasons. Consumers
have become more discriminating food buyers. Increased
demand of prepared food and concerns about nutrition
and food safety are the important determinants for
strengthening vertical coordination (Berkama and
Drabenstoll 1995). Delivering food products with
improved safety characteristics requires coordination
among producers, first handlers, processors, and retailers
(Caswell et al. 1994). The primary motivation for such
arrangements is to obtain greater control over the
physical characteristics and quantities of commodities
exchanged (Buccola and French 1981).

It is a fact that production technologies have been
improving very rapidly. Market failure in conveying
information about quality is one of the motives for
increased vertical coordination (Hennessy, 1996).
Contract farming is seen as a sound way to push
innovation of new technologies and provide more
efficient production.

The establishment of a new processing plant requires
large investment resulting in high fixed costs. An uneven
supply of raw material greatly increases unit costs.
Therefore these firms have an interest in keeping raw
material inflows at a steady level close to plant capacity
(Roy 1963; Harryman 1994). Relying on open market
purchases is unlikely achieve this steady raw material
flow.

Contract farming is also thought of as a way of
commercialization and industrialization in agriculture
especially for the developing and less developed
countries. Contract farming will help small family farms
and farm laborers who need capital and managerial
assistance (Moore 1994). The majority of the farms are
small and subsistence. In nature, it is commonly
recognized that small family farms are potentially an
important source of growth in agricultural production
and small scaled agriculture has some socio-economic
advantages (Rehber 1996). But there are serious
constraints on small farm production related to problems
of access to production inputs, services, and information.
Small farmers often lack the necessary production and
marketing information pertaining to new crops and
varieties. Even with sufficient information, they do not
have the financial resources necessary and access to
credit facilities are limited mainly because of the lack of
collateral. Contract farming is an example of such a
mechanism that deals with many of these constraints in
an integrated manner (Roy 1963 ; Doye et al. 1992).
Government intervention and subsidization policy could
be seen as an alternative to contract farming. Public
interventions and support policies are ineffective
especially in the developing countries and they do not
help to remove the obstacles mentioned above.
Government efforts to subsidize are mostly in favor of
large farmers. “The New World Order“ of global
restructuring of the food industry symbolized by the
GATT and newly established WTO which are mainly
aiming at lessening or cutting agricultural subsidies must
be considered here.

One of the main reasons for the integrators may be
to avoid government restrictions (Shepperd 1990).
Internal transfer of intermediate input and flexibility of
adjusting production cost through internalization can be
used as a way reducing tax. Internal exchange is a means
of avoiding control when the intermediate input is
subject to price controls.

Beside the reasons mentioned above, recent
sophisticated ideas such as environmentally sound,
sustainable and economically viable agriculture and
standards and regulation related to both environment and
health safety are the main initiatives behind the fast
growing use of vertical coordination and contractual
arrangements in agriculture (Boehlje et al.1995)

Although the reasons for change from open
production and market exchange to all types of vertical
relationships are essentially similar, some inherent
characteristics of agricultural production and marketing
dominate contractual relationships in agriculture.
Despite the changes toward a market oriented structure,
the rapid decline in numbers and growth in sizes
especially in the developed western world, historically

Food Marketing Policy Center Research Report #52

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