Synthesizing the various theories of Contract Farming:

Source: Young and Hobbs (2002). At the top, convention theory sets some of the external context, in which vertical integration and contract farming takes place. The external context is also influenced by the political, social, legal and economic environment of the location or country. Valerie Imbruce(2008) explains how price wars between firms improve service to the farmers to retain the farmers favour, while analysing the production relations of contract farming of Asian vegetables, in Honduras. (Convention theory). He explains that price wars do not lead to breaching of contracts rather it leads the farmers to switch to other firms when the contract expires. He also points out that other reason for switching firms is that firms reject harvested crops on false quality crops. Convention theory mainly focuses on the quality attributes of the produce. Four types of coordination are presented in convention theory (Young and Hobbs, 2002): market coordination (in which the price differentials reflect the quality differences); domestic coordination (which

relies on long-term relationships and trust); industrial coordination (where an independent party sets thresholds like certification bodies); and civic coordination (where there is a collective agreement among firms to avoid conflict and set standards).

In the Inter-firm environment, there is Transaction-cost theory where Coase elaborates on the firms existence to minimise the transaction costs of exchange. These transaction costs arise due to market inefficiencies and information deficiencies (Asymmetric Information). Williamson (1979) has identified two types of transaction costs: ex ante (costs incurred in negotiating the terms of the contract, drafting etc.) and ex post ( costs incurred in enforcing a contract). Williamson says that the level of transaction costs will depend upon three factors: Uncertainty, asset specificity and frequency of exchange. There are many case studies which show that farmers and firms enter into contracts in order to minimize transaction costs. And the missing markets or imperfect markets of credit, insurance, information, specialized inputs and product markets are the main reasons for the farmers to enter into contracts. Key and Rusten (1999).

In their paper, Norsida Man and Nolila Mohd Nawi (2010) highlight the factors that induce farmers participation in contracts as easy market access, price of the produce being protected, credit support given by sponsors, technical and extension services. Agency theory focuses on the contractual relationship between two parties, in which the agent performs tasks for the principal. The optimal contractual relationship will depend on the information, negotiation, monitoring and enforcement costs involved in creating an incentive structure which sends the right signals to the agent. It also depends on the relative degrees of risk aversion between principal and agent. Transaction costs are central to agency theory, as is information asymmetry. (Grossman and Hart 1986) Pratap S.Birthal, P.K.Joshi and Ashok Gulati (2005) explain that there is a striking increase in the profits or incomes of contract farmers when compared to non-contract farmers in all the three commodities. In Milk the contract farmers received nearly double the net profit received by the non-contract farmers, in broilers the difference was 11% whereas in the case of fruits and vegetables the difference was 78%. There was also the advantage for contract farmers in the savings of production and marketing costs. As these transaction costs were much lower for the

contract farmers. The predictions made regarding the shifting of non-contract farmers into contracts and vice versa showed that a majority of milk producers (86%) and vegetable farmers (65) were willing to enter into contracts. Majority of the studies show that income benefits and reduction in the transaction costs both for the firm and the farmers are the main reasons for the rapid expansion of contract farming ventures. However there is contract enforcement theory that focuses on the incentives to honour contracts. These incentives can be public (such as forms of legal redress), private (the match between the contents of the contract and market conditions at the time of exchange), or a mixture of both. Gow et al. (2000) posit that at any point in time during a contract, both parties assess the costs and benefits of breaking their deal. If market conditions change unexpectedly, such that the benefits of delaying or breaking the contract are greater than the capital and reputation losses for one party, then this will lead to a holdup (in other words, exchange will be delayed and the contract will not be honoured). Conversely, if the benefits estimated from such unexpected changes do not exceed the capital and reputation losses, then the contract will be fulfilled. Gow et al. (2000) refer to the range within which the contract will be completed as the selfenforcement range. However studies by Valerie Imbruce(2008), Pratap S.Birthal, P.K.Joshi and Ashok Gulati (2005) emphasise that instead of breaching the contract or breaking the deal, majority of the farmers switch to other firms for contracts in the future. This leads to competency theory. The competency approach is heterogeneous, drawing on business history, strategy,

evolutionary economics and technology studies. Hodgson (1998) explains the situation as follows: the contractual approach (including transaction cost economics and agency theory) is centered on the informational difficulties involved in devising, monitoring and policing contracts in a world of uncertainty and bounded rationality; whereas the competency theory views is more humanistic ,with the firm viewed as a repository of knowledge. Many firms talk about relationship building with the farmers in order to sustain in the long run. Pratap S.Birthal, P.K.Joshi and Ashok Gulati (2005). Political Economy Theory emphasizes that capitalists extract the surplus from the agrarian societies based on the Marxist and neo-Marxists views in the 1970s and 80s through exploitative means. This theory mainly criticizes the role of contract farming in exploiting the poor farmers and extracting their surpluses. If the role of the state is minimal, monopsonies transfer the risks generally to the farmers. These substantial spill-over effects of contract farming

have negative effects on the economy. Valerie Imbruce (2008),Flavia Echanove & Cristina Stefen(2005) while analyzing the power relations between the farmers and the firm emphasize that participation of farmers in contracts was due to the fact they has no other profitable alternatives, for financing technical assistance and access to markets. Whether the small farmers are dictated recipients of the dictated clauses (with only illusory control over production) or whether they have cooperative relations with other farmers to assert their bargaining power is still a question to be answered. The varied outcomes of contracting are influenced by political, economic and cultural variables of that location and the heterogeneity and context of contract farming makes it difficult to synthesize.

Small farmer participation in Contract Farming Arrangements: There were four reasons why the firms dealt with small-holders. : 1) More assured supply even in the case of crop failures for one or two farmers 2) Flexible production portfolio of small farmers that would help to quickly adapt to changing consumer preferences 3) Better quality as they involve family labor and have lower bargaining power 4) Marketable surplus being low increases the farmers dependency on the firm for profit maximization. Pratap S.Birthal, P.K.Joshi and Ashok Gulati (2005). Key and Rusten (1999) analyze the contracts of two international companies Bird Eye and Green-giant, in the central Mexico. What was found out was that the international firms contracted with small holders only during the time of boom, when the demand for the produce was high, and abandoned contracting with the small holders during the other periods. Initially all the contracts were resource providing contracts, that provided the inputs to the farmers, later when industry developed, factor markets emerged, that led the farmers to buy the inputs from the markets. The higher yield risk in the case of non-traditional crops and the poor performance of the legal system has led the international firms to contract out more with the large farmers, as these farmers are in a better position to smoothen out yield risks and breach of contract is lesser. Another important factor for dealing with large farmers was the increased costs associated with

dealing with a large number of small farmers- the inputs provided, the risks involved, extension services provided, etc. Flavia Echanove and Christina Stefen (2005) analyze the contract farming arrangements in Central Mexico and find that most firms enter into contracts with large and medium size farmers as the transaction costs are low and large farmers have certain kind of infrastructure and certain degree of economic solvency and access to irrigation. Key and Rusten (1999) have identified market imperfections or the missing markets associated with the non-traditional crops that influence the spurt of contract farming in the developing countries. However, the point that is not clear is the fact, why have the farmers shifted over to non-traditional crops from the traditional crops in the first place. Is it associated with risk taking behavior? Or is it follow the herd behavior? Or are they influenced by the s ocio-economic pressures? Or is it the Government in the developing countries trying to create a situation wherein contract farming spreads through out, so as to cater to the export needs? Research Gaps: The main gaps in the study of contract farming in the developing countries would be why the farmers (small and large) are opting to shift for non-traditional crops. By comparison, much less survey-based research has been done on the impacts of that such a shift on farmers and farm workers. This gap is particularly important because there is developing substantial controversy around two issues: to what extent and under what conditions: (1) does the shift to nontraditional crops via contracts include or exclude small farmers and farm workers? (2) Does inclusion raise incomes and modernize technologies of farmers? Research Area: My Research area is on contract farming in Tamil Nadu. Over the years, contract farming has picked up in almost all states in India and also in other developing countries. State-wise data shows that 236,610 hectares are under contract farming in Tamil Nadu. In Tamil Nadu contract farming in cotton is done by Appache cotton. Super Spinning mills of Tamil Nadu has entered into contract farming in cotton in Tamil Nadu since 2003 in the districts of Salem, Coimbatore,

Vellore, Namakkal, Madurai and Theni. A major effort to cultivate medicinal herbal plants such as coleus, turmeric, and red clover through contract farming is under way. Sami Labs Ltd, a Rs 259-crore company involved in the manufacture of products based on medicinal plants, fine chemicals, and spice extracts. The company adopts contract farming for the production of medicinal plants. Contract farming of Coleus forskholii (Marundu koorkan in Tamil ) is gaining popularity among small and marginal farmers in Salem district and its neighborhood. E.I.D. Parry operates four sugar factories that crush 35 lakh tonnes of sugarcane a year purchased from about one-lakh farmers. The Nellikuppam mill processes sugarcane into a wide range of products. Finally contract farming for poultry is also practiced in Tamil Nadu (Suguna Poultry) and recently emu farming (contract farming) is also gaining importance. This study seeks to study the acceptance of CF among the small and marginal farmers in Tamil Nadu and analyze the benefits that accrue to them due to contract farming? Are contracts properly enforced? Do farmers get proper prices for their produce and at the proper time? My research objectives are described below.

Research questions:

1.

Why is contract farming more concentrated in some specific high value crops such as fruits

and vegetables and livestock and not in food crops in Tamil Nadu? What the factors that influence the shift from traditional to non-traditional crops? 2. Does this shift to non-traditional crops include or exclude small farmers? If inclusion is taking place, does it raise the income of these small farmers in Tamil Nadu? 3. What are the reasons for the income differentials between the contract and non-contract farmers? 4. Are the farmers forced to take up to contracts due to social and economic constraints or are

they taking it up on their own will?