Private mechanisms, informal incentives, and policy intervention in agricultural contracts.

Farm advocates and policy makers have become increasingly concerned about the fairness of agricultural contracts, creating political pressure to enact new laws to regulate agricultural contracts. While some states have either enacted or proposed new legislation (e.g., the Producer Protection Act of 2000), there is currently a paucity of formal economic analysis to inform policy makers of the potential economic impacts of such interventions. In addition, the theory of contract regulation is still an evolving area (Schwartz 2002), so there is no clear consensus concerning the appropriate role of the government.

Of course, the law and economics literature offers some well-known principles concerning contracts. Most law and economics scholars focus on the regulation of incomplete contracts (ICs) or those with unenforceable components. Contracts can be incomplete for many reasons, including indescribable contingencies, prohibitive costs of writing complete contracts, and barriers to enforcement. When contracts are incomplete, an unspecified contingency might arise, creating the need for ex post renegotiation over the terms of trade and giving rise to economic distortions that may justify government intervention (Wu 2006). Thus, a central theme from the law and economics literature is that the government ought to "fill gaps" in ICs through legal rules that improve efficiency by making contracts "more complete." For example, the specification of termination damages in Section 8 of the Producer Protection Act can be interpreted as a response to a failure by parties to specify liquidated damages.

Another means by which the government might facilitate "more complete" contracts is by creating institutions or laws that improve verifiability of performance, thereby improving third-party enforcement. For example, Georgia passed HB 648 in 2004, which requires processors to provide "any statistical information and data used to determine compensation paid" at a grower's request. The government can also conduct quality grading or create institutions for measuring quality, so that conflicts over quality determination or other performance factors can be minimized. (1)

The purpose of this article is to discuss whether regulations that make contracts "more complete" are necessarily welfare improving. While conventional wisdom seems to suggest that statutorily or judicially amending contracts to make them "more complete" is desirable, a new generation of contracting models may challenge this assertion. Recent theory suggests that in a second-best world, where complete contracts are impossible to write, some parties will inevitably be left with discretion. Hence, it may be optimal for contracting parties to increase the level of incompleteness in formal contracts in order to balance discretionary powers and thus limit opportunism (Bernheim and Whinston 1998). Simple contracts that appear highly incomplete may actually be optimal in a second-best context. Moreover, when parties interact repeatedly over time, they will form relationships and these relationships can potentially deliver informal incentives that are often more effective than formal incentives at governing performance. However, the set of feasible relational contracts depends on the structure of the formal contract, which affects the amount of discretion available to parties. Thus, government attempts to make contracts more complete through regulatory intervention may have negative consequences.

Simple Contracts and Economic Efficiency

A central assumption in IC theory is that important dimensions of performance are nonverifiable by a third party. While this assumption may offer a reasonable description of real-world contracting, it does not necessarily preclude complete contracting, because parties can, in principle, design "message games" to make information verifiable (Maskin 1999). For example, a "complete" contract might ask each party to announce what they observe and, if there is disagreement, both parties would be punished: such mechanisms can induce truth-telling as a Nash equilibrium. Nonetheless, a criticism of these message games is that they are rarely observed in practice and that they are not robust to renegotiation (Hart and Moore 1999). As such, contract theorists have looked for alternatives to message games in problems with nonverifiable information.

Two related strands of research suggest that contracting parties can minimize the distortionary effects of nonverifiability even when contracts can be renegotiated. First, the work of Bernheim and Whinston (1998) on strategic incompleteness suggests that an ex ante contract can define the scope of discretionary powers available to parties; that is, less complete contracts increase discretionary latitude. Thus, an important aspect of contract design in a second-best world is to ensure a proper balance of discretionary latitude between parties so as to limit exploitation. Second, research based on mechanism design principles concludes that first-best outcomes can sometimes be achieved through simple initial contracts that are later renegotiated. (2) Even though these simple contracts have apparent "gaps" in them, they can be "optimal" in the sense that they are able to achieve first-best outcomes when combined with ex post renegotiation. Thus, any government attempts to make the initial contract more "complete" can only reduce efficiency.

To illustrate our points, suppose that a processor and a grower can potentially trade one unit of a good, y [epsilon] {0, 1}, where 1 implies trade and 0 implies no trade. This good can also take quality levels q [epsilon] [[q.bar], [bar.q]], where q is observable but not verifiable by a third party. If trade occurs at some contractually specified price, P, the payoffs to the processor and grower are [[pi].sup.p] = R(q) - P and U = P - c(q), where the revenue function, R(q), obeys R([q.bar]) = 0, R'(q) > 0, and R"(q) [less than or equal to] 0. The cost of producing a good of quality q is given by the function c(q), where c([q.bar]) = 0, c'(q) > 0, and c"(q) > 0. Hence, the processor's and grower's profits from exchange (y = 1) are functions of the quality. If no trade occurs (y = 0), then the processor earns [bar.[pi]] and the grower earns a reservation payoff [bar.u]. Social surplus is then given by S = R(q) - c(q) - [bar.u] - [bar.[pi]]. Assume that S [greater than or equal to] 0 and R'(q) [greater than or equal to] c'(q), [angstrom]q [epsilon] [[q.bar], [bar.q]], so that y = 1 and q = [bar.q] imply social efficiency.

The timing of the relationships is as follows. At time 0, the parties may sign a contract specifying the verifiable actions and obligations. At time 1, the grower chooses q. At time 2, after q is observed, the parties may renegotiate all obligations that were not specified in the original contract or are not enforceable. We assume that the processor has full bargaining power and can make a take-it-or-leave-it offer to the grower.

In this example, a third party such as a court can verify whether trade took place (y = 1 or y = 0) and enforce the contract price, P. However, the court cannot verify q and therefore would not be able to enforce a quality-contingent price schedule. Under these assumptions, it is possible to construct contracts with varying degrees of completeness to explore the potential consequences of government intervention.

Case 1: The "Complete" Contract

We point out that limits to verifiability imply a second-best world where it would be impossible to structure a contract that fully specifies all actions. Without verifiability of q, the grower will always retain some discretion in choosing quality. However, a contract can be conditionally complete in the sense of Bernheim and Whinston (1998) if it restricts the processor's and grower's actions to the maximal extent allowable given limits to verifiability. Thus, if the government undertakes to "fill gaps" in the contract to the fullest extent possible, a "complete" contract requires enforcement of any agreement that fixes y and P so that no renegotiation of these obligations can occur. Under such a "complete" contract, the last mover in the sequential contracting game is the grower, who chooses q given y = 1 and P. Since P is fixed, the grower will set q = [q.bar], which is clearly suboptimal. Because the processor anticipates that the grower will choose q = [q.bar], it will set price [??] = c([q.bar]) + [bar.u], so that the grower's profits equal her outside payoff. Clearly, such a contract is suboptimal as it delivers only minimal quality and surplus under trade.

Case 2: An "Incomplete" Contract