Contract enforcement, social efficiency, and distribution: some experimental evidence.

Recent controversies surrounding contract production in agriculture have raised concerns among policy makers that vertically coordinated industries might favor large agribusiness at the expense of growers. Among the issues that have received attention include the apparent lack of bargaining power possessed by growers when negotiating and performing under contracts, and the lack of transparency concerning how performance and payments are determined (Pierce and Stewart 1997). As an example of the latter, Schrader and Wilson (2001) analyze data from a survey of broiler growers and suggest that many growers were concerned about the quality of inputs they received from contractors and the timeliness and accuracy of bird weighing. Because both input quality and the accuracy of weighing can affect performance outcomes, which in turn, determine compensation, there might be a lack of transparency in the determination of pay. (1) Along similar lines, Hamilton (2001) points out that many broiler contracts contain a provision that allows a contractor to unilaterally change payment methods or rates, which provides integrators with the option of making discretionary ex post adjustments in pay. The lack of transparency can make it difficult for third parties, such as courts or regulators, to enforce contracts. This means contracts may be rendered incomplete by limits to enforcement.

While enforcement problems appear to be key issues for policy makers, there have been few efforts to clarify the consequences of contractual enforcement on efficiency and distribution. Textbook principal-agent models are inadequate for studying enforcement problems because an assumption of these models is that third-party enforcement of contracts is perfect. Thus, law and economics scholars focus on contracting environments where there are limits to third-party enforcement so that contracts are incomplete.

An analysis of the impact of third-party contract enforcement is complicated by the fact that traders can devise informal enforcement mechanisms to self enforce contracts. Incomplete contracts combined with the possibility of repeated trading, which is common in some agricultural subsectors, (2) enable private parties to devise informal enforcement mechanisms (i.e., form relational contracts) to mitigate hold-ups and other distortions (Telser 1980; Klein 1996; Macleod and Malcomson 1989; Levin 2003). Relational contracts fit many of the stylized facts of agricultural contracting because even if explicit contracts exist, some dimensions of performance (e.g., quantity commitments, timing of deliveries, contract renewal) are frequently omitted from explicit agricultural contracts, opening the door for informal incentives.

Apart from theoretical issues, there is a paucity of data for studying policy issues in vertically coordinated industries. Explicit terms in contracts are often buttressed by unwritten rules, informal incentives, and tacit expectations so that it is difficult to find observational data that captures every important aspect of the contracting environment. There is also a lack of historic precedent for many of the contracting issues that have emerged recently in U.S. agriculture. Thus, there is little data available for assessing the impact of alternative enforcement regimes on trading outcomes.

Given the lack of theoretical and empirical research, it is not surprising that economists and policy makers hold numerous opinions about how government regulations of agricultural contracts would affect efficiency and distribution. Some economists suggest that too much regulation spurs unintended consequences that, for example, may cause livestock industries to leave states in which regulations are binding (Boehlje et al. 2001). Others suggest that regulations and enforcement are necessary to enhance both fairness and competitiveness in contract agriculture (Harl et al. 2001; Taylor 2002).

This study uses experimental economics to investigate the effects of third-party enforcement on contractually based markets with buyer concentration. Our experimental setup is based on the design of Brown, Falk, and Fehr (2004); two treatments are identical to theirs while a third treatment unique to our study facilitates examination of issues pertinent to agricultural contracting. An experimental approach allows for exogenous variation in enforcement regimes, which facilitates estimation of causal relationships. We view this study as an initial step in understanding the microeconomic forces that shape trading patterns in a contractually based economy where buyers have bargaining power and third-party contractual enforcement might be imperfect. The insights generated in this study can shed light on how policies that increase transparency and/or third-party enforcement of contracts can affect efficiency and the distribution of rents.

Noussair and Plott (1995) argue that experiments need not replicate field situations and all institutional details to retain relevance for policy analysis. Instead, experiments are valuable in that they allow economists to examine general theories that should apply more broadly. If a theory does not apply in simple, controlled environments, one must question whether the theory is appropriate for explaining behavior or predicting responses in more complex environments. Moreover, abstracting from reality is not unique to experiments; indeed, most economic studies incorporate simplifying assumptions and abstractions.

One main finding is that perfect third-party enforcement promotes social efficiency. However, we also find that a regime devoid of third-party enforcement can generate comparable social efficiency. In such regimes, many subjects use contractual renewal and discretionary adjustments in contract terms to provide informal enforcement that can be nearly perfectly substitutable with formal enforcement in terms of generating social surplus. This finding is consistent with the case studies provided by Anderson (1999) and Gow, Streeter, and Swinnen (2000), which show that self-enforcing agreements can substitute for inefficient third-party enforcement. However, we find that a nontrivial fraction of trades resulted in sellers (i.e., growers) making ex post profits that fell below reservation payoffs due to opportunistic buyer behavior. Another interesting result is that one-sided formal enforcement (buyers' obligations only) constrains subjects' ability to use informal enforcement, which resulted in significant efficiency losses.

Experimental Design

Motivation

Agricultural contracts facilitate vertical coordination because processors can provide incentives for performance factors that enhance profits. In a typical contract, a grower agrees to produce crops or animals in a manner consistent with conditions in a written or verbal agreement. (3) Growers are then paid according to a price established in the agreement.

In practice, a processor may care about a range of performance factors, including quality, on-time delivery, product consistency, and efficient input use. While there is considerable heterogeneity in performance factors across contracts, the key point is that contracts are essentially incentive devices for increasing productivity and the value of trade. Thus, in designing our experiments, we were primarily interested in a design that would allow us to assess the incentive effects of contracts.

In complete contracting environments, where third-party enforcement is assumed perfect, the crucial question is how variations in explicit incentive structures affect productivity. However, if there are impediments to complete contracting, such as limits to enforcement, then parties may be constrained in their ability to structure explicit incentives and must also rely on implicit or informal incentives. In practice, contractors use discretionary adjustments in pay and contract termination policies. Such discretionary ex post adjustments in contract terms can affect future trading equilibria.

Given that there often are barriers to third-party enforcement of agricultural contracts, implicit incentives cannot be ignored. Moreover, even if explicit incentives exist in an incomplete contract, informal incentives will still supplement explicit incentives in motivating performance. For example, although broiler contracts contain explicit incentives for efficient input use, processors may supplement these incentives with discretionary adjustments in pay and/or the number and frequency of flock placements, which affect future pay. Some have suggested that when there are limits to enforcement, it may be optimal to omit explicit incentives entirely even if some dimensions of performance are enforceable (Bernheim and Whinston 1998). Thus, the focus of our study is on informal incentives and how interventions (e.g., new policies or institutions) that impact third-party enforcement will affect trading outcomes.

Details of the Design