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Understanding Economics of Contracting: Key Concepts and Considerations

Learn about the fundamentals of contracting, value division, risk allocation, decision rights, and transaction costs in economic terms. Explore the intricacies of negotiation, monitoring, and enforcement in contracts. Discover the impact of changes in the value chain and hidden value sources. Delve into the complexities of measurement, risk management, and the interdependence of value, risk, and decision rights allocations.

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Understanding Economics of Contracting: Key Concepts and Considerations

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  1. Economics of contracting Based on presentation by Dr. Michael Sykuta

  2. A Contract is… • A legally enforceable mutual promise to perform an act (to do or to refrain from doing something) that is not already required by law. • An institutional structure governing (outlining the terms of) a transaction…”the rules of the game.”

  3. Every transaction entails a(n): • Division of Value • Division of Risk • Allocation of Decision (Property) Rights • The 3 are interdependent • Use Hershey-WalMart deal to illustrate

  4. Division of Value • Gains from trade- how do Hershey and WalMart share profits? • Sources of Value: • Price • Quantity • Quality and/or Specific Product Traits

  5. Division of Risk • Each value source has its own set of uncertainties that create source-specific risk • Price Uncertainty • Quantity • Yield Uncertainty • Delivery/Performance • Quality (particularly endogenous traits) • If it doesn’t work out, who loses what?

  6. Division of Decision Rights • Input Decisions • Management Decisions(field/equipment/services) • Timing Decisions (planting/harvesting/delivery/pricing) • Pricing decisions • Performance decision • Hershey decides what candy and what price – WalMart measures performance

  7. Value, Risk and Decision Right allocations are interdependent. All affect incentive structures. • Key Point:Decision Rights are valuable in and of themselves! The ability to make a choice has value.

  8. The Costs of Transacting • Transaction costs associated with contracting: • searching out contract partner/contracting info • negotiating terms of the contract • performance • monitoring and enforcement • Changes in these costs are driving much of the push for contracting • larger scale hog production makes contracting worth the trouble

  9. Changes in the Value Chain • Consumers are want dimensions of quality and consistency • Competitive pressures call for greater coordination – timing in hog plants • Traditional commodity marketing channels are not equipped to do this

  10. Search Costs • Who has what you want or, from the producer’s perspective, who wants what you have to sell? • high-oil corn • What kinds of products are out there and how do they fit your needs? • The more specialized your needs, the higher the search costs - the more important the trading partner.

  11. Negotiating Costs • Often, one side writes the contract …and there is not much negotiating. • Designing contracts not easy

  12. Monitoring and Enforcement • How do we verify that we’re getting what we pay for? • How difficult is it to determine (measurement costs) • How costly is the difference? • How can we enforce the deal? • Go to court • Liquidated damages

  13. Measurement and Contracting • Directly: Measure output and reward producers based on output quality (e.g., grade and yield) • Indirectly: Measure inputs and control output quality by choice of inputs • Which is more cost-effective? Depends – pollution control focuses on inputs – most ag stuff on outputs (exception – sprays)

  14. Changes in measurement costs • Standard grading scales are often inadequate • No. 2 yellow corn and No. 1 red wheat don’t give enough information. • Imbedded character traits have value • Those output traits are frequently determined by choice of inputs.

  15. The bio-tech factor • Developers of biotechnology want to protect that value and recover the costs of development.

  16. Questions to consider • What is the value in the transaction and what is each party’s contribution? • How does the transaction reflect measurement costs? • What are the sources of risk in the deal?

  17. Who’s bearing the risk? • Price - primarily still the producer • Quantity - primarily the buyer • Quality - primarily the buyer

  18. Sources of “Hidden” Value • The option to default • The timing option • particularly delivery schedules (buyer’s call vs. harvest deliveries)

  19. Raising Heifers • Many farmers outsourcing heifers • Often retired dairy farmers doing it • What must be in the contract

  20. Final Thoughts • Generally one side wants the contract worse than the other • They must provide some value to get the other party to accept • Sometimes both parties want it badly • In all contracts the small print is important

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