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Economics of Contracting: Viability, Risks, and Management

This article explores the economic viability, risks, and management involved in contracting. It discusses the division of value, risk, and decision rights in transactions, as well as the costs associated with contracting. Changes in the value chain and measurement costs are also analyzed. The article concludes with a discussion on the hidden value of options in contracting.

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Economics of Contracting: Viability, Risks, and Management

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  1. Economics behind contractingPIE 231, April 3-4, 2000Contracting: Economic Viability, Risks, and Management Dr. Michael Sykuta Agribusiness Research Institute University of Missouri

  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

  4. Division of Value • Gains from trade • 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)

  6. Division of Decision Rights • Input Decisions • Management Decisions(field/equipment/services) • Timing Decisions (planting/harvesting/delivery/pricing) • Pricing decisions • Performance decision

  7. The Three Amigos • Value, Risk and Decision Right allocations are interdependent. Each affects the other. All affect incentive structures. • Key Point:Decisions 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

  9. Changes in the Value Chain • Consumers at every level are driving demand for different dimensions of quality and consistency • Competitive pressures at every level call for greater degree of coordination between trading parties • Traditional commodity marketing channels are not equipped to handle these needs.

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

  11. Negotiating Costs • In general, at present, the buyer is writing the contract…and there is not much negotiating. • However, processors are spending a lot of money figuring out how to design their contracts.

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

  13. Measurement and Contracting • Separability vs. Task-programmability • Separability: • Ability to measure output and reward producers based on output quality (e.g., grade and yield) • Task programmability: • Ability to measure input and control ouput quality by choice of inputs. • Which is more cost-effective?

  14. Changes in measurement costs • Standard grading scales are no longer as useful: • No. 2 yellow corn and No. 1 red wheat don’t give enough information. • Imbedded character traits are where the value lies. • Those output traits are frequently determined by choice of inputs.

  15. Effects of measurement costs • If you can tell by the input what the output will be, it may be easier to contract for the input…including the management package.

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

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

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

  19. Sources of “Hidden” Value • The option to default • particularly producer’s option to invest more or less in additional premiums throughout the growing season. • The timing option • particularly delivery schedules (buyer’s call vs. harvest deliveries)

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