Poor, rural farmers are often left out of the market. They may not be able to compete with large farmers who can provide firms, such as grocery store chains or exporters, a consistent and high quality product. These barriers to entry may be an outcome of the scale of production but also of small farmers’ inability to commit to a contract. At the time of sale, if market prices are higher than contracted prices, farmers may renege and sell in the open market. While a farmer who reneges on a contract will probably pay the price of doing so by not having his contract renewed, the empirical evidence suggests that this is not a strong enough deterrent. There is also evidence that firms renege on the contract at the point of sale. To address this problem, we designed an experiment that manipulated the amount of collateral that a firm and a producer would pledge. The firm provided money in advance to a rural credit union for amounts of credit that farmers would receive at random. Firms also committed to purchase farmers’ products at prices that would incentivize increases in productivity. By randomizing the amounts of credit given, we alter the level of liability that both the firm and farmers experienced. Due to a weather shock and the corresponding fear of large losses, however, the credit union abandoned the experiment after selection into the program and randomization into treatments had occurred. Nonetheless, the firm decided to provide credit and inputs, with only the farmer’s reputation as collateral, to a subgroup of producers in the selected group and a subgroup of producers in the rejected/uninterested group, in a year in which demand for the product was unusually high. This provided a natural experiment on the effect of the hold-out problem underlying contractual arrangements in economies with weak legal systems. Our analysis shows that regardless of selection issues, producers receiving help from the firm benefited by increased production as well as higher prices at the time of harvest. Both the firm and the farmers seem to be engaged in a risk-sharing agreement with limited liability.
Paper: Some Experimental Approaches of Contracting Out of Poverty in Peru