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Economics of contracting

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

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Economics of contracting

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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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