Have a look at our trailer for a brief introduction to this course: https://youtu.be/GADAgxTHjgE In this course, you learn how the agro-food value chain approaches the challenge of constantly improving its competitiveness by producing high quality food and products and also aiming to attain greater sustainability. Some of the topics of this course are: • The notion of quality for food and agricultural products and consumer value. • How to conduct market research in this field. • Labelling, branding and pricing strategies, as-well as innovation in the agro-food sector. • How sustainability can be used as a competitive advantage through corporate social responsibility. • The role and different types of industrial standards. • The different forms of coordination in the chain, in particular with regard to the retailing and distribution sector. This course is taught by a group of international experts from Universities in Italy, Germany, Ireland, Scotland and the Netherlands. Each of them will give you insights into a specific topic related to food quality and the organization of the agro-food value chains.
Part 1: Contracts and the Incentive Problem
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En provenance du cours de Technische Universität München (TUM)
The Economics of Agro-Food Value Chains
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Module 11: Coordination in the Agro-food Value Chain
In this module you will learn about the coordination continuum, when coordination is profitable and possible incentive conflicts.
Rencontrer les enseignants
Hannes LangResearch Associate
Technical University of Munich
Luisa MenapaceProfessor
Technical University of Munich
Faical AkaichiResearch Economist
Scotland’s Rural College
Francesco BimboResearch Economist
Wageningen University
Montserrat Costa-FontResearch Economist
Scotland’s Rural College
Carlo RussoAssociate Professor
University of Cassino and Lazio Meridionale
Chenguang LiResearch Economist
University College Dublin
Welcome to this module about "Coordination in the Agri-Food Chain".
This is Lesson 2 and we will talk about Contracts in the Agri-food Value Chains.
My name is “Carlo Russo” and I am an Associate Professor in Agricultural Economics at
the Department of Economics and Law at the University of Cassino and Lazio Meridionale.
Here is the roadmap of Module 11.
In Lesson 1 we covered the definition of coordination.
We defined what we mean by efficient coordination, and we learned that there are many ways to organize a transaction.
We learned that transaction costs are important and we defined the conditions when coordination
is more efficient than spot market.
If you are not clear about these points or if you missed Lesson 1, this is a good time
to go back and review the material.
You will need them as a background for today’s lecture.
Today, in Lesson 2, we focus on a specific form of coordination: Contracts.
As usual, we start by providing a definition and general notions about contracts.
Then, we move on to the design of efficient contracts.
This is a very important problem in Agri-Food Value Chains.
For this purpose, we use the simplest approach, the principal-agent model.
We will give special attention to a key issue in contract design: the incentive problem,
which is the problem of making sure that all participants involved in the transaction share
common objectives and goal.
Only if you are able to solve the incentive problem, can coordination be really successful.
This topic concludes Lesson 2.
In Lesson 3 I will cover a simple example of the general notions we have learned so far.
At the end of this video, you will be able to:
understand and explain what is a contract from an economic perspective is,
identify incentive misalignments among forms participating in a transaction,
provide possible solutions for basic misalignment problems.
A contract is “A voluntary agreement that is legally binding among parties”.
There are three key points in this definition.
The contract is a voluntary agreement, meaning that it is a free choice of the parties.
In principle, there is no coercion in contracting.
If in a dark valley a bad guy with a gun asks you “the money or your life”, that is not a contract.
This point has an important connection with the idea of free bargaining that we discussed in Lesson 1.
In particular, no one signs a contract that makes him or her worse off.
Note that I can sign a contract because I consider it the lesser of the two evils.
Nevertheless, this is a free choice and I am still better off with the contract than without it.
The second important point is that the contract is only “legally” binding.
This means that your counterpart has NO absolute obligation to fulfil the contract.
He/she can breach the contract whenever he/she thinks it is profitable (again, it is a free choice).
The only thing you can do is to sue him/her in court.
This point connects with the importance of enforcement in efficient bargaining that we discussed in Lesson 1.
Finally, a contract is an agreement among private firms under commercial law.
You can have a contract with the public sector (the government), but in this case,
the government acts as a private entity.
This is important because it implies that contracting happens between parties holding
the same rights and obligations.
A contract is defined by four key elements.
The parties, that is, the firms or the individuals signing the contract
The content, that is, the obligations that each party commits to.
The contract can be considered as a set of reciprocal obligations.
Each party commits to an action (for example, gives goods or provides a service)
in order to benefit from the actions of the counterpart (for example, a price).
The default conditions define the situations in such a way, so that we can claim that
the counterpart did not fulfil the obligations.
For example, because the product sold was defective.
The Institutions are the set of laws, regulations and rules that are relevant to the contract.
We have already mentioned commercial laws.
Other examples might include safety regulations, or rules about consumers’ guarantees, etc.
These rules complement the contract and affect the behavior of the parties.
Now let’s see how contracts work from an economic point of view.
Contracts are studied by scholars of different fields, mainly Law Sciences and Economics.
As we will see shortly, the two points of view are quite different in the conclusions they reach.
We sign contracts because we want something from other firms or individuals.
In particular, after signing a contract we have expectations about the other party’s behavior.
We would like that the other party behaves according to our expectations.
Because of free bargaining, if we want something from that the other party,
we need to be willing to give something in return.
This exchange is the core of the contract.
We are willing to pay in order to make sure that the other party behaves according to our expectations.
Before signing such a contract, we run a cost-benefit analysis.
We compare the benefit from the other party’s expected behavior with the cost of the obligations we commit to in return.
Because contracts are free agreements, we sign the contract only if the benefits exceed the costs.
What if the other party behaves differently from our expectations?
Maybe because of a misunderstanding, maybe because of some external cause, maybe because
the other party voluntarily breaches the contract,
we face a behavior that is not what we expected when we signed the contract.
For example, the product we bought is not what we assumed it was, for example,
the tomatoes we bought were not organic.
If this happens, then it is likely that our Cost-Benefit evaluation was wrong.
There is a potential for a loss in profits (or utility).
In our example, we paid that high price because we assumed we were buying organic tomatoes.
However, the price was definitely too high for conventional tomatoes.
Here is where Law studies and Economics take different directions.
If you ask a lawyer about this problem.
He/she says that you can ask for compensation.
You suffered for an unfair loss in utility, and therefore, you are entitled of to compensation.
A Judge will assess the liabilities and the fair reparation.
The economist’s point of view is different.
The main idea is that lawsuits are risky and costly in time and resources.
It is better to stay away from them.
It is better to prevent the whole situation.
It is much preferable to design a contract in such a way, so that the other party has
not incentive to unexpected behavior.
The trick is making strategic concessions to make unexpected behavior unprofitable.
It may sound confusing now, but I hope it will be clear by the end of the module.
For now let’s focus on this study question: “How can we write a contract in such a way,
so that the other parties behave exactly as we expect them to do?”
Of course, being economists, we are interested in achieving our objective while minimizing the costs.
Let’s start our analysis describing “the perfect contract”, which is a contract that
makes us sure that our expectations are met.
We can be sure of this if several conditions are satisfied.
In particular, it must be possible and costless to write a contract that:
is perfectly clear and leaves no rooms for misunderstanding.
It considers all possible cases and actions, leaving no loopholes of any kind.
The actions of all parties are perfectly observable.
All parties know exactly if whether and how the others fulfill their obligations.
If somebody breaches the contract, all other parties detect the violation and can assess its extent perfectly.
Once violations are detected, the party can be forced to fulfill the obligations.
Otherwise, perfect compensation is obtained from a costless, immediate and perfect judgment.
If all these conditions are met, we have a “Complete” contract.
A complete contract is efficient according to the Coase Theorem in Lesson 1 and effective.
Unfortunately, perfect contracts are also almost impossible to achieve.
In real life, things are different: writing a clear contract requires costly expertise,
for example, the work of a good lawyer. It is practically impossible
to rule out all conceivable loopholes.
Perfect monitoring is very rare.
Lawsuits are costly. In real life complete contracts are almost impossible.
Therefore, we need to use incomplete contracts.
This means that we need to deal with a serious issue: opportunism.
Opportunism is defined as “the taking of opportunities as and when they arise,
regardless of planning or principle”.
In our setting, opportunities arise from incomplete contracts.
If the contract is incomplete, changes in the business environment (such as a new customer,
changes in prices, or even the action of the other parties) may create new opportunities for profits.
Then, the opportunists might maximize their own profits by behaving differently from others expectations.
Breaching the contract in order to achieve a personal profit is highly unethical.
Of course, the world of business is full of honorable persons who would never break their word.
Dealing with such honorable persons is not a problem.
However, we also know that this is not always the case.
Most importantly, we usually cannot tell one from the other before it is too late.
Thus, we had better to be prepared, just in case.
Just to be clear, this lecture is not intended to teach you how to be opportunistic.
You do not need to be an economist for this.
The lecture is about defending yourself against opportunistic behavior.
The goal of the economist is to prevent opportunistic behavior.
What the economist is trying to achieve is a “Self-Enforcing Contract”, which is
a contract s leading to no economic incentive to opportunism.
There is a simple trick to test if a contract is a self-enforcing one.
Put yourself in the shoes of the party you are concerned doing business with.
Assume that all other parties are fulfilling their obligations and ask yourself:
Do I maximize my utility or profits by breaching the contract?
If the answer is “No”, then it is a self-enforcing contract.
If the answer is “Yes”, then the contract is NOT self enforcing and you need to worry about opportunism.
The definition of self-enforcing contracts has a clear connection with Nash’s equilibrium.
Consider a simple contract in which each party has only one binary choice:
either to breach the contract or to fulfill the obligation Then the contract is self-enforcing if:
for all parties the best response to the opponents’ “Fulfill” strategy is to “Fulfill”.
Such a condition means that in a self-enforcing contract there is no incentive to breaching the contract.
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