Understanding Production Contracts: Testing an Agency Theory Model

We construct and test an agency-theoretic model of broiler production contracts. Our empirical results generally support our model, and provide insight into the incentives underlying the design of the contract and the sources of returns to broiler processors and growers. The authors are, respectively, Assistant Professor, Department of Agricultural and Resource Economics, University of California at Davis, Robert Gordon Sproul Distinguished Professor and Adjunct Associate Professor, Department of Agricultural and Resource Economics, University of California at Berkeley. Goodhue and Rausser are members of the Giannini Foundation of Agricultural Economics. This paper is based on Chapter Four of Goodhue’s dissertation. Benjamin Hermalin, Jeff Perloff, and David Zilberman provided many helpful comments during the dissertation-writing process. Walter Thurman provided the broiler industry data. Bob Lyons provided assistance with SAS, LTEX and Mathematica. Goodhue acknowledges the financial support of a National Science Foundation Graduate Fellowship and a Poultry Science Association Maurice Stein Fellowship. Comments and suggestions are appreciated. Contact information: email [email protected] phone (530) 754 7812 fax (530) 752 5614. Copyright 1998 by Rachael Goodhue, Gordon Rausser and Leo Simon. All rights reserved. Readers may make verbatim copies of this document for non-commercial purposes by any means, provided that this copyright notice appears on all such copies. Production contracts between farmers and other stages of the agrofood chain have always been important in American agriculture. Relatively little is known, however, about the fundamental forces governing the adoption and design of these vertical coordination measures in the agricultural context. In order to gain insight into the incentives embedded in production contracts, we construct and test an agency-theoretic model of broiler production contracts. We then discuss the implications of our analysis for industry participants and government policy. The broiler industry was one of the first agricultural sectors to widely employ production contracts.1 Over 90% of broiler production is contracted, with the remainder primarily raised at processor-owned facilities. Due to the importance of contracting in the broiler industry, it is a ideal candidate for examining the incentives underlying contract design. A typical contract design requires a broiler processor to provide chicks and feed to a grower, who provides the necessary labor and capital equipment. On average, a processor may contract with 100-200 growers for a single processing facility. In a typical contract, growers are paid on a perpound basis. The base price per pound of chicken produced is adjusted for each grower depending on his “settlement cost” relative to the average settlement cost of the group of growers slaughtering flocks within a oneto two-week comparison window. A grower’s settlement cost measures how efficiently he converts the processor-provided chicks and feed to final product. Growers with lower settlement costs receive a higher price per pound. Thus, broiler production contracts commonly have a relative compensation element. Other researchers have investigated broiler contracts. Knoeber (1989) credits the use of broiler contracts and relative compensation with encouraging productivity-improving innovation in the sector. Knoeber and Thurman (1995) compare the price, common production and idiosyncratic risk borne by growers and processors on a per-flock basis under existing contracts, counterfactual contracts without relative compensation, and a counterfactual spot market. They find that growers 1 The fruit and vegetable industry has been another sector which has intensively utilized contracting. Elsewhere, we discuss contracts in the fresh and processed tomato industries (Goodhue and Rausser 1998, Goodhue 1997).