The Risk-Incentive Tradeoff: A Case of Illinois Hog Production Contracts

Production contracts have gained significant popularity as a mechanism of vertical coordication in several agricultural industries. However, the compensation received from such contracts does not always satisfy the grower’s optimal compensation strategy. Furthermore, these contracts are non-adjustable over the contract term although a grower’s risk position often does change. This analysis illustrates that it may be beneficial for integrators to offer a range of compensation formulas to the grower in order to attract new growers and reduce hold-ups. Introduction The use of contracts as a mechanism to coordinate and organize production in agriculture has been growing topic of discussion for many researchers over the past decade. For the most part, the focus of much of this discussion has dealt with descriptive surveys detailing the use of contracts (Lawrence et al., 2001; Ward et al., 2001), evaluation of optimal organizational structure (Johnson & Foster, 1994; Roberts, 1999), and analysis of the nature of risk-shifting in production contracts (Knoeber & Thurman, 1995; Martin, 1997). Previous research with respect to production contracts has focused on the risk shifting nature of production contracts. Knoeber and Thurman (1995) and Martin (1997) demonstrate that production contracts not only shield farmers from price risk, but in certain contracts where relative performance is a part of the compensation package (i.e. tournament pricing), production risk is at least partially shifted away from the grower as well. In a similar study, Johnson and Foster (1994) focus on preferred contract choices in a mean-variance context using one of the accepted risk efficiency criteria.