Egerton University

Department of Agricultural Economics and

Agribusiness Management

Policy options on contract farming in developing countries and their implication on stakeholders.

Khainga, D.N., Kibet, W.K., Robert, G.B.

Abstract

There is an emerging concern about the viability of contract farming in developing countries among the
smallholder farmers and larger agribusiness firms particularly in the context of on-going process of
globalization. It is contended that profitability of small farms can be improved through diversification of
agriculture into higher-value crops like fruits and vegetables. This paper has assessed the benefits and
constraints faced by contracted farmers and contracting firms as well as policy options available to the
developing countries to promote contract farming for fruits and vegetables. Theres is empirical evidence
that fruit and vegetable production is more profitable and labour-intensive; therefore it fits well in the
small farm production systems (Joshi, et al, 2006). Fruits and vegetable production is the emerging sector
in agricultural diversification that would augment income of smallholders and generate employment
opportunities in rural areas. Promoting women participation in negotiation and management of contracts
is critical to the sustainability of contract farming. The need to fully involve all the stakeholders in
formulation and implementation of the contracts is essential to ensure that all their interests are taken into
consideration for its success in the long run. However, prevailing constraints do not allow smallholders to
fully expropriate the emerging opportunities in fruits and vegetable production. Fruits and vegetable
prices are volatile, which severely affect the profitability in the event of marginal increase in their supply.
Low volumes of marketable surplus also adversely affect the bargaining power of smallholders and thus
results in realizing lower prices. The possible solution for overcoming this is through developing
institutional arrangements that strengthen farm-firm linkages. Contract farming is one such arrangement
that helps smallholders to overcome the constraints in production and marketing fruits and vegetables in
developing countries. Thus, the need for developing policy framework that promotes and safeguards the
interests of all the stakeholders in contract farming schemes

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Table of Contents
Abstract ................................................................................................................................................................. i

Stakeholders ......................................................................................................................................................... 1

1. Participating farmers ................................................................................................................................... 1

2. Non-participating farmers........................................................................................................................... 2

3. Contracting firms ........................................................................................................................................ 2

4. The government........................................................................................................................................... 2

5. Farmer organizations .................................................................................................................................. 2

6. Non governmental organizations ............................................................................................................. 2

Benefits of contract farming ............................................................................................................................... 3

Constraints of contract farming in developing countries .................................................................................. 3

Policy options for developing countries............................................................................................................. 4

Summary .............................................................................................................................................................. 8

References ............................................................................................................................................................ 9

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Background

Minot (2007) defines contract farming as agricultural production that is carried out according to prior
agreement in which the farmer commits to produce a certain product in a given manner and the
buyer(contracting firm) commits to purchase it. Production and selling under contract has been a common
arrangement in agricultural production and marketing in both developing and developed countries. This
implies that contract farming has been in existence for a long period, particularly for perishable products
such as vegetables, milk and fruits (Bijman, 2008).
In most developing countries there are two types of contracts in contract farming, one is formal contract
and the other is informal contract. Formal contracts are legal and can be enforced at the court of law
whereas oral contracts are implicit and greatly rely on self enforcement. There are probably many types of
contracts in contract farming but there are common distinguishing factors from other alternatives in that
contract farming impacts on the marketing of the produce in three stages comprising of agricultural
micro-system of input supply, production and processing (Abler David et al, 2011). Contract farming is
usually attempts by agribusiness firms to expand their operations by increasing on their profitability and
risk management by diversifying the sources of their agricultural products.
As contract farming becomes more important for agric-food industries especially for vegetables and
fruits, there is demand on better insight on the conditions under which contract farming works for it to be
efficient and fair. This can be achieved by eliminating bounded rationality and opportunistic behaviour
among the parties (Bijman, 2008). The majority of empirical studies suggest that contract farming
schemes generally raise the income of farmers participating in contract farming but it is not clear to what
extend are the contracting firms are willing to contract small holder farmers. The solution depends on the
commodity, the market and mainly on the policy environment.

Stakeholders

1. Participating farmers
These are farmers who participate in contract farming. They face unequal power relations
between them and the contracting firms. They usually participate in the contract for their own
interests for instance access to inputs, guaranteed lucrative markets and stable prices. When
prices are higher than the contract prices they are tempted to sell their produce in spot markets
risking losing the contract if discovered.

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2. Non-participating farmers
These are farmers who are undecided about joining the contracts or not. Some were in the
contracts but they decided to quit or they breached the contracts or the contracts ended. The
motivating factor that can make them participate or join contracts is access to inputs and stable
prices. Most of non-participating farmers are those who sell their produce on spot markets and
they bear high risks because they are not guaranteed stable prices and access to inputs. They may
be unable to participate in the contracts due to barriers of entry such as criteria established by the
firm regarding the contracts.

3. Contracting firms
These are Agribusiness companies that engage in production of a given product at a guaranteed
future price. Their aim is to ensure steady flow of high quality agricultural products at the lowest
cost. These firms face difficult decisions between working with the lowest number of large scale
farmers who are difficult to bargain with and the pressure from the government to work with
small farmers and help promote rural development.

4. The government
The government provides infrastructure that leads to improvement in the modern agricultural
sector, extension services and policy guidelines that encourage the contractors extend the contract
periods. The government benefits from contract farming through tax revenues, increase in the
exports resulting in high foreign exchange rates and balance in trade. Contract farming leads to
creation of employment addressing the problems of rural area development through increase in
earnings and overall rural development.

5. Farmer organizations
These are groups and organizations formed by the farmers, mostly by farmers with common
interest, at times referred to as common interest groups. They facilitate trainings and help in
negotiating better prices for the farmers and rules on grading and standards. They also do bulk
building thus benefiting from the economies of scale.

6. Non governmental organizations

They act intermediary between the contracting firms and participating farmers. They offer
training to farmers and link them to input suppliers. They disseminate experiences and develop
best agricultural practice guidelines for the farmers. NGOs assist in forming farmer groups

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 and can increase business and technical skills of groups, developing good working relationship
among the groups and agribusiness firms.

Benefits of contract farming

Contract farming in developing countries has numerous benefits to the stakeholders. These benefits differ
from large to small scale farmers. First, farmers have access to markets for their produce. This guarantees
farmers access to ready lucrative markets that fetch high prices for their output which has an impact on
their household income. Secondly, the farmers will have input access, technical assistance and credit
facilities. The farmers are provided with the right and quality inputs for planting and technical assistance
on how to manage the crop till maturation. The farmers are also assisted in harvesting and post-harvest
handling through provision of agro-chemicals such as pesticides, herbicides and fungicides. Thirdly,
contract farming leads to reduced production and marketing risks. The participating farmers are
guaranteed price for their produce by the contract which is a motivation for them to produce. The contract
reduces the number of brokers in the agricultural industry. Fourthly, contract farming results to higher and
stable incomes to the small holder farmer in developing countries contributing to reduction in rural
poverty. Fifthly, contract farming has the potential to create employment opportunities to the rural people
through new technologies. This makes use of family labour which has ripple effect on family income.
Sixth, contract farming reduces contractors transaction costs, coordination costs and input cost. By
providing inputs the contractor reduces cost per unit of input thus leading to lower output prices. Buying
from contracted farmers reduces the coordination cost such that it links transaction activities upstream and
downstream. Spot market buying needs a lot of screening and selection unlike purchasing from contracted
farmers where there exists a relationship between the buyer and the seller. Finally, by providing technical
assistance to farmers, contractors are able to obtain a more uniform product, raise the product quality and
improve safety standard requirements though frequent visits to the production farms. This enables the
contractor to obtain sufficient produce at the right time and quality for the market.

Constraints of contract farming in developing countries

Despite the glaring benefits derived from contract farming in developing countries, farmers face a number
of challenges. They include:
1. Lack of information about production methods and market opportunities, particularly on export
crops.
2. Farmers lack sufficient information about profitable investments. Wrong enterprise choice leads
to low productivity among participating farmers.

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 3. Small scale farmers often lack the necessary financial reserves to cushion themselves against
unfavourable weather conditions in the developing countries.
4. The farmer lack awareness about available arbitration services in case of breach of contract or
those that are available are expensive to them. This leads to long legal process in court making
contracts undesirable to small scale farmers.
5. Farmers have limited access to credit due to lack of collateral and/or by the high interest rates
demanded.
6. Small scale farmers operating near subsistence are more risk averse than large scale farmers. This
makes contractors especially of foreign origin to prefer dealing with large scale farmers.
7. Contract farming shifts farm production to cash crops, which may adversely affect the production
of basic food crops. It may also lead to more narrow local farm markets resulting from
agricultural resources being diverted to contract farming. This creates problems for non-contract
producers who then face thin markets and lower prices.
8. Contract farming in developing countries leads to a dependency relationship between producers
and contractors, which make the producers vulnerable to sudden changes in the strategy of the
(foreign) contractors and result in exploitative behaviour by the contractors.
9. Contract farming leads to gender inequalities both in quantity and quality of work for women and
children. In developing countries, most work is done by women especially farming.
10. Contract farming leads to overexploitation of natural resources. In pursuit of high yields from
small farm, farmers try to overuse agro-chemicals which compromise the environment and
natural resources conservation through leaching, soil mining and pollution.

Policy options for developing countries

1. Facilitate conducive investment environment in agricultural sector

The developing country governments should create a favorable investment climate for both the
contractors and the small scale farmers to stimulate the level of agricultural production for both fruits and
vegetables. Conducive investment climate will create an incentive for more contractors to participate in
the industry. This can be achieved by provision of adequate infrastructure to lower transaction costs and
reduce administrative bureaucracies involved when contracting. The government through line ministries
and private sector partnerships can put in place good roads, cooling facilities and communication
channels to allow free flow of information among the stakeholders since fruits and vegetables are
perishable. Contract farming helps small scale farmers to reduce transaction costs of accessing new
markets, borrowing, managing risks, acquiring information and increased employment opportunities to

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the society. The success of contracts reflects both the contracting environment and management policies
(Simmons, 2002).

2. Promote competition through provision of relevant information to both the contractors and the
participating farmers
This policy is meant to reduce the impacts of information asymmetry and opportunistic behaviours by
dishonest contracting parties. The government should create a pool of information that should be
available to farmers about viable and profitable contracts and contractors to transact with. This is likely to
expose those contractors who misuse farmers and to achieve profits at the expense of farmers efforts. Its
imperative that contractors also be informed of the attributes of the farmers they are dealing with so as to
shield their interests to make contract farming appealing. Recent expansion of contract farming is often
viewed as part of the broader globalization phenomenon whereby removal of trade restrictions will lead to
increased flows of agricultural products especially from developing to developed countries. Prices paid
for contracted crops are usually lower than market prices. Singh, (2004) revealed that most farmers try to
sell their produce to spot markets for better prices instead of factories where they had contracted.
However, Baumann, (2000) stated that it is easy for a company to manipulate prices when the market is
competitive and prices are volatile. This policy will help the farmers and contractors to offer the right
quality and price for the produce since price stability is essential if firms are to continue contracting with
their growers and growers are to obtain income stability (Sriboonchitta and Wiboonpoongse, 2008).

3. Promote cooperation among all stakeholders in the agricultural sector

There is need for developing country governments to promote cooperation among private farms, non-
governmental organizations, and contractors in the provision of extension services so as to enable small
holder farmers to meet market requirements. These requirements include the right product standards
needed by the buyer, for instance product quality, grades, size and inspection for safety. This can be
achieved when the stakeholders including the government work as partners. There is need to incorporate
all the stakeholders so as to achieve success in contract farming otherwise, pull out by the contractors
would simply mean collapse of the contract farming. Porter and Philips-Howard (1997) describe contract
management failure in Africa resulting from use of expatriate staff with inappropriate cultural values in
management roles. They argue that lack of knowledge of cultural values contribute to underperformance
and failure of contracts through misunderstanding of issues, inappropriate conflict resolution processes
and miscommunication. Thus need for a policy framework for developing countries to provide for
inclusion of all the stakeholders in contract farming.

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4. Provide mediation services and affordable arbitration options
The government should provide mediation services between the buyers and farmers and explore
innovative ways to enforce contracts. This can be achieved by setting up a legal system under the ministry
of agriculture to enforce contracts and limit opportunistic behaviours. The state can also introduce special
contract law and provide affordable arbitration options for disputes between farmers and contractors. The
policy intends to create awareness among stakeholders of the available options to them to achieve healthy
contract farming. Contract farming offers a huge opportunity for commercializing smallholder
agriculture, smallholder farmers have reportedly experienced some contractual problems in dealing with
large agribusiness firms, resulting in smallholder farmers giving up contract farming. Similarly,
agribusinesses have also reportedly encountered some contractual problems when dealing with some
smallholder farmers that could have led to the exclusion of the latter from contract farming. In general,
these contractual problems have been largely attributed to the failure of one of the parties to the contract,
either agribusiness firm or smallholder farmer, to honour agreed-upon contracts (Wiegratz et al., 2007)
Thus the need to learn from success story of Malawi, where the government has established guidelines for
dispute resolution in agricultural contracts and offers the services of an officer of ministry of labour for
mediation (Eaton & Shephard 2001).

5. Encourage formation of farmer organizations and trade association

The country governments should encourage formation of farmer organizations to link the farmers to the
trading firms/markets and give them a strong bargaining power in contract formation. Trade associations
and better agribusiness bureaus under the ministry of agriculture will help discourage dishonesty by
establishing code of conduct among the players in contract farming and expose firms that use
unscrupulous practices. Such firms can be blacklisted such that they should not be allowed to contract
with farmers in the country. Farmer groups also play an important role in the success of a contract by
encouraging new technology and adjustments to changing market conditions; they facilitate contract
management by dealing with disagreements between growers and contractors. Experienced farmers in the
group may be a source of extension services for less experienced farmers (Simmons, 2002). Farmer
groups can benefit from economies of scale that can be important in bargaining for better prices, access to
inputs, credit facilities and other important services that encourage agribusiness. The formation of farmer
groups can be achieved through the partnership of ministry of agriculture with other stakeholders in
encouraging famers to form groups and educating them on the importance of the groups and how they can
be run.

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6. Establish and enforce standards acceptable in the international market
Governments through research institutions and standardization bodies can develop grades and standards
for the quality requirements of fruits and vegetables in the international market. They include food safety
and quality requirements. Supply reliability demanded by supermarkets raise challenges to small
producers (Boselie, D., Henson and D. Weatherspoon, 2003). Contracting firms and government
extension officers can help small holders through the provision of technical assistance to comply with the
(private) food safety standards and regulations (Bijman, 2008). Safety in the food chain is a major
concern in all countries, and increasing resources are being directed in many countries to safeguard
domestic consumers. Vigilance starts with setting up an appropriate structure at governmental level with
the application of correct on-farm practices, and is particularly important during harvesting, storage,
processing and marketing. This aims at regulating the market by ensuring that contractors do not abuse
their market power.

7. Provide incentives to contractors to set up processing firms in rural areas

The governments should provide incentives to fruit and vegetable processing firms to set up processing
plants in rural areas. This policy strives to reduce high transaction costs resulting from uncertain quality;
supply and price risk ensuring stable incomes to the participating farmers and also serves to encourage
rural development. This can be achieved through promotion of activities such as preserving, packaging,
freezing and transporting that meet consumer requirements (Simmons, 2002). This can also be realized
through tax reliefs and good infrastructural development that can act as an incentive to contracting firms
to set up those facilities. The government should encourage contractors to initiate new contracts and
support farmers in making suitable contract selection. Farmers should be helped through direct subsidies
to expand production of vegetables and fruits and provide affordable crop insurance options. Setting up of
processing plants such as cooling plants by contractors in the rural areas ensures that the contract farming
will last for a longer period.

8. Promote and women participation and empowerment in agricultural production

Contract farming leads to gender inequalities both in quality and quantity of work for women and children
(Bijman, 2008). Therefore the developing country governments should empower women because women
do most of the production work (at least in Africa). This is aimed at reducing skewed power relations as
this may lead to overexploitation of the powerless by the powerful (Little and Watts, 1994). Women
empowerment can be achieved by making contracts more sustainable by involving women during
negotiations, signing of the contract and payments made directly to women.

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Summary
Contract farming in fruit and vegetable production is an emerging sector in agricultural diversification
and is growing fast given the returns from these high value crops. Smallholder farmer participation in
contract farming is crucial in developing countries as a way of reducing rural poverty through
employment opportunities, rural development and generation of household incomes. Through the stated
policy options, the stakeholders can come together and help promote contract farming given the high
returns accrued. Non-participating farmers should be encouraged to join the contracts to access inputs and
stable market prices. Provision of technical assistance, input access and credit facilities to participating
farmers especially smallholder farmers will be an incentive to higher production levels. Developing
country governments should encourage the contracting firms to involve more smallholder farmers as a
way of rural development. These governments should also emphasize on ways of protecting farmers from
opportunistic contractors and brokers through the encouragement of the farmers to form farmer
organisations. Promotion and empowerment of women in contract farming will help promote production.
Fruits and vegetables being highly perishable, through arrangements like contract farming they can be
marketed soon after harvest. The developing countries can also try to alleviate the constraints of contract
farming to make the system favourable to all the stakeholders through promotion of cooperation among
all the stakeholders. Hence the need for a policy framework that is inclusive of all stakeholders interests.

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References
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