Strategy & Policy Brief #11-3, August - 2008

Transaction risks in market chains

Gerdien Meijerink, Derek Eaton, Jos Bijman

Introduction
The LNV-DGIS policy document Agriculture, Rural Entrepreneurship and Food Security has highlighted that well
functioning market chains can contribute to income generation of (small-scale) producers, transporters,
processors and service providers, thus leading to poverty reduction and economic development. However,
because market chains are often beset with transaction risks, the potential benefits are only partly realized.
For instance, many small-scale producers in Sub-Sahara Africa are currently not fully benefiting from the high
food prices because of dysfunctional markets. This brief outlines the types and sources of risks of transaction
failure (transaction risks) in market chains in developing countries and argues that the focus of policy
interventions should be targeted at reducing these transaction risks. We will illustrate this with our findings on
contract farming in oranges and pineapple in Tanzania (based on Eaton et al., 2008).

Different sources of transaction risks

There are various causes of transaction risks. In general, transactions will be prone to opportunistic behaviour,
including withholding and distorting information, or otherwise confusing or misleading partners in exchange.
Such problems increase when market participants find it difficult or costly to obtain information or when they
face limits in formulating and solving complex problems and in processing (receiving, storing, retrieving,
transmitting) information. Especially in developing countries, where information technology is less developed,
this can be an important impediment to exchange, although the use of mobile telephones is rapidly filling this
gap. Transaction risks also emanate from specific attributes of transactions, which we will discuss next.

When one or both parties have made investments that are specific to that transaction, they will run a
transaction risk. Default by the other party will lead to lost investments or an unfilled order when there is no
alternative market. Especially in “thin” markets with few buyers and sellers, transaction risks will be high.
Examples are investments made to produce a crop with specific characteristics (taste, colour, quality), or by a
specific production process (e.g. organic, Eurep/GlobalGap certified). Investments may be made to deliver on
a specific time (e.g. irrigation, greenhouses, cold storage) which is related to the product’s perishability.
Investments may be made in a certain locations where the produce grows well but which are far away from
consumer locations. The potential dependency between producer and buyer is a serious problem in many
developing countries and might lead to producers abstaining from investments that would otherwise be
efficient. In other words, they will not invest to become suppliers in modern market chains, but continue to
grow traditional commodities for which there is a secure market or for home consumption. For illustration:
farmers producing organic pineapples in Tanzania have made specific investments (e.g. equipment, boxes,
skills on how to grow organically). Farmers will lose money when the purchasing company fails to buy their
produce. Although farmers might be able to sell (part) in the regular spot markets, it will be probably at a lower
price.

Uncertainty is a basic feature of agricultural production. Uncontrollable factors such as climate and the fact
that biological processes lead to long production lags, cause volatile markets with possibly cyclically
fluctuating prices. This uncertainty leads to transaction risks because renegotiating and adaptation might be
required when unforeseen events emerge.
In contract farming for oranges for instance, when prices of
oranges are high in times of harvesting, the farmer may sell (part
of) the oranges to another buyer instead of selling to the
contracted buyer against the agreed but lower price. The buyer
has to incur costs to prevent this.
Often contracting parties find it difficult to measure the
performance of the other party in fulfilling the terms of the
contract. For instance, it may be difficult to measure the quality
of a product without investing in costly testing procedures.
Difficult and costly performance measurement leaves room for
opportunistic behaviour, which is a transaction risk. The effect of
this behavioural uncertainty is unwillingness to invest in higher
quality. Also the low trust that is accompanied by high
behavioural uncertainty leads to additional transaction costs. For
instance, it is difficult to distinguish organic pineapples from
those produced non-organically. The company has to incur costs
to verify whether farmers have produced the pineapples
organically.
Finally, transactions usually do not take place in an isolated
manner but are dependent on other transactions in the supply
chain or in the sector1. For example, farmers first need to
procure inputs (cash, seeds, fertilisers) before they can start
producing and selling. In developing countries, input markets are
often relatively undeveloped and inputs are not available at the
right time, in the right quantities or at the right quality. Thus, the
lack of coordination or connectedness to other transactions
is another source of transaction risk and leads to limited
commercialisation of farmers who prefer to rely on subsistence
crops on at least part of their land.
Transaction costs
To protect oneself against (perceived) risks of transaction failure,
market participants incur costs (called transaction costs). A large
share of transaction costs consists of the expenditure of time on
the part of buyers or sellers. In general, three types of
transaction costs related to exchange can be distinguished:
1. Search and information costs: someone considering a
transaction must search for a suitable party with whom to
trade and this search process involves costs. These costs
may consist of visits to possible traders (e.g. in markets),
communication (e.g. telephone calls), looking up prices,
testing and quality control.
2. Bargaining and decision costs: these costs relate to time
and (legal) advice that is put into bargaining and negotiating
the agreement between parties. This agreement can be put
1
See: Dorward, A., J. Kydd, C. Poulton and D. Bezemer (2007).
Coordination risk and cost impacts on economic development in poor
rural areas, Munich Personal RePEc Archive.
into a formal (written) contract or an informal (verbal) deal.
As information is often asymmetrically distributed and the
party having information may not disclose it, contract
partners often have to spend time and effort in
strengthening their own bargaining position.
3. Monitoring and enforcement costs: these costs are related
to time put into and costs made to monitor and, if
necessary, to enforce agreement. Monitoring can be costly
because parties may have an incentive to hide their
(opportunistic) actions.
By establishing a set of rules or agreements (an institutional
arrangement), a group of economic actors decrease transaction
risks and reduce the transaction costs in trading among each
other. Devising new sets of rules to lower transaction risks and
related costs can be seen as institutional innovation. Examples
are contract farming schemes or the establishment of a
producers’ organisation. However, establishing an institutional
arrangement and making it work is not easy as it might take
substantial organisational skills and human capacity.
Institutional innovation
Institutional arrangements take place within a broader socio-
economic framework. This institutional environment consists of
both formal and informal institutions. Formal institutions are
embodied in constitutions, laws, etc. and in government policies
and regulations enforced by courts, police, etc. Informal
institutions are norms of conduct, traditions enforced by custom
or habit. A weak institutional environment, particularly in terms of
legal frameworks, leads to difficulties in enforcing institutional
arrangements. High transaction risks and a weak institutional
environment therefore inhibit the development of (new) market
chains.
The LNV-DGIS policy document Agriculture, Rural
Entrepreneurship and Food Security has subscribed to the
proposed approach of the World Bank in its 2008 World
Development Report to invest more in agricultural development
through institutional innovations, development of markets that
are accessible to small scale farmers, and institutions for trade
and markets. This brief emphasizes that intervention and support
should focus on minimising various forms of transaction risks.
This requires, ex ante, analysis of the extent and causes of
transaction risks, and how they are distributed among the
(potential) chain participants. Intervention, then, should be
targeted at reducing the transaction risks related to specific
investments, environmental and behavioural uncertainty and the
need for coordination in the chain.