The Effects of Uncertainty and Contract Structure in Specialty Grain Markets

The increase in vertical integration in agriculture has been motivated by many factors including the evolving demand of consumers as well as factors specific to agricultural markets (i.e. production and price uncertainty and farm policy). The literature on agricultural contracts has focused more on contracting in the livestock sector relative to crop production under contract, most likely due to the fact that contracting in livestock production has been historically more prevalent. However, crop production under contract has also realized extensive growth, especially in the markets for crops with specialty traits. This paper provides a theoretical model of a contracting relationship between a risk-neutral monopsonistic processor of a specialty crop and risk-neutral producers. The processor induces farmers to accept production contracts, based on acreage or total bushels, to grow the specialty crop by offering a premium above the commodity price for contracted production. It is commonly assumed in the literature that acreage contracts will be the preferred structure due to producers being relatively more risk average than processors. However, this paper presents a market environment in which the opposite result is found. It is shown that a bushel contract exists which Pareto dominates the optimal acreage contract, although that bushel contract may not be the processor's optimal bushel contract, and that both the processor and producers will be able to achieve higher expected profits by using a bushel contract structure. While explicit analytic solutions for the model do not exist, a numerical example is provided to illustrate effects of farm level yield volatility and the spatial correlation of farm yields on expected profits, premium levels, and farmer participation for the acreage and bushel contract equilibriums.