Why do agricultural value chains fail? A transaction cost explanation

Agricultural value chains are important in producing goods and services to the community, 

generating employment and increasing family wealth – Pic by Shehan Gunasekara

Introduction

Agricultural value chains are an important element of the economy. They are a significant component of household income, especially for poor farmers. Agricultural value chains are local-oriented as well as export-oriented. For example, a farmer who sells vegetables on the roadside might only deal with the local vegetable consumers or anyone passing by. However another farmer might be selling his produce to an exporter with the produce ending up in another country. Either way, agricultural value chains are important in producing goods and services to the community, generating employment and increasing family wealth. 

I argue that the survival rates of agricultural business are low. Farmers emerge as businessmen/women very quickly, but they tend to fade away within the first couple of years. This is common to any business that engages in agricultural value chains either exporting raw vegetables or any value added product. Only a handful of exporters have survived through the ups and downs of the global economy. Most development indicators try to capture the emergence of an agricultural value chain, especially by looking at the number of farmers that are in cultivation or the number of new firms entering into agricultural business. However, success should be measured on the sustainability of the businesses in the long run. If you take a sample of Government, private and non-Governmental organisations that work in enterprise development, livelihood improvement or small business development, the amount of resources they allocate to teach and train entrepreneurs not to fail is very large. This exemplifies the tendency of farmers and firms in agricultural value chains to fail. 

Therefore, an important question to ask is, “why most farmers and businesses in agricultural value chains fail?” One might start spelling out the popular reasons for failure including: lack of motivation, lack of financial strength, lack of planning, little evaluation of market opportunities and even lack of business management skills. All these are very valid reasons and there is enough research to prove that. However, I argue that they are not the only factors.

Assuming that a farmer or an entrepreneur has the ability to eliminate all the above factors of failure, there is still a significant probability that the informal business would fail due to ‘transaction costs’. The first part of the rest of the article will touch upon the theory of transaction costs. The latter will discuss in detail the evidences of transaction costs and ways to minimise them in agricultural value chains. 

What are transaction costs?

Transaction costs are a significant component of a business operation. A firm that engages in business faces these costs every day. Studies show that most businesses tend to produce intermediary components of their final products within the firm rather than buying from outside markets Economists argue that if firms are efficient and markets are competitive why most firms produce within firms rather than buying from the market? The answer is in the transaction costs. For example, 50% of the United States transactions take place within firms rather than in the outside market. In addition, statistics show that one third of international trade is within firms, among the branches in different countries. 

In theory there are two types of transaction costs. First are the ex-ante transaction costs, first proposed by Economist Ronal Coase. I will explain this with the example of a vegetable farmer who is selling his produce to an exporter. In this transaction both parties need to agree with the characteristics of the produce (these are linked to specific standards such as Good Agricultural Practices, colour, size, shape, absence of diseases and/or pesticides etc.), price, storage methods and delivery mechanisms. At the end, all these have to be written into a contract that is enforceable in a court of law. Now the use of contracts might be bit strange to the conventional value chains of ours, but it is a common feature of high value chains that operate with co-operative contracts and future/forward contracts. In simpler terms: we could term these as ‘writing down costs’ or ‘haggling costs’. The justification is that if these costs were really high then the business activities would not happen. If a farmer has to spens a lot of money and time to form a contract with the exporter, the farmer is then better off either moving away from the high value chain (moving away from export value chain to a local value chain), or may be give up the particular agricultural crop. 

Second are the ex-post transaction costs. These costs occur after a farmer finds a trader and agrees on the ex-ante costs. These transactions costs can also be characterised by popular economic phenomenon such as bounded rationality and information asymmetry. Simpler ways to describe these costs are as contract negotiation and re-negotiation costs connected to investment made by the farmer and/or the buyer. Most of the time, these investments are relationship specific investments and serve to reduce marginal costs or increase consumer valuations. Take the example of a farmer supplying vegetables to an exporter who wants to add another destination to his exported products. The new destinations might require an improvement in the quality of the vegetables (the use of organic fertiliser for example). In this scenario, the transfer from inorganic produce to organic would require more investment from the farmer; therefore it would also require contract re-negotiation. The new quality improvement would attract higher prices but if the ex-post costs are high the farmer is better off staying in the former value chain, rather than investing in quality improvements. Sometimes this leads to stalling and can totally prevent investment from happening. The famous economist Oliver Williamson proposed this.

Let’s dig deeper: apply this to a Sri Lankan context

Consider farmers that supply vegetables to the local market as well as to the export market through vegetable exporters. Some of their produce goes to the Middle Eastern, North America, Australia and Maldives and some work with the European Union countries as well. Farmers who supply to the local market are micro-scale and mostly take their produce directly to the local market place or to the wholesaler/local retailer. On the other hand, farmers who are in the export value chain are more organised, they do large scale cultivations, and the exporter usually comes to them to collect produce from the field, they work with many certification standard such as Good Agricultural Practices (GAP) and organic and many have contracts with the exporter. 

The ex-ante transaction costs are usually common to both farmers in the local and export value chain. The cost of achieving the desired characteristics of the produce, cost of negotiating the price and cost of transportation are applicable to both groups of farmers. However, their power over negotiating some of these costs may vary. For example, a farmer in the export value chain produces more, hence has the ability to obtain economies of scale and bargain over the price. 

Though ex-ante transaction costs are very common among farmers, the impact of it is very significant. Reduction of these costs would lead to the reduction of the marginal cost, which is a very attractive proposition for a farmer. Therefore, a farmer, especially one in the local value chain, would like to bargain transaction costs with the marginal cost. For example, a farmer who is producing organic vegetables to the local market would not practice ‘true organic’, reducing the marginal costs. However, he might be able to attract a higher price, if the consumer is willing to pay. One would think this is a very attractive position, since the farmer would eliminate the transaction cost but would achieve higher profits. But what about the consumer? A consumer pays a higher price for an attribute (being organic), which is not there. Therefore, ex-ante transaction costs lead to a situation where moral hazards could create consumer disloyalty. 

Transportation is another significant ex-ante cost component for a farmer. Imagine a farmer is in a local value chain that is conscious about transportation costs. Usually, they do not have their own transportation facilities. Therefore, in order to reduce the transportation cost, a farmer would allow the trader to come to his field, reducing the bargaining power over the price. One would think that this is good bargaining, however many studies show that farmers get a very low price whenever the trader comes to the field to collect. This sometimes does not improve even when the farmer takes his produce to the market place. A popular scenario at most vegetable collection/wholesale centres is that farmers get a very low price. Farmers usually arrive very early, but some just have to wait until the end of the day to make a deal. At the end of the day many sell their produce for a lower price because it is costly for them to take the harvest back. In addition to not having storage facilities, most farmers come to the vegetable auction on a rented vehicle. It is costly for them to come back at another time, therefore at the end of the day they would settle for whatever price they can get.  

Ex-post transaction costs are mostly associated with farmers who are in the export value chain. A majority of these farmers are large-scale producers in contract with the exporter. The contract specifies the production requirements, quality standards, prices, and delivery mechanism. Ex-post transaction costs are linked to relationship investments. In general these investments are called for improvements in the value chain. For example, imagine a farmer is in contract with an exporter and his produce goes to the Middle East and Maldives. Now imagine a situation where the exporter is seeing a demand from the European Union (EU) region. However the EU region might have specific requirements, such as certifications. Such popular certification is the Good Agricultural practices (GAP) certification. If a farmer has to adhere to these certifications his management practices should change based on the guidelines published by the Department of Agriculture. However, there is a cost involved in following the GAP standards. Usually, the farmer would get a higher price but it varies greatly. The buying price of the exporter might change based on the world market prices unless there is a future contract specified for multiple seasons. There is a cost involved for the exporter as well. The exporter has to monitor whether the farmer is following the correct standards. For example the standards specify the level of fertiliser to be used and may be zero pesticide applications. Though the farmer is expected to follow guidelines, the exporter might have to evaluate these. Hence there is a cost for a machine and testing services that detects unauthorised chemicals. 

If the farmer and the exporter is expected formulate a contract, it should specify the necessary investments required by both parties and the price has to be agreed based on those costs. Unless there is a common agreement on the investments and the price is based on the marginal costs of investments, a contract cannot be drawn between the farmer and the exporter. Each party can potentially hold up the necessary investments and the value chain for the EU market might collapse.

What can be done to eliminate these transaction costs?

Reducing the ex-post transaction costs are not easy, but economists have suggested several ways. One popular way is the asset ownership model. The argument goes as follows. Imagine a productive asset, such as land. If the exporter owns the land and the farmer is renting the land, then the exporter has the ability to bargain more on who should make the necessary investments for quality improvements of the produce (basically the exporter can hold off). In such a case, the exporter might be able to ask the farmer to adhere to the GAP standards and check for quality before brining it for sale. Then the farmer has to take on the cost of the testing machine and testing services as well. The asset ownership model therefore argues as to ‘who should own the productive asset’. It suggests that the party that owns the productive asset should do the majority of the investment. If the exporter owns the land then they should bare the majority of the transaction cost. By contrast, if the farmer owns the land, then the majority of the investment should come from him. The asset ownership model only solves the problem of ex-post transaction cost for a single party. However, there are other competing models that come from ‘mechanism design literature’. It solves the hold-up problem for both the buyer and the seller. Here, a contact can be drawn so that the party with fewer investments has a default option of giving guarantees of enough returns to investment. The remaining returns are for the party that does the larger investment. In a simpler form, if the farmer owns the land, he makes the bigger investment, presumably on the organic management practices and quality checking. In return, he has the bargaining power over price (which would allow him to attract a larger portion of the return). At the same time, the exporter invests on a traceability system that is a one-time investment for quality assurance. 

The ex-ante transaction costs are the easiest to manage. For example, the transport costs can be easily reduced if farmers act as a group. Rather than hiring individual vehicles, they could pool the harvest together for transport. The same collective action will allow farmers to increase their bargaining power. If they can produce to a similar quality (which is easily possible since most cultivate the same varieties and the management practices and fertiliser rarely changes), it is possible to bargain a price as a large quantity.

Eliminating transaction costs totally might not be possible; however there are ways that they can be minimised. Transaction costs will not be totally eliminated since no market transactions are entirely efficient. Today, the out-grower model and the co-operative model is gaining popularity in the export value chain as opposed to the conventional subsidy-based models. Therefore, we can argue that contracts are becoming more important than ever in the agricultural value chain. It is the right time to think about reducing ex-ante and ex-post transaction costs in order for the agricultural value chains to function efficiently. 

(Chatura Rodrigo PhD is an agriculture and environment economist. The author can be reached at [email protected] and 94 77 986 7007.)