Kub's Den

Contract Theory

Elaine Kub
By  Elaine Kub , Contributing Analyst
Correctly designing ag contracts can profoundly affect market profitability. (DTN photo illustration by Elaine Kub

Earlier this month, many farmers were hauling newly harvested $3 corn into the elevator and wondering how they ever got locked into some high-priced land contracts. Meanwhile, two professors were receiving a prize worth 8 million Swedish krona for studying that very phenomenon.

Specifically, Oliver Hart and Bengt Holmstrom, two economics professors at Harvard and MIT, respectively, were awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016. Their achievement of this legendary goal -- a Nobel Prize -- came because they've spent their careers understanding and explaining contract theory. Contract theory underpins almost every economic transaction across the globe and throughout history, but it's particularly useful to explain some bits of the grain markets.

In fact, agriculture has provided some of the classic examples that kickstarted the field of contract theory, and even the field of economics, going back as far as Adam Smith's work in the 18th century. Economists have used sharecropping arrangements to frame basic questions about who benefits from a contract, who takes on the financial risk, who pays the transactions costs, and who has incentive to invest in a relationship. In an old-school sharecropping arrangement, the tenant farmer only receives a portion back of the results of his efforts. But he also gets to share the risk directly with the landowner, who may save some transaction costs through the arrangement.

Anyway, the field of study has grown, and the Nobel Prize winners' work digs into some rather deep insights. Bengt Holmstrom ventured beyond simply describing contracts and the intuitions that come from examples. In 1979, he formalized a theory to quantitatively study the trade-offs between sharing risks and incentives. He defined the "informativeness principle," which is useful to evaluate pay-for-performance contracts. Are the performance measures in those contracts useful? Do they adequately reflect things that are within the agent's control? Do they introduce inefficient elements of moral hazard?

For instance, in agriculture, maybe someone might design a cash rent scheme that calculates rent based on the land's corn yield each year. Or maybe a farm management company might try to set their compensation by that nice measurable statistic. But that would eventually lead to one party taking advantage of the other party. Contracts need to filter out any noise in the data that is beyond an agent's control, and we all know that yield is sometimes beyond a farmer's control. The renter or farm manager may do everything correctly. He may invest adequate time, effort, and input costs into a field but then a drought will linger and his yields will be poor, anyway. Holmstrom's work cautions that we need to carefully set good contract conditions that are based on observable, describable actions that can be verified by a court.

That insight has led to some other conclusions:

-- It may take years of actions to adequately evaluate an agent's performance, and some moral hazards may be mitigated by an agent's long-term career concerns. That is to say, a farmer might get away with duping a landlord or neighbor once, but over his lifetime he needs to maintain a positive local reputation to stay in business.

-- In practice, there is a negative relationship between risk and incentive power, meaning that less-risk-averse farmers will prefer to plant riskier crops. Even life choices can be explained by Holmstrom's findings. For complex jobs that can't be measured in observable, describable actions and results, salary pay is more appropriate than performance pay. And given those trade-off considerations of available incentives and risks, people will self-select into either less-risky salaried occupations or more-risky paid-for-performance occupations. Farmers certainly know which choice they made there.

Oliver Hart's work regards "incomplete contracts," where the decision-making rights of ownership compensate for the difficulty of designing contracts in scenarios where there are no nice, observable, describable, verifiable actions to measure. He who owns an asset gets to decide what to do with that asset and how to distribute its financial risks and rewards. That's an insight that has more to do with how entire industries are formed rather than individual contracts.

Again, agriculture benefits directly from understanding this theory. Consider farmers, who own commodity grain that is only worth something if it can be aggregated and efficiently shipped out, and elevators, who own the equipment to aggregate, store, and ship out grain, but all that equipment isn't worth much if the farmers don't bring some grain to them. Who should own all that? Should there be some vertical integration in the industry, with grain companies starting to produce their own grain from the land? Or perhaps the farmers should join together in cooperatives and own the aggregating equipment? That's the kind of thing Hart has spent decades studying, then delving into the question of who should provide certain services. If the government owns a service industry (schools, hospitals, prisons, utilities, transportation services, etc.), then there is no practical incentive for them to reduce costs. On the other hand, if a service industry is privately owned, it will pursue a low-cost but low-benefit model. Benefits to the public (good teachers, state-of-the-art medical technology, etc.) are very difficult to write into a contract. Hart's work does provide a conclusion: The greater the consequence of cost-cutting on non-contractible quality, the more likely that an industry should stay under government ownership.

While reading through all the scientific background on the work of these two fascinating economists, I was struck by how frequently agricultural case studies kept popping up. We have a unique industry, don't we? Agriculture tells such clear and quantifiable stories that repeat year after year, with lots of individual decision makers all trying different things in different ways. There's lots of data for the academics to parse out and fold into equations.

But I'm happy they do all that, and I'm happy the prize committee chose to highlight contract theory this year. It has given us at least two good takeaway lessons. Holmstrom says, in essence, we should design incentives only for things that are more than just chance. Hart says, in essence, if an asset is only worth anything when certain people are there to do the work, then those are the people who should own that asset.

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Elaine Kub is the author of "Mastering the Grain Markets: How Profits Are Really Made" and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub.

(CZ/Sk)

Elaine Kub