Agriculture Reference
In-Depth Information
6
Risk Sharing and the Choice of Contract
6.1
Introduction
Although Cheung's (1969) model of contract choice for cropsharing includes transaction
costs, it also depends on risk aversion on the part of the farmer.
1
Cheung essentially
asserts that cropshare contracts entailed higher transaction costs but allows the risk to be
shared between the farmer and landowner. In his words (1969), “the choice of contractual
arrangement is made so as to maximize the gain from risk dispersion subject to the constraint
of transaction costs” (64). From this somewhat simple beginning, modern contract theory
subsequently emerged with a focus on sharecropping that postulated a trade-off between
risk sharing and moral hazard incentives.
2
The risk-sharing foundation remains more or
less intact today and has been used to explain various contractual arrangements including
executive compensation (Garen 1994), franchising (Martin 1988), insurance (Townsend
1994), leasing (Leland 1978), partnerships (Gaynor and Gertler 1995), and sharecropping.
Milgrom and Roberts (1992) summarize the dominant result: “Efficient contracts balance
the costs of risk bearing against the incentive gains that result” (207). For economists
studying agriculture, in both developed and undeveloped economies, this risk-sharing
framework in the context of a classic principal-agent model was adopted quickly and still
retains its primacy.
Before developing and testing the model, it is important to distinguish the critical dif-
ference between the “standard” principal-agent approach to contracts and the transaction
cost approach. Both are fundamentally concerned with the incentives created by different
contract structures and the costs of making the incentives compatible with wealth maxi-
mization. The critical difference is in the costs of aligning incentives. With the standard
principal-agent approach, risk bearing is the cost of having the farmer bear more respon-
sibility for his actions. Under our transaction cost approach, the costs of better incentives
on one margin are offset by monitoring costs or moral hazard on another margin. There are
other minor differences as well, but our focus in this chapter is on the critical component
of risk sharing. Although we raise several arguments against using risk sharing to explain
contract choice, our main focus is empirical.
We take this approach because despite the prominence of the risk-sharing paradigm,
the empirical evidence to support its implications is scarce.
3
Moreover, when compared
to an alternative transaction cost model, risk-sharing models do rather poorly. Table 6.1
summarizes the literature in which competing predictions have been tested against con-
tract data. In studies examining everything from farm contracts to franchises, the evi-
dence in support of transaction cost models outperforms the predictions based on risk
sharing.
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