Ratchet Effects in Agricultural Contracts - The Nature of the Farm - page 121

7 Ratchet Effects in Agricultural Contracts

The tendency for performance standards to increase after a period of good performance is called the
ratchet effect.
—Paul Milgrom and John Roberts, Economics, Organization and Management

7.1 Introduction

In chapter 3 we argued that farmers and landowners, though their contracts were short and
simple, often contract with one another for long periods of time. We also argued that the
nature of farming communities allowed reputations to develop, and that these policed many
of the gross opportunities for misbehavior that might otherwise occur with such seemingly
simple contracts. It turns out, however, that with the principal-agent model analyzed in
chapter 6, we get distinct implications for behavior when the farmer and landowner deal
with each other over time. This chapter continues to explore the model presented in chapter
6 by examining one of its most famous dynamic predictions—the ratchet effect. As with
the common predictions of risk sharing, we find little evidence supporting this exotic
implication. 1
In classic risk-sharing models in agriculture, where farmer performance is measured with
error, landowners design optimal contracts that are both incentive compatible and profit
maximizing. In general, the optimal contract provides incentives for the farmer, so that
higher levels of output lead to higher levels of pay. If the landowner and the farmer engage
in a series of contracts over time, information is collected on past performance, and this
information could be used to set new standards of farmer behavior in order to increase the
wealth of the landowner when he cannot otherwise commit to constant contract terms. It
is well known, however, that using past performance to define standards creates incorrect
incentives in the absence of long-term commitments by the contracting parties. Farmers
who shirked in the past, and whose poor performance is partially attributed to nature, are
rewarded with contracts based on low expectations of output. On the other hand, farmers
who performed well in the past, and provided information on how productive they are, are
penalized with high future standards. A landowner's incentive to increase standards over
time in light of past performance is known as the ratchet effect .
The term ratchet effect comes from early studies of the Soviet Union where planners
would often penalize plant managers for the increased output under new incentive schemes,
claiming that the higher output proved shirking in the earlier period. 2 From these earlier
studies, and from the theoretical literature, it is well known that using past performance to
define future standards creates imperfect incentives for the agent. Thus in order for optimal
contracts to emerge, it is important that the landowner be able to commit himself to a stable