The relation between contract type and market power: Evidence from a high-value crop in India

Abstract

Theoretical considerations suggest that production contracts systematically lead to higher market concentration and increase contracting firms’ ability to mark down farm gate prices compared to marketing contracts. Existing research on contract farming rarely differentiates market power in different types of contracts. This study investigates the impact of marketing and production contracts on farm gate prices and net profits. The analysis is based on survey data from okra production in India and controls for unobserved heterogeneity between farmer villages, a novel procedure that circumvents the problem of multicollinearity between the treatment variable and village fixed effects. Findings indicate that monopsonist production contractors depress farm gate prices below the level of oligopsonist marketing contractors. The net profits are, however, still higher for farmers with a production contract. A subsequent scenario simulation quantifies the potential income gains for farmers if contractors’ market power could be reduced, finding that the incomes of production contract farmers could increase by one-fourth in the absence of market power. Policymakers could design incentives to increase competition between contracting firms and, thus, enhance the benefits of production contracts to smallholders in contract farming.