Welcome to this module about "Coordination in the Agri-Food Value Chain". This is Lesson 3 and we will walk through an example of a contract. In this way, we can apply the notions we have learned in Lessons 1 and 2. My name is “Carlo Russo” and I am an Associate Professor in Agricultural Economics at the Department of Economics and Law at the University of Cassino and Lazio Merdidionale. This is the last lesson of Module 11. We began in Lesson 1 with the basics of coordination. We laid down the foundations for our work. We defined coordination as the action of organizing a group of individuals efficiently, for a common goal. Then we defined the Pareto efficiency criterion, and we studied the Coase Theorem in order to find out the conditions for efficient coordination. We learned that there are many forms of coordination and we defined key concepts for organization designs such as “Transaction Costs” and “Design Attributes”. If you missed Lesson 1 or if there is something you want to review, this might be a good time to go back and watch the video again. You will need that material in today’s lesson. In Lesson 2, we focused on a special form or coordination: contracts. Contracts are important institutions in Agri-food Value Chains and are particularly suited for our discussion. We walked through the definition of contracts. Then we addressed contract design and we studied the Principal-agent Model. In particular, we addressed the Incentive compatibility and Individual Rationality constraints. We ended the lecture introducing the incentive problem. If you are not familiar with any of these terms, please take some time to review Lesson 2. Probably you will need it during today’s lesson. Today we cover Lesson 3, and we will use a simple example to apply the general principles to a specific situation, before moving to Module 12. The main learning objective of this lesson is to guide you in the application of general principles of contract design to real-life problems. The best way to learn this is by examples. Thus, we will work together on one, just to give you the general idea. You will find more examples in Module 12. You will learn to identify the critical information set that can make a contract arrangement work efficiently. As we will see shortly, what you can or what you cannot observe really drives the optimal contract choice. This is an application of the concept of perfect monitoring and enforcement. In incomplete contracts, the exact specification of your monitoring and enforcement possibilities really can make the difference. Also you will be able to compare the outcome to alternative contractual arrangements. Consider a landowner and a farmer. The landowner owns a plot of land, but she/he does not want to farm it herself/himself. She/He is looking for a famer who is willing to farm the plot on her/his behalf. The farmer plays the role of the agent. The landowner is the principal and she/he is wondering what type of contract to offer to an agent (the farmer). We want to find/present the efficient contract design. Following the principal-agent model, we begin by specifying the utility functions. The landowner is a profit maximizer. Her/His utility is the difference between the revenues and the compensation C that she/he must pay to the agent. Revenues are calculated as the product of exogenous output prices (pbar) and the yield (Q). The agent wants to maximize the difference between the compensation and a function giving a monetary evaluation of the cost of effort, for example, a quadratic function. In our simple example, the monetary evaluation of the cost of effort is equal to the intensity of the effort e squared. The yield from the plot is a function of the agent’s effort. We assume that the yield Q is equal to the intensity of effort e plus a zero-mean random variable epsilon, representing weather conditions. You can see the essence of the incentive problem here, as we defined it in Lesson 2. The principal wants a high level of effort from the agent, because in this way she/he can get more yield and higher revenues. At the same time she/he would like to save on the compensation C. The agent’s objective goes in the opposite direction. He would like to minimize the effort. He maximizes utility if e is equal to zero. At the same time, he would like to have the highest compensation possible. We want to find an efficient contract bringing a farmer and a landowner with conflicting objectives together. If the transaction fails, both parties obtain their reservation utility and the coordination surplus is lost. For simplicity, we consider only three possible alternative contracts. A fixed wage contract. The landowner offers a fixed amount of money for a given amount of effort. A sharecropping contract. The landowner offers the agent a per cent share of the revenues. In return, the agent farms the plot and the landowner gets the yield. No amount of effort is specified in the contract. A land rental contract. The farmer pays the landowner a fixed amount of money. In return, the farmer can farm the plot and keep the entire revenues. Let’s start with the fixed wage contract. For example, the landowner offers a salary of 600 Euros per week and asks for an effort of 40 hours per week. The key variable in this case is the agent’s reservation salary. That is the minimum salary that the agent is willing to accept for the job. It depends on the farmer’s outside options and the working conditions. Consider a given revenue from farming. We can break the total value into three components, as we did in Lesson 2. We highlight the parties’ reservation utilities and the coordination surplus. Obviously, the principal would like to appropriate the whole surplus by setting the optimal wage equal to the farmer’s reservation salary. The actual amount of effort that the landowner requires can be found by equating the principal marginal benefit and the agent’s marginal cost, as we did at the end of Lecture 2. The question is: “Is this agreement a self-enforcing contract?” To answer this question, consider the farmer’s utility function. For any given level of compensation, the farmer maximizes his own utility by setting effort equal to zero. More formally, consider the first order condition of utility maximization with respect to effort. The marginal benefit of effort is zero, because the compensation is fixed, regardless the amount of effort. The marginal cost of effort, instead is increasing with e. This means that an increase in effort determines an increase in cost, without giving any benefit to the farmer. Consequently, the only case where marginal cost is equal to marginal benefit is for estar equals zero. Note that this result is different from the contract terms. The principal asked for estar equals 40, that is, much more than zero. This result proves the potential for opportunism. In the absence of monitoring or enforcement, the agent maximizes his own profits by working less than 40 hours. His behaviour diverges from the principal’s expectations. This means that at the end of the season, the principal obtains a less than expected revenue and – unless the weather is really good and crops grow spontaneously – a profit loss. The contract is not self-enforcing. Perfect monitoring and enforcing are needed. In particular, the effort level e must be immediately observable and shirking farmers must be fired and replaced freely. Only under these strict conditions is the contract is efficient.