Contracts, Quality, and Default: Endogenizing a Buyer's Rejection Rate

This paper represents a first attempt to examine within an analytical framework the issue of endogenous rejection of contracted production by buyers, a phenomenon of considerable concern in developing countries, as rapid industrialization of the agricultural sector increases the incidence of contract production in these countries. We study whether produce buyers might use a rejection rate that is not only dependent on product quality, but also on the market conditions they face or their capacity. Further, we explore whether rejection might be used to influence the price farmers receive in both the contract and spot markets. The spot market often does not provide incentives for high-quality production due to pooling and resulting adverse selection problems. We show, however, that the spot market remains important in a setting with contracting because it determines the contract price needed to meet producers' participation constraints. However, stochastic production of high-quality products is problematic for buyers in this setting because the buyer cannot determine ex ante the amount of contracts needed to maximize profits ex post. We show that the advent of contracting for high-quality production actually makes the spot market an increasingly inappropriate outlet for acquisition of high-quality product because contract producers sell exclusively low-quality production in the spot market, reducing the share of high-quality production available there, relative to an equilibrium with only the spot market.