A rich literature on principal-agent relationships has long contended that contracts can be used to transfer risk from a risk-averse to a risk-neutral party in settings where the insurance market is thin or nonexistent. We look at whether participation in contract farming, wherein a processing firm contracts out the production of an agricultural commodity to a grower household, is associated with lower levels of income variability or income risk in a sample of 1,200 households in rural Madagascar.
Relying on a framed field experiment aimed at eliciting respondent marginal utility of participation in contract farming for identification in a selection-on-observables design, we find that participation in contract farming is associated with a 0.20-s.d. decrease in income variability. Looking at the potential mechanisms behind this finding, not only do we find support for the hypothesis that fixed-price contracts explain the reduction in income variability associated with contract farming, we use a newly developed method to assess mechanisms and find that fixed-price contracts appear to be the only mechanism behind our core finding. Then, because the same assumption that makes the selection-on-observables design possible also satisfies the conditional independence assumption, we estimate propensity score matching models.
Matching results show that our core results are robust and, surprisingly, that participation in contract farming would have greater beneficial effects for those households that do not participate than for those who do, i.e., the magnitude of the average treatment effect on the untreated exceeds that of the average treatment effect on the treated. Our findings thus show that contracts can help grower households partially insure against income risk by transferring price risk to processing firms.