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LAND TENURE CONTRACTS: THE ROLE OF RISK AND ASYMMETRIC INFORMATION Harriet Mugera Department of Economics and Management, University of Trento.

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Presentation on theme: "LAND TENURE CONTRACTS: THE ROLE OF RISK AND ASYMMETRIC INFORMATION Harriet Mugera Department of Economics and Management, University of Trento."— Presentation transcript:

1 LAND TENURE CONTRACTS: THE ROLE OF RISK AND ASYMMETRIC INFORMATION Harriet Mugera Department of Economics and Management, University of Trento

2 Introduction  Agricultural tenancy has attracted a lot of attention. In particular, the agency-principal contract relations has been at the center of debate.  Despite the growth of interest little convergence has emerged on the opinions of the tenancy contracts.  The main challenge facing agricultural tenancy is the ability to explain the existence of sharecropping and the other forms of land tenure like fixed rental and fixed wage contracts.  Some of explanations that have been offered for the existence of different types of tenure contracts: (i)the existence of a tradeoff between risk sharing and transaction costs; (ii)screening of workers that poses different qualities; (iii)imperfections for inputs market.

3 Objective of paper  To explore the role of asymmetric information in land tenure contracts. In particular, by distinguishing the ex- ante and ex-post nature of information.  The first part of the paper introduces land tenure contracts and the marshallian inefficiency dilemma.  The second part examines the role of risk and asymmetric information and how these affect land tenure contracts and in particular sharecropping contracts.

4 Land Tenure Contracts

5 Land Tenure and Contracts

6 Given the above assumptions, three possible solutions can be derived:  A fixed wage (contract farming): the landlord is in a position to manage and supervise and thus he decides to hire wage laborers. This option can be identified as the extreme left of the horizontal axis where the efficiency of the land lord to manage is at maximum (i.e., close to 1);  Fixed rental: the tenant is able to manage and supervise production and thus he pays the landlord a fixed rental payment. This position is represented by the highest point on the vertical axis where the efficiency of the tenant to supervise inputs and production is at maximum (i.e., close to 1);  Sharecropping: this is the “intermediate” position where the landlord is able to manage and the tenant supervises, and thus the output produced is divided by the two parties. This position gives the best outcome if the landlord cannot efficiently supervise inputs and the tenant cannot make efficient management decisions (i.e., close to 0.5 on both axis).

7 Land Tenure and Contracts-Efficiency of tenants and landlords

8 Share cropping and Marshallian inefficiency  The essence his critique is that sharecropping is an inefficient system.  His analytical framework enabled him to identify the moral hazard problem associated with share cropping tenancy.  The costs of supervision of the tenant by the landlord is high. The tenant will provide labour only up to the point where the value of his marginal product of labour equals the opportunity cost of choosing the sharecropping contract. Given that the tenant receives only a fraction of the value of the marginal product of labour, and that the marginal product of labour is assumed to be decreasing, the tenant will tend to provided less labour with respect to a fixed rent contract.  In the fixed rental contract, the tenant has the incentive to maximize the surplus where he keeps the entire output and pays an agreed amount of rent to the landlord. The landlord, who has the bargaining power, can then extract the entire additional surplus by determining the rent.

9 Share cropping and Marshallian inefficiency  The moral hazard problem associated with sharecropping— lack of supervision of labor by the landlord which leads to under provision of labor by the tenant generating the “Marshallian inefficiency.” Apart from being inefficient, sharecropping is also apparently suboptimal for the landlord.  The use of contracts other than fixed-rent contract distorts the tenant’s input supply away from the efficient level. In particular, sharecropping leads to undersupply of the tenants inputs. Sharecropping results in poor incentives to the farmer (tenant).  The Marshallian “dilemma” of sharecropping: If fixed rent system is superior to sharecropping arrangement, both from a social efficiency perspective and from the landlord’s individual rationality, why then do we still observe the sharecropping behaviour in the real world?  Different authors have tried to give an explanation of this phenomenon. In particular, some authors have argued that sharecropping can be justified by the trade-off between risk-sharing and incentive provision.

10 Risk and the role of information - Contract theory  Centered on the principal-agent model This model analyzes the strategic interactions between two economic agents and it assumes that some asymmetry in terms of information exists between them.  The principal is assumed to move first and by maximizing his expected utility, decides the type of contract to offer to the agent.  In order to achieve his goal, the principal anticipates the reaction of the agent and thus chooses the contract accordingly, taking into consideration the incentives of the agent that are necessary for the acceptance of the contract.  The presence of incomplete and asymmetric information among agents remains a crucial issue since it not only influences how markets are structured, but it affects the nature of economic transactions and the contractual arrangements among individuals.

11 Risk and the role of information - Contract theory The two main types of informational problems are: i.Hidden action (moral hazard): where the payoff of a transaction to one party depends on some action taken by the other party. This action is not observable and it is difficult to prove that the party did or did not exert the effort required. ii.Hidden information: One of the two parties has some knowledge which the other party does not know. The principal thus tries to devise a contract or scheme that will reveal the information of the agent. An example of this kind of problem is captured in the screening model. Screening explains the coexistence of sharecropping with fixed-rent and wage contracts; and it fits with the observation that share tenancy is often associated with lower productivity than fixed rent contracts since screening predicts that the more able (and more productive) tenants will choose fixed-rent contracts and the less able will choose sharecropping.

12 Hidden Action (moral hazard) and Tenancy Contracts

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14 Full information principal-agent model : The First-Best Contract

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16 Moral hazard: - The Second-Best Contract

17 Contract restrictions and Marshallian inefficiency

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19 Hidden Information - Screening in Land Tenure  Hidden information arises when the landlord cannot observe the true ability and productivity of potential tenants and he therefore tries to distinguish high-ability tenants from those with low ability.  The landlord could ask the tenant to choose between two contracts: one in which a share of the output is offered and another in which fixed rent must be paid. By offering different contracts, the landlord can get prospective tenants of different ability to select different contracts. This allows the landlord to obtain the “hidden information” from his prospective tenants and allows him to identify their types. Potential tenants are thus in a way “screened” based on their ability.  It is possible, under given circumstances, to choose from this menu of contracts in order to satisfy the following conditions:  A high-ability tenant will prefer the fixed rent contract to the sharecropping contract even though the implicit rent in the fixed rent contract is higher. The reason is that he can retain a large share of his high marginal product while if he were to choose the sharecropping contract he would have to give away some of this;  A low-ability tenant will prefer the sharecropping contract to the fixed rent contract. In this case, the low-ability tenant divides his low product with the landlord. The fixed rent is too high compared to the extra marginal product that he would get in return.

20 Hidden Information - Screening in Land Tenure

21 Hidden Information - Screening in Land Tenure (model)

22 Hidden Information - Screening in Land Tenure

23 Screening and Land Variability in Sharecropping

24 Concluding remarks  Three forms of land tenure contracts exist; pure rental contract, contract farming and sharecropping. The choice among these contracts and the efficient allocation of resources depends on the landlord’s ability to monitor or observe the effort and actions of the tenant (agent).  The landlord maximizes his utility function by equating the marginal costs to marginal revenue and thus pays the tenant a fixed amount, just enough to cover the agent’s reservation utility. The first best solution is no longer obtainable in the context where the landlord cannot observe the tenants actions (both ex-ante or ex-post) due to the presence of asymmetric information.  Alfred Marshall emphasized the moral hazard problem that is associated with sharecropping and how this further leads to inefficiencies. He claimed that any contract other than fixed rent contract distorts the tenant’s input supply away from what he termed as the “efficient level.

25 Concluding remarks  empirical evidence continues to show the existence and persistence of sharecropping as a mechanism of land tenure and this is particularly true in the developing world where most individuals are farmers or do practice farming activities. Why then does sharecropping continue to persist?  Focusing the evidence of land tenure in the developing countries this paper tries to answer a very controversial question by making two main concluding remarks.  The definition of efficiency. In his model, Marshall’s assumes that the landlord is “rational” and so he will always maximise the earnings and thus prefer a fixed rent contract compared to the sharecropping alternative. This leads to posing the question whether agents are always utility maximises. Whether or not landlords and agents pay attention exclusively on the amount of effort or actions of the agents. Is the effort of the agent the only factor that influences his output levels or are there other factors are also taken into consideration like, the risk attitudes of both the principal (landlord) and the agent (tenant) and how the risks are shared among these agents in their decision making process.

26 Concluding remarks  Monitoring costs. Marshall in his work identifies the high costs of supervision of tenants by the landlord as the central cause of inefficiency in sharecropping. Agricultural and farming activities in developing countries are often practised in a context where strong social and cultural norms exists. Small scale farmers do not migrate often and thus create some sort of reputation based on trust with the landlord. Social and cultural norms are strongly perceived and abided to in these contexts. Moreover, peer monitoring is also practised in these contexts due to family ties and the above mentioned strong social norms. These factors render the costs of monitoring for the landlord reasonably lower than in other contexts.  No single model can be used to identify or explain the presence of one land tenure contract or another. Other factors like the risk attitudes of the agents, factors that affect monitoring costs and the ability of the landlord to screen the tenants need to be taken into consideration. Sharecropping may emerge inefficient from a purely Marshallian view. It however allows agents to mitigate other issues such as risk at the cost of efficiency.

27 Thank you for your attention


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