Economic analysis of earnest money in agricultural contract: an investigation analysis

DENG Hongtu1,2 MA Taichao3,4

(1.School of Economics and Statistics, Guangzhou University)
(2.Research Center of New Structural Economics, Guangzhou University)
(3.School of Economics, Nankai University )
(4. Collaborative Innovation Center for China Economy)

【Abstract】From the perspective of hostages and working capital, this paper is both a theoretical analysis and a case study about earnest money. Firstly, theoretical analysis shows that hostages come into being because of the information asymmetry between the two parties involved in the transaction. However, some critical conditions must be satisfied to promote transaction. Specifically speaking, for trustees, the value of a hostage should fall into a bounded closed interval. In addition, as for trustors, there should be a minimum amount on the value of the hostage. Secondly, the case study finds that earnest money functions as both hostage and working capital, which not only restrains farmers’ opportunistic behaviors, but also facilitates the company to get enough liquidity. As the core of quasi-vertical integration, earnest money achieves the incentive compatibility of both sides of the transaction. The stability of the contract of “company + farmers” can thus be improved.

【Keywords】 hostage; earnest money; trust; quasi-vertical integration; contract selection;

【DOI】

【Funds】 Key Project of National Social Science Fund of China (17ZDA067)

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    Footnote

    [1]. ① According to the person in charge of a sheep company in Taigu County Shanxi Province, feed sales accounted for 20% of the company’s net profit. [^Back]

    [2]. ① The authors’ field research found that the cost of each lamb in the sheep company is about CNY 300, but the farmer has to pay the company earnest money of CNY 550 for each lamb that is adopted. [^Back]

    [3]. ② Slightly different from the previous analysis, the hostage here has the same value to both parties to the transaction. Therefore, the hostage of earnest money can be regarded as a “special case” of hostage in the analysis of the second part of this paper. [^Back]

    [4]. ③ Sheep industry (aquaculture) production is different from the production of crops such as grain, which has a high demand for land. In contrast, the sheep industry needs less land and the funds required are high. The sheep company will choose contract arrangements that can alleviate capital constraints. Therefore, the earnest money has become an important factor in the company’s success. [^Back]

    [5]. ④ The authors inspected over a dozen cooperatives in Shouguang City and Yiyuan County of Shandong Province, Yushe County and Taigu County of Shanxi Province, Shuangliu District and Wenjiang District of Chengdu City of Sichuan Province, Puyang City of Henan Province, Jinghai District and Jixian County of Tianjin, and Yan’an City of Shaanxi Province, Guazhou County of Jiuquan City of Gansu Province, and Anji County of Zhejiang Province. They found that the financing constraints of cooperatives were tight. [^Back]

    [6]. ① In the interview with the head of the sheep company by the authors, the person in charge of the company pointed out that the law has a requirement for the number of members of the cooperative with the participation of the company, and the majority of the farmers in the composition of the cooperative members. The existence of farmer members makes the company consider the opinions of the farmer members when making decisions, resulting in long decision-making time and high cost. Therefore, the company does not form cooperatives. Moreover, whether a company forms a cooperative is related to the government’s special subsidies, but this is only one factor. Other factors (such as the cost of forming a cooperative and the cost of managing the cooperative.) also affect whether the company chooses to form a cooperative. However, given the existence of the “leading company + farmer” model (as in the case of this paper), companies often do not receive government subsidies for cooperatives. [^Back]

    [7]. ② Given that some farmers have relatively tight financial constraints, the company will guarantee the bank to ensure that the farmers have sufficient funds to pay the earnest money. Any guarantee is risky, so the guarantee behavior can be regarded as the “hostage” provided by the company to the farmers, which is a strong constraint on the company’s opportunistic behavior. However, if the guarantee does not bring a marginal benefit to the company, it will not guarantee the farmer. In the context of this paper, the company guarantees farmers to alleviate the financial constraints of farmers, but more importantly, this part of the loan will enable the company to achieve low-cost financing in the form of earnest money. [^Back]

    [8]. ① The so-called “circuitous” financing means that such a contract is not a direct financing contract, but indirect financing that is realized by “exchange” with lambs and the earnest money between the company and the farmers, as well as the corresponding relationship between the amount of the earnest money and the purchase price. [^Back]

    [9]. ② In the analytical framework of this paper, the earnest money is used by the sheep company and objectively becomes the capital factor of the sheep company. [^Back]

    [10]. ③ Although this stage also involves “transactions,” such as the transfer of lambs from the company to the farmers, and the transfer of the earnest money from the farmers to the company, the purpose of these transfers is for adult sheep trade in the production phase and the phase of completion of the transaction. In other words, the above transfer is the result of the transaction process rather than the completion of the transaction, so this paper refers to it as “auxiliary transaction.” [^Back]

    [11]. ④ Borrowing Williamson’s (2002) classification of governance mechanisms, this paper refers to the intermediate state between market transactions and bureaucratic transactions as “mixed transactions.” [^Back]

    [12]. ① According to field research, the company has a strict scoring system for farmers, which involves many dimensions such as breeding environment, epidemic prevention work, and pens management. If the total score is less than 60, it will be unqualified. [^Back]

    [13]. ② In order to reduce the impact of uncontrollable factors (such as natural disasters) on farmers, the company gives farmers 2% mortality of exemption. In other words, if the mortality rate of the lambs is less than 2%, the loss is borne by the company and is not counted as a breach of contract by the farmers. [^Back]

    [14]. ③ According to the person in charge of the company, in the future, the company will mark the lambs in the form of biological ear tags to achieve precise control of quality and more clear accountability of farmers. [^Back]

    [15]. ① Here it mainly refers to the realization of the docking of a sheep company in Taigu County, Shanxi Province, and a commercial company in Beijing. The latter has completely accepted the former adult sheep, and relieved the “market pressure” of the sheep company. Sheep company and a commercial company in Beijing have ensured the stability of the adult sheep trade by concluding contracts that benefit both parties, which means that the sheep company has successfully locked the market. [^Back]

    [16]. ② This uncertainty is mainly reflected in the market environment such as the uncertainty of sales and the uncertainty of natural conditions. [^Back]

    [17]. ① See Tadelis (1999), Henderson and Steen (2015). [^Back]

    [18]. ① As described in the third subsection of Part 3, for the convenience of analysis, this paper divides the transaction process into three interrelated stages. “Auxiliary transaction” is intended to indicate that it is linked to the “final transaction” rather than being completely independent. The relationship between the two parties begins with the “auxiliary transaction,” and the transaction of “final product” is completed as a transaction process after the production and management of the transaction. [^Back]

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This Article

ISSN:1006-4583

CN: 11-3586/F

Vol , No. 02, Pages 2-17

March 2019

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Article Outline

Abstract

  • 1 Introduction
  • 2 Hostage and earnest money: meaning and logic
  • 3 Earnest money in agricultural contracts
  • 4 Expansion of analytical logic: quasi-hostage, social trust and contract stability
  • 5 Conclusions and extensions
  • Footnote

    References