The Effects of Governance on Relational and Formal Contracts: Theory and Evidence from Groundwater Irrigation Markets by Mr. Jeffrey Michler

8/10/2019 The Effects of Governance on Relational and Formal Contracts: Theory and Evidence from Groundwater Irrigation Markets by Mr. Jeffrey Michler

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Introduction Irrigation Contracts Data & Results Conclusions

The Effects of Governance on Relational andFormal Contracts:

Theory and Evidence from Groundwater Irrigation Markets

Jeffrey D. Michler Steven Y. Wu

Department of Agricultural EconomicsPurdue University

IRRI SSD Seminar

Los Banos, Philippines

5 November 2014

Michler (Purdue) Contracts for Groundwater Irrigation 1/27

IRRI 2014 1 / 27


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Land Tenure Contracts

Hayami and Otsuka (1993) inThe Economics of Contract Choice: An

Agrarian Perspectivedevelop a general theory of land tenure

contracts. They look to explain...

Why there is a variety of land tenure contracts

Why some contracts are preferred to other contracts

The role of risk sharing in contract choice

Interlinkages between tenure contracts and credit

How contracts are enforced despite poor legal system


IRRI 2014 2 / 27


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IRRI 2014 2 / 27


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Michler (Purdue) Contracts for Groundwater Irrigation 2/27 IRRI 2014 2 / 27


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C C


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I t d ti I i ti C t t D t & R lt C l i


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Groundwater Contracts

Mukherji (2004)

There has so far been no attempt at formulating a general theory of

groundwater markets. Thus, the current mode of functioning of

groundwater markets still leaves a lot of unanswered questions such

as why do several modes of water contracts coexist under seemingly

similar conditions and why do they respond differently to similar sets of

incentives and disincentives?




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Motivation

Observation

Markets for groundwater irrigation are informal and unregulated

Research Questions

1. Why do farmers choose to use a particular type of contract?

2. What is the role of different types of governance in determining

contract choice?




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Motivation

Observation

Markets for groundwater irrigation are informal and unregulated

Research Questions



contract choice?




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Implications

Contract choice involves balancing an inter-temporal trade-off:

Short-term: exploit groundwater to maximize production and

achieve or maintain food security. Long-term: conserve groundwater to insure against risk posed by

future extreme environmental events.

How do we design interventions or new market mechanisms to ensure

groundwater conservation while continuing largeBororice yields?




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Implications

Contract choice involves balancing an inter-temporal trade-off:

Short-term: exploit groundwater to maximize production and

achieve or maintain food security. Long-term: conserve groundwater to insure against risk posed by

future extreme environmental events.






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Methodology

Relational Contract Theory

We adapt a theoretical model of human behavior and institutional

governance developed by Dixit (2004). Allows us to think of contracting as a non-cooperative game with

contracts distinguished by who has the last move in the game.

Explains how contracts remain effective despite a lack of outside

enforcement.




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g

Types of Water Contracts

Fixed Charge- One-time fee paid by buyer at start of season for

water throughout season

Labor Charge- Buyer provides labor throughout season to seller

in exchange for water

Piece Rate- Buyer pays fee for each application throughoutseason

Output Share- One-time fee paid at end of season and

dependent on crop yield

Input Share- Seller provides inputs to buyer in exchange forlarger output share

Fixed Rent- One-time fee paid by seller at start of season for use

of land




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g











of land




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of land




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of land




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of land




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of land




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of land




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The Water Selling Agent:Cost and Signals

Cost function

c(a ) = (1/2)a a (1)

Sufficient water

Pr(y= 1|a ) = y a (2)

Crop output

x= x a + (3)




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Cost function

c(a ) = (1/2)a a (1)

Sufficient water

Pr(y= 1|a ) = y a (2)

Crop output

x= x a + (3)




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Cost function

c(a ) = (1/2)a a (1)

Sufficient water

Pr(y= 1|a ) = y a (2)

Crop output

x= x a + (3)




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The Water Selling Agent:Compensation Package

U= S

Fixe

dPaym

ent

+ y a

Rela

tionalC

ontract

+ x a

Enforceable

Contract

(1/2)a a

C

ost

(4)

Fixed charge = 0,= 0,S>0.

Piece rate0<


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U= S

Fixe

dPaym

ent

+ y a

Rela

tionalC

ontra

ct

+ x a

Enforceable

Contra

ct

(1/2)a a

C

ost

(4)


Piece rate0<


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U= S

Fixe

dPay

men

t

+ y a

Rela

tionalC

ontra

ct

+ x a

Enforceable

Contra

ct

(1/2)a a

C

ost

(4)


Piece rate0<


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U= S

Fixe

dPay

men

t

+ y a

Rela

tionalCon

tract

+ x a

Enforceable

Contra

ct

(1/2)a a

C

ost

(4)


Piece rate0<


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The Water Selling Agent:Agents Maximization Problem

Incentive Compatibility Constraint assumes agents maximization

problem is

maxa

U= S+ x a + y a (1/2)a a (5)

Maximized Utility

U

= S+ 1/2(

2

+ 2k +

2

) u0 (6)

Assume agents Participation Constraint satisfied with equality

Michler (Purdue) Contracts for Groundwater Irrigation 10/27IRRI 2014 10 / 27



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problem is

maxa

U= S+ x a + y a (1/2)a a (5)

Maximized Utility

U

= S+ 1/2(

2

+ 2k +

2

) u0 (6)





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problem is

maxa

U= S+ x a + y a (1/2)a a (5)

Maximized Utility

U

= S+ 1/2(

2

+ 2k +

2

) u0 (6)





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The Water Selling Agent:The Value ofK

k= x y (7)

Geometrically,kis cosine of angle between x andy

By Cauchy-Schwarzk2 1

Economically,k is correlation between marginal effects ofa onx

andy




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The Water Buying PrincipalPrincipals Maximization Problem

Maximization Problem

max(,)

V(, ) = (k+ ) 1/2(2 + 2k + 2) (8)

s.t. V(, ) r VEC 0

Self Enforcement Constraint

(9)

r- short term gain from defecting on Relational Contract VEC - value from defaulting to Enforceable Contract




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max(,)

V(, ) = (k+ ) 1/2(2 + 2k + 2) (8)

s.t. V(, ) r VEC 0


(9)





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max(,)

V(, ) = (k+ ) 1/2(2 + 2k + 2) (8)

s.t. V(, ) r VEC 0


(9)





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Solutions

= rk/(1 k2) (10a)

= (1 k2 r)/(1 k2) (10b)

Relational Contract: = 0,= 0, = 1 Fixed charge Piece rate

Enforceable Contract: = 1,= k,= 0 Output share



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Comparative Statics


When discount rates (r) are low, RCs are more likely than ECs.

When performance signals (k) are inaccurate, RCs are morelikely than ECs.


contract choice?

Weak punishment/governance makes RCs more likely than ECs




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Comparative Statics





contract choice?





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Comparative Statics





contract choice?





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Survey Data

Conducted with support from

U.S. Borlaug Fellowship, IRRI &

Bangladesh Ag. University

96 villages selected randomlyfrom 48Bororice growing

districts

10 households randomly

selected from each village Collected at end of Bororice

season (May - July) 2013




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Personal Discount Rates

We use simple inter-temporal

choice experiment to elicitindividual interest rates

We convert to discount ratesfor regression

r= 11+i




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Performance Signal

We use soil quality as ourperformance signal

k= Cov(x,y)Var(x)Var(y)

As soil quality , Var (y) andk




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Third-Party Enforcement




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Punishment Types

Given third-party arbitration

exists, we observe three typesof punishment

Use indicators for each type,with no third-party arbitration

as base case



E i M d l


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Econometric Model

Pr(RC = 1|X) = (0 + 1ri+ 2ki+ 3VEC

j + Zi1 + Wi2)

ri- discount rate

ki- performance signal

VECj - severity of village level punishment

Zi- vector of buyer characteristics

Wi- vector of well characteristics

We instrumentriwith distance between buyers and sellers house



E t i M d l


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Econometric Model

Pr(RC = 1|X) = (0 + 1ri+ 2ki+ 3VEC

j + Zi1 + Wi2)

ri- discount rate

ki- performance signal

VECj - severity of village level punishment

Zi- vector of buyer characteristics

Wi- vector of well characteristics

We instrumentriwith distance between buyers and sellers house



D t i t f C t t Ch i


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Determinants of Contract Choice

All Water Buyers

Base: Enforceable Contract LPM Probit IV

Discount Rate (r)

Discount Rate (0-12 months) 0.031 0.481 9.048

(0.113) (0.941) (5.182)

Performance Signal (k)Standard Soil Quality 0.028 0.322 0.455

(0.023) (0.230) (0.172)Good Soil Quality 0.001 0.638 0.722

(0.029) (0.258) (0.225)

Punishment (VEC )

Private Punishment 0.133 0.307 0.249(0.118) (0.719) (0.538)

Economic Punishment 0.074 0.702 0.505(0.038) (0.335) (0.373)

Social Punishment 0.155 1.485 1.244

(0.071) (0.321) (0.483)



Eff t f G b C t t T


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Effect of Governance by Contract Type

Village Enforcement No Village Enforcement

Base: Fixed Charge Share Piece Rate Share Piece Rate

Discount Rate (r)

Discount Rate (0-12 months) 1.905 3.911 0.633 5.228

(3.308) (2.104) (3.799) (2.955)

Accuracy Signal (k)

Standard Soil Quality 0.868 0.282 1.029 0.179(0.500) (0.454) (0.866) (0.507)

Good Soil Quality 1.303 0.051 2.156 0.031(0.773) (0.646) (0.931) (0.439)

Punishment (VEC

)Economic Punishment 3.003 0.467

(1.533) (0.716)Economic Social 4.104 0.498

(1.534) (0.588)



Conclusions


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Conclusions


High discount rate decreases probability of relational contracts.

Existence of an accurate performance signal decreases

probability of relational contracts.


contract choice?

Severe punishment of enforceable contracts decreases probability

of relational contracts.



Conclusions


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Conclusions


High discount rate decreases probability of relational contracts.

Existence of an accurate performance signal decreases

probability of relational contracts.


contract choice?

Severe punishment of enforceable contracts decreases probability

of relational contracts.



General Policy Implications


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Adopt a systematic approach to analyzing the market Policies must consider the governance structure and institutional

framework

Attempts to strengthen governance may result in sub-optimal

outcomes





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Adopt a systematic approach to analyzing the market

Policies must consider the governance structure and institutional

framework


outcomes





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framework


outcomes





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framework


outcomes



Specific Policy Implications


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If goal is to incentive households to conserve water...

Output share wastes water most but is good for credit constrained

buyers Fixed charge conserves water most but is bad for credit

constrained buyers

Piece rate balances these two issues





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constrained buyers






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constrained buyers




Questions Remain


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Questions Remain

Does price of piece rate contract account for "true" price of water?

Village governance may be able to address the common pool

resource problem But, better governance makes piece rate less likely

How does one design productivity enhancing, water conserving,

incentive compatible contracts within a given governance structure?



Questions Remain


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Questions Remain








Questions Remain


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Quest o s e a








Thank You


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QUESTIONS? COMMENTS? SUGGESTIONS?


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The Effects of Governance on Relational and Formal Contracts: Theory and Evidence from Groundwater Irrigation Markets by Mr. Jeffrey Michler