Quality and quantity incentives under downstream contracts: A role for agricultural cooperatives?

Abstract

This article provides a new explanation for the positive role of cooperatives in quality provision along the agri‐food chain. We study the economic rationale for cooperative acting as an intermediary between producers and a downstream (DS) firm when the DS firm cannot observe the individual quality of producers but only the average quality. We derive the optimal contract to elicit the quality and quantity incentives for producers, depending on whether the DS firm directly deals with producers or indirectly deals with them through a producer‐owned cooperative. We find that when the DS firm directly deals with producers via secret contracts, the opportunistic behavior of the DS firm on producers leads to lower quality and quantity levels. The opportunistic behavior is prevented when the DS firm deals with the producer cooperative. However, the contract should offer a sufficiently high quality payment to overcome the free‐riding inefficiency of the producer members.