2015 Series • No. 15–7
Research Department Working Papers
The Distributional Effects of Contractual Norms: The Case of Cropshare Agreements
According to principal-agent theory, a share contract strikes an optimal balance between risk-sharing and incentive provision when it is difficult to gauge the agent's contribution. This theory predicts that the size of the share should vary with economic fundamentals. In practice, however, the share divisions that are specified often cluster around "usual and customary" levels-even when there is substantial heterogeneity among principal-agent pairs.
Using Illinois farm-level data observed between 1980 and 1994 that include soil productivity ratings, tenant net income, and crop yields, the author examines the economic consequences of adhering to established contractual norms. Almost all share agreements in the northern two-thirds of the state specify an equal division of crops between the landowner and tenant farmer, while the majority of share contracts in the southern third allot either three-fifths or two-thirds of all production to the tenant. The paper tests whether existing share arrangements distort the division of surplus between the principal (landowner) and the agent (tenant farmer), or if these potential distortions are somehow preempted by adjustments along other contractual margins. No previous study has attempted to empirically estimate the effect that uniformity in share contracts has on factor returns.
- Tenants on higher-quality farmland, as measured by the soil productivity rating, capture a sizable portion of the land rent or return to soil productivity. The author terms these distortions "conformity rents," which represent returns to higher soil quality that are captured (unearned) by the tenant given that the contract adheres to established regional norms for the share division without adjusting terms to reflect the soil quality.
- Tenants do not compensate owners for the conformity rents by producing above-average crop yields for the given soil quality. Conformity rents are also not readily rationalized as compensation for greater income variability or longer tenure on the farm.
- The author hypothesizes that landowners sacrifice conformity rents in exchange for minimizing the costs of bargaining over contract terms.
These results, based on share contracts that were competitively negotiated in a market economy with strong institutions, suggest that a full explanation of contractual rigidities must include reasons other than institutional constraints and a noncompetitive setting. The author suggests that customary share divisions reflect the average conditions present in a region, and do not adjust to idiosyncratic differences within the same region. While following such "usual and customary" practices may cause factor returns to deviate from their competitive levels, adhering to these norms offers the contracting parties a valuable form of social capital, so such unequal distributional effects do not necessarily imply economic inefficiency.
Share contracts are common in principal-agent relationships when returns are uncertain and it is costly to measure the agent's contribution. Well-known examples of these types of arrangements include sales commissions for real estate agents, contingency fees for attorneys, and cropshare contracts used in agriculture. An empirical feature of these contracts is that the shares specified are often based on focal points or historical norms, and seem excessively uniform given large and observable differences among the contracting parties. Using extensive survey data on cropshare contracts in Illinois, I test the hypothesis that contractual norms have measurable effects on factor returns. I find that tenants on higher-quality farmland capture a sizable portion of the land rent, controlling for nonlabor inputs, differences in labor quality, assortative matching effects, and riskiness in returns. Because the existence of a contractual norm is a valuable form of social capital for the bargaining parties, I argue that these distributional effects do not necessarily imply economic inefficiency.