Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements

Steven Cheung

Fixed rent contracts

• In China fixed rents were more frequent than share rents in the 1930s.

• Ex. … the annual rent per acre includes [so many catties] of wheat, and [so many catties] of millet, soybeans, and Indian corn. The payment in wheat will be 1 month after the wheat harvest, and autumn crops 2 months after the autumn harvest. In a famine year, rental payments shall be adjusted downwards according to local customs. The duration of lease is [so many years].

Share contracts

• Ex. … tenant A provides [so many head] of water buffalo, [so many bodies] of men; and every year the tenant must cultivate wheat once, Indian corn 3 times, and soybeans twice. Fertilizer expenses are to be shared [in certain proportions]. The yields of all crops are to be shared [in certain proportions]. The lease may terminate only after the autumn harvest.

Share contracts involve higher transaction costs

• The absentee landlords send their agents, or go themselves, to the fields and estimate the yield of the crop and the share given by the tenant is based on this estimate. …The tenant commonly cheats by skillfully hiding some of the threshed grain before division takes place and also by giving the landlord inferior crops. On the other hand, the landlord or his agent often uses a large measure. When the agent collects rent the tenant has to treat the agent very well and often has to bribe him in order to keep the land for cultivation another year.

Why share contracts?

• Risk sharing• In China, share tenancy more frequent in the wheat

region than in the rice region• Mean yield and proportional variance of wheat and

rice hectare yield (kg), Taiwan1901-10 1911-20 1921-30 1931-40 1941-50

μ Wheat 880 710 759 1,058 625

Rice 1,318 1,379 1,588 1,927 1,648

Wheat 291 118 357 1,180 1,158

Rice 31 32 46 62 180

inflation

• With inflation occurring in 1938, owing to the Sino-Japanese War, beginning in 1937, 13.3% of fixed cash rents were converted into crop rents and 15.3% were converted into share rents.

Escape clause of fixed-rent contracts

• Frequent inclusion of the provision for rental reduction in a “famine” year

• Why not a wide range of similar clauses each associated with a different level of “famine”?– Increasing transaction cost associated with

additional escape clauses– A share contract as an alternative device

Lease duration

• Contractual renegotiation when there are changes in relative product prices which call for shifts to different crops, or innovations which call for the adoption of new seeds or new methods of cultivation– Largely confined to share contracts

• Unsuccessful renegotiation when individual knowledge differs– A short lease duration is a convenient device in this situation

• Durations of share leases are generally shorter than those of fixed rents.