Sustainable Sourcing of Agricultural Products: Fixed vs. Flexible Premiums

Sustainability certifications have gained increasing popularity for agricultural product sourcing. To help improve smallholder farmers' livelihoods, these certifications set a premium that firms must pay to farmers for certified crops on top of the market price. This premium can be structured in different ways: A popular approach adopted by several major certifications is called a fixed premium, under which farmers receive a fixed level of premium independent of the market price. However, this approach has been criticized for not sufficiently protecting farmers when the market price is low. Accordingly, an alternative approach called a flexible premium, under which farmers receive a higher premium when the market price is lower, has been promoted by farmer advocacy groups and recently implemented by some certifications. We analyze and compare the effectiveness of these premium approaches and offer several managerial insights. First, contrary to expectation, we show that the flexible premium approach can lead to a lower expected farmer income than the fixed premium approach. Even when a flexible premium improves farmer income, it can lead to a lower expected sustainable sourcing quantity and firm profit. Second, we nevertheless identify that a flexible premium can lead to a "win-win-win" outcome for farmer income, sustainable sourcing quantity, and firm profit, but only in settings with ample certified supply relative to demand. Finally, motivated by the trend of firms creating their own sustainability labels, we show that such self-labeling can lead to a higher sustainable sourcing quantity but lower farmer income compared to NGO labeling.