Contract farming is defined as an agreement, which may range from a simple verbal commitment to a written document, between a farmer and a firm, in which the farmer agrees to deliver fresh or partially processed products and the firm commits itself to purchasing the produce under certain agreed price and non-price conditions. Contract farming is usually considered a substitute for poorly functioning or absent markets. The literature on contract farming presents two opposite views of the potential of this alternative market institution as a bridge for trading between smallholders and agroprocessing firms. Some researchers argue that contracts are an adequate mechanism for integrating smallholders into dynamic markets by overcoming the constraints of a failing market. Others warn about the downside of contracting. We present the rationales for different types of contractual regimes between small-scale pepper producers and agroprocessing firms in the northern region of Costa Rica under two market configurations— namely, a competitive market and a local monopsony. Three types of contractual agreements (written contracts, verbal commitments, and no agreement) are found. The analysis is based on a survey of pepper producers using a semistructured questionnaire to obtain data on production systems and marketing arrangements. Pepper is an attractive diversification activity for smallholders because it is a labor-intensive crop, does not require complex technologies or machinery, requires detailed attention and frequent disease control through the cropping cycle, and can reach high, fairly stable yields per hectare. A major drawback is the high entry cost during the start-up phase, stemming from the need for initial investments in crop establishment and the long maturation time before the first harvest. Contracts may help overcome these constraints and permit market entry at a reduced level of uncertainty. A farmer's level and sources of income have a clear effect on his or her contract choice and bargaining power. Income diversification enables farmers to increase their asset specificity in pepper crops,1 even without the insurance provided by contracts. Therefore, pepper companies prefer to offer contracts to less-endowed farmers who have some farming experience but limited income diversification. These farmers are likely to engage in contract farming owing to their limited bargaining power. Even though the enterprise operating in the monopsonistic market also maintains high asset specificity, it is able to buy from some farmers without any prior agreement, since the latter possess limited bargaining options for valuing their asset-specific investments. Farmers with contracts definitely invest more inputs and time in soil maintenance activities on their pepper plots. Resource-providing contracts in the competitive market have a stronger effect on farmers' investments than simple market specification contracts in the monopsonistic market. This finding confirms the literature regarding the importance of resource-providing contracts and vertical integration for sustainable agricultural intensification (Kuyvenhoven and Ruben 2002). Budgetconstrained farmers that intend to tailor their investment decisions in line with the designed technological package may substitute for the default level of fertilizer use with additional labor investments in soil maintenance activities. Your assignment is to recommend a government policy to assure an acceptable level of competition and to facilitate increasing incomes and reduced risks for low-income pepper farmers in Costa Rica.