The expansion of oil palm plantations in Indonesia has doubled within the last decade but the productivity keeps low. Understanding why such a problem arise at smallholders needs in-depth study because of the different physical, market and social condition faced by independent smallholders and dependent smallholders (plasma farmers). The kinds of institutions and governance structures needed for regulating palm oil production of smalloders are the inquiry of this research. This study applies the Institutions of Sustainability (IoS) framework and takes transactions as the basic unit of analysis. The expansion of independent-smallholders’ plantations occur at the expense of forest and arable land. The high demand for fresh fruit bunch, indicated by a large number of palm oil mills in those regions, has promoted a powerful institutional setting in the oil palm fruit market with vigorous economic actors, which has persuaded more farmers to convert forest and arable land into oil palm plantations. Close monitoring and restrictive practice of authorizing new palm oil processing facilities are preconditions to match the demand for palm oil with the limited natural resources available (including arable land and forest).
Plasma farmers involves in contract arrangements with palm oil firms and they organize their activities under cooperatives. The research found that the contracts do not comply with basic needs of smallholders thus raise higher transaction costs and uncertainty for the farmers. Many farmer cooperatives are less effective to increase productivity of plasma farmers’ plantations and their welfare. This happens because the interests of individual farmers do not always harmonize with the collective interest. Institutional gaps appear because of the missing collective choice rules within the cooperative, which influence the cooperative’s performance. Filling the gap between constitutional situations and operational situations with collective choice rules could reinforce integrated governance of the whole system in plasma plantations.