Smallholder farmers in sub-Saharan Africa that sequestrate carbon through agroforestry provide ecosystem services that generate payment for ecosystem services (PES). When these farmers are inadequately compensated for the provision of additional ecosystem services they have no incentive to participate while over-compensation may lead to inefficient schemes. Stakeholders must consider farm-level interactions between agricultural production and ecosystem services’ provision when evaluating the adequate level of compensation and efficiency of PES scheme. We address this by measuring the marginal cost of ecosystem services based on farm level bio-economic interactions. A classification of the relationship between marketed agricultural output and non-marketed ecosystem services into complementary, supplementary or competitive is conducted. We use the flexible transformation function for our theoretical analysis and surveyed 120 smallholder farmers receiving PES for agroforestry carbon sequestration in Kenya. The results suggest that the joint production for a number of smallholder farms in Kenya may not be of a complementary nature. PES schemes could be designed in a more efficient manner if they would target smallholder farms based on the aforementioned classification by offering a range of contracts to encourage competitive bidding.