In the mid-hills of Nepal, as in many developing countries, gradually developing urban centers and increasing demand for agricultural produce, due to population growth and early development activities, have persuaded farm households to reorient their subsistence farming to become farm systems growing surplus food to be sold in the markets. To cope with these changes, institutions play an important role and, for these institutions to be effective, farmers must perceive their participation as not being coerced. Their participation is influenced by individual household characteristics and proximity to support services and markets. Our main findings from the analysis of household surveys based on the level of market participation included: (1) the education level and amount of training attended by family members are influencing social variables, while farm size and gross farm income are dominant economic variables influencing household participation and perceived institutional effectiveness; (2) these variations revealed significant differences in the levels of market economy for household participation and institutional effectiveness within the watershed; and (3) the factor analysis further categorized several socioeconomic variables into three major factors explaining household participation and institutional effectiveness; these included labor quality and resources, supplementary income coming from migration and off-farm activities, and awareness and modern skills acquired by farm household members living within the watershed.