Effects of federal risk management programs on investment, production, and contract design under uncertainty

Abstract

Agricultural producers face uncertain agricultural production and market conditions. Much of the uncertainty faced by agricultural producers cannot be controlled by the producer, but can be managed. Several risk management programs are available in the U.S. to help manage uncertainties in agricultural production, marketing, and finance. This study focuses on the farm level economic implications of the federal risk management programs. In particular, the effects of the federal risk management programs on investment, production, and contract design are investigated. The dissertation is comprised of three essays. The unifying theme of these essays is the economic analysis of crop insurance programs. The first essay examines the effects of revenue insurance on the entry and exit thresholds of table grape producers using a real option approach. The results show that revenue insurance decreases the entry and exit thresholds compared with no revenue insurance, thus increasing the investment and current farming operation. If the policy goal is to induce more farmers in grape farming, the insurance policy with a high coverage level and high subsidy rate is effective. In the second essay, a mathematical programming model is used to examine the effects of federal risk management programs on optimal nitrogen fertilizer use and land allocation simultaneously. Current insurance programs and the Marketing Loan Program increase the optimal fertilizer rate 2% and increase the optimal cotton acreage 119-130% in a Texas cotton-sorghum system. Assuming nitrogen is harmful to the environment and cotton requires higher nitrogen use, these risk management programs counteract federal environmental programs. The third essay uses a principal-agent model to examine the optimal contract design that induces the best effort from the farmer when crop insurance is purchased. With the introduction of crop insurance, the investor’s optimal equity financing contract requires that the farmer bear more risk in order to have the incentive to work hard, which is achieved by increasing variable compensation and decreasing fixed compensation.