Agricultural Supply Response Under Contract

Agricultural producers typically face considerable production and price risk in their operations. As a result, the role of risk in shaping farm-level decisions has been the focus of much research (e.g., Moschini and Hennessy). But why do risk-averse producers face such risk? In a world of complete markets and perfect information, a profit-maximizing intermediary would provide full insurance to producers. Thus, some aspect of the production and marketing of agricultural commodities must limit the scope for this type of insurance. When considering reasons why growers of fresh produce might face price risk, Hueth and Ligon suggest the possibility of unobserved actions in the provision of quality. If quality cannot be measured perfectly, and some downstream price contains information about a farmer's investment in quality, then conditioning a grower's compensation on this price may help the intermediary to monitor farmer effort. A similar argument holds in the case of production risk: if unobserved actions influence yield, an optimal compensation scheme might expose farmers to considerable production risk in order to provide incentive for high output. This suggests that the type of intermediation available to farmers can have important consequences for the risks that farmers face. Previous analyses of the role of risk in producer decisions make one of two polar assumptions regarding intermediation: either there is none (e.g., Sandmo, Leland), or producers have access to an exogenously specified source of intermediation that may take the form of a futures market (e.g., Holthausen), public or private insurance (e.g., Ramaswami, Babcock and Hennessy), or perhaps a particular government program (e.g., Lin, Chavas and Holt). Although each of these analyses represent important contributions toward an understanding of how producers respond in different risk environments, they are each silent on how the institutions themselves