Optimal Risk in Agricultural Contracts

Abstract

It is a commonplace observation that risk-averse farmers ought to prefer less risk. In this paper, we provide three qualifications to this commonplace. First, we note that (properly defined) “less risk” need not imply “smaller variance.” Second, we note that when farmers produce under contract, there may be an important tension between risk and incentives, and we provide a simple characterization of the optimal risk in any production system. Third, we note that while at the margin the behavior of risk-averse farmers may appear to be nearly risk-neutral, it does not follow that one can generally treat such producers “as if” they were risk-neutral without being greatly led astray.