CROP INSURANCE - THE RELATIONSHIP BETWEEN INDEMNITY PRICE AND EXPECTED OUTPUT PRICE

Crop insurance contracts typically constrain the choice of price at wh ich indemnification occurs to less that the expected output price. Thi s restriction is first analysed assuming only risk-averse farmers, and yield and price uncertainty. General conditions under which the optim al price selection is bounded above by the expected output price are f ound to be difficult to derive. The results of numerical simulations b ased on a range of different utility functional forms are presented, a nd a strong tendency is observed for the optimal price selection to be bounded from below by the expected output price. The effect of increa sing output price variability on the optimal price selection is also c onsidered. The simulations results suggest that the optimal price sele ction is often non-increasing with a mean-preserving spread of the out put price distribution. Lastly, it is noted that even in the presence of hidden-action moral hazard, if the incentives for shirking are not too high, the constraint that price selections be lower than the expec ted output price may still be binding.