Farmers face both financial and production (low yield per acre) risks. Financial risks include changes in output price, physical factor input cost, and labor cost. Production risks are due to weather such as droughts, and freezes, pests, diseases, and floods. A survey of California farmers show that they take direct actions, diversify, buy insurance, and hedge to reduce risks. Direct approaches to reducing yield variability include installing wind machines, helicopters, and other equipment to protect crops during sudden frosts, and installing irrigation systems to protect against droughts. One fifth of California farmers gain some risk protection from using government programs that stabilize prices (see Chapter 9). A few (1.2%) sign labor contracts to reduce wage fluctuations. Nearly a quarter, 23.4%, of California farmers forward contract. A forward contract is signed before the growing season and usually specifies a price (or range of possible prices) to be paid upon delivery. If the contract guarantees the farmer a price of $5 per bushel, the gains or losses of higher or lower prices are borne by the buyer. Any farmer can forward contract if some other party is willing to absorb the risk. Only 6.2% of farmers hedge to reduce risks. Many farmers fail to hedge because no futures or options market exists for their crops, they do not understand hedging, or they do not trust these markets. These farmers favor forward contracts because they can lock in prices for longer periods of time. Crop insurance, which protects the farmer against unexpected drops in yield, is used by 24.4% of California farmers. Crop insurance is only available for some crops. Because federal crop insurance programs were designed primarily for farmers in the Midwest, they are not always attractive to California farmers. A farmer can collect only if the loss exceeds a certain percentage of the average yield. Because California farmers face less yield variability and are less likely to collect on the insurance, the federal rates are often not attractive for many of them. Only 60% of the farmers that do buy crop insurance buy it every year. About one-third buy it only in years where they expect adverse weather conditions. If they have better information than federal insurers, this practice can lead to adverse selection. California farmers’ main approach to avoiding financial and yield risks is to diversify across crops or between agricultural and nonagricultural activities. Nearly half of the farmers diversify across agricultural activities. Nearly two-thirds (63%) of producers receive nonagricultural income, accounting for 47% of their total family income. Diversification helps protect against both financial and production risks.

1. How has the globalization of agricultural markets affected U.S. farmers’ need for insurance? 

2. Suppose a new weather forecasting method was derived that was 50% more accurate than the current method. How would this affect the insurance market? 

3. What is the relationship between risk and length of the product cycle?