While the preceding analysis is simple and does not capture all of the interacting factors that happen at the farm level, it suggests that a national drought does not necessarily result in lower revenue for U.S. corn and soybean farms as a group relative to the revenue they expected when the crop was planted. The reason is that the decline in yield can be sector wide, or systemic to use the economic term. Thus, price increases, offsetting some, maybe all, and maybe more than all, of the average decline in yield. It is important to underscore that this statement holds even if insurance does not exist and that it does not hold for all farms, notably those with yield declines greater than average yield decline for the U.S. as a whole.

The availability of the harvest price option in crop insurance further means that, depending on the size of the increase in price, and assuming that a high enough insurance coverage level was purchased, a farm may have minimum revenue at harvest that exceeds the revenue expected when the crop was planted no matter what yield is, including zero. Given the more than 35% increase in corn and soybean insurance price that currently has occurred, this situation appears likely for the 2012 drought at some of the higher insurance coverage levels.

The situation discussed in the previous paragraph has prompted an emerging policy issue: should taxpayers subsidize the harvest price option for farms? Note, the issue is not whether crop farms should have access to the harvest price option, but whether it should be subsidized by the public.

In seeking to understand why this issue has arisen, it is important to first point out that a primary reason historically cited for consumer and taxpayer support of farm programs is an assured supply of food. Crop insurance can be viewed as furthering this goal by offering farms protection against the risk of production or revenue declines. However, when farms decide to purchase insurance, they in essence are saying that they are willing to produce the crop for the planting insurance price. Hence, the planting insurance price, not the harvest insurance price, aligns with the historical U.S. policy concern regarding an assured supply of food.

A second reason for the emergence of this issue is that insurance is designed to protect not against the physical loss of an asset but against the financial loss associated with the physical loss of an asset. This is a subtle but important distinction. For example, if the physical loss of an asset causes no financial harm, it is doubtful that most individuals would buy insurance to cover the physical loss. In this context, the physical loss of yield does not necessarily translate into a financial loss relative to the revenue expected when the decision was made to plant the crop. The reason is that yield risk can be systemic or wide spread. Thus, price can increase more than yield declines, resulting in no financial loss associated with the physical loss of yield. Note, this question does not arise with a yield loss that is specific to an individual farm because such a loss is not enough to impact price. Hence, the issue of whether the harvest price option should be subsidized by the public arises in part because crop insurance does not distinguish between farm specific and systemic yield loss.

Advocates for the harvest price option point out that it allows crop farms to feel more comfortable forward contracting grain. The harvest price option covers the financial risk exposure of having to buy grain in the market to cover their inability to fulfill their forward contracts. The counterpoint is that the harvest price option can encourage farmers to forward contract more than is consistent with prudent risk management, especially in years of sizable yield declines. In the author’s view, both of these observations are valid.

The decision on whether the harvest price option should be subsidized will come down to answering the question, what is fair and appropriate policy. This is never an easy determination. As a guide that might be of use, I have always found it worthwhile to switch places and ask, if I was taxpayer who was not a farmer, how would I feel about the policy? And, if I was both a farmer and a taxpayer, how would I feel about the policy?


This publication is also available at http://aede.osu.edu/publications.

 

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