Production under uncertainty with insurance or hedging

Abstract

This paper examines the output decision of a risk-averse producer facing profit risk in the presence of insurance or hedging. Conditions under which the producer’s output increases upon the introduction of generic insurance are derived, giving rise to conditions for deductible insurance (commodity call options), coinsurance-type insurance (commodity futures), and restricted deductible insurance, respectively. This paper improves upon the literature by considering general profit risk, possibly revenue risk or cost risk, that may not be multiplicative. Moreover, unlike Machnes and Wong’s [Geneva Pap. Risk Insurance Theory 28 (2003) 73–80] condition on the loading factor that may not lead to an explicit and unique value, the condition derived in this paper gives rise to a unique upper bound for the loading factor. Finally, their assumptions on the utility function, such as quadratic utility and constant absolute risk aversion for the case of restrictive deductible insurance and zero-loading are made substantial less restrictive.