Supply Response under Risk: Implications for Counter-Cyclical Payments' Production Impact

Abstract

This study investigates the role of risk in farmers' acreage decisions for major field crops in the North Central region by revisiting an earlier study by Chavas and Holt. The empirical model is forward-looking and reflects better variable measurement. We test the effects of wealth and revenue risk on supply response. Estimated results are also used to examine the production impact of counter-cyclical payments (CCPs). We find that the effects of risk on supply response are not strong. An increase in initial wealth would lead to greater crop acreage, consistent with decreasing absolute risk aversion. The effect of CCPs on production appears to be negligible. T he 2002 Farm Act offers producers income support and revenue risk reduction through counter-cyclical payments (CCPs). These payments are made available to producers of covered commodities whenever the effective price--the sum of the direct payment rate and the national average farm price or loan rate (whichever is higher)-is less than the target price.' CCPs received by producers do not depend on current commodity production, but on historical base acreage and payment yields. CCPs protect producers from down-side price risk and so might have an impact on their production decisions. The potential for CCPs to cause production and trade distortions due to wealth and risk reduction effects has been noted in the ongoing agricultural trade policy debate. A seminal study by Chavas and Holt has been cited as the primary evidence of potential production and trade distortions caused by decoupled payments (such as direct payments) and partially decoupled payments (such as CCPs). The Chavas and Holt study shows that wealth and price risk have statistically significant effects on U.S. corn and soybean acreage decisions, but the impacts are small. However, the study is outdated because data used in the empirical model extend only through the mid 1980s. Since then, the policy environment has evolved away from supply controls and toward greater planting flexibility.