The role of risk in contract choice

Abstract

Structuring contracts to share risk in light of incentive problems is the central premise of contract theory, yet the risk-sharing implications have rarely been thoroughly tested using micro-level contract data. In this article we test the major implications of a principal-agent model of contracts using detailed data on more than 4000 individual contracts from modern North American agriculture. On a case-by-case basis, our evidence fails to support the standard principal-agent model with risk aversion as an explanation of contract choice in modern North American farming. At the same time, we find some support for models that assume risk-neutral contracting parties and stress multiple margins for moral hazard and enforcement costs.

An Empirical Analysis of the Determinants of Marketing Contract Structures for Corn and Soybeans

“…For example, income, wealth, age, off-farm income, and the debt-to-asset ratio are often used as proxies for risk aversion (Huffman and Just, 2004;Mishra and El-Osta, 2002;Allen and Lueck, 1999;Lajili et al, 1997;Smith and Baquet, 1996), while education and experience are commonly used proxies for risk-aversion (Velandia et al, 2009;Sherrick et al, 2004) and farm-level productivity (Lockheed et al, 1980). Succinctly, the problem with estimating (3) by means of standard methods (e.g., OLS) is that the coefficients are biased if agents endogenously match with activities and/or principals.…”

“…As highlighted by Allen and Lueck (1999), there exists highly developed commodity, credit, and, for corn and soybean, subsidized insurance markets that can be used to manage and mitigate price and production risks. The importance and ability of risk-sharing to be achieved through contract design may be dominated by the opportunities afforded by these other risk management alternatives.…”

“…That contracts are structured, in equilibrium, to efficiently allocate risk between the parties towards the goal of aligning incentives is an assumption based in the principal-agent approach to contract theory (Sheldon, 1996;Allen and Lueck, 1999). There are two very general (and related) hypotheses stemming from the standard principal-agent approach, namely, (a) higher levels of risk in the contracted activity (i.e., agricultural production) should result in contracts more highly motivated by risksharing between the contracting parties, 2 and (b) optimal contract design will shift a relatively greater share of the risk to the less risk-averse party (Stiglitz, 1974).…”

“…Given these hypotheses, one would expect the preferences and characteristics of 1 MacDonald and Korb (2008) report premiums in the range of 10-20 percent above average U.S. spot prices received for corn and soybean from 1996-2005 using the USDA ARMS data. 2 See Allen and Lueck (1999) for further discussion and additional references. the contractor and contractee, as well as the characteristics of the commodity being contracted, to determine the attributes of the optimal contract.…”

The Optimal Length of Contracts With Application to Outsourcing

“…The adapted service would have mostly duplicated the basic service and its additional value (given Amex's limited service need) did not justify EDS's avoidable costs of substituting for IBM. 3 As a result, Amex depended on IBM to exploit its adaptation.…”