Winter 2002, Vol. 8 No. 1
In this issue...
Public or Private Price Protection?
Bruce A. Babcock
Assuring that farmers have an adequate financial safety net is appealing to most people. But acceptance of this idea does not mean that the public sector needs to provide it. Other industries manage large financial risks without turning to government for help. So could farmers. A corn farmer can buy a "put" option on the Chicago Board of Trade (CBOT) December corn contract that gives the farmer the right to sell corn for $2.40 a bushel in December. This put option creates an effective floor price. The current market price for this price protection is about $0.18 per bushel. Should the farmer buy this protection? The answer depends on both how much price risk the farmer wants to bear and how much price protection is available free of charge from the public sector.
Figures 1 and 2 provide insight into both factors. The horizontal axis measures the range of possible fall harvest prices. The height of the bars measures the probability of a given price outcome. For corn, the most likely local price is between $1.90 and $2.00 per bushel. For soybeans, the most likely price is between $4.00 and $4.10 per bushel. But corn prices could drop lower than $1.50 and increase to more than $3.00 per bushel. And the likely range of soybean prices is from $3.00 to $6.00 per bushel.
Should either corn or soybean farmers buy private price protection? For Story County, Iowa, a put option on the CBOT corn contract would create a price floor of about $2.05 per bushel. Figure 1 shows that the price floor provided by the public sector, through the corn loan rate, is $1.76. That is, the farmer really only faces $0.29 in downside price risk. The question becomes, how valuable is $0.29 worth of price protection? Probably less than the $0.18 cost.
For soybeans, an "at the money" put option on the CBOT offers a local price floor of $4.05 per bushel, at a cost of $0.20 per bushel. But the government offers a price floor of $5.16 per bushel free of charge. Clearly, there is no reason for a farmer to buy price protection from the private market when the amount of protection offered for sale is at least $1.00 per bushel less than what the government offers at no cost.
Over the past three years, nearly $22 billion has been spent on the marketing loan program. One objective of the crop insurance reform act of 2000 was to entice the private sector to develop innovative risk management tools through government-subsidized research and development costs of privately developed products. An alternative strategy would have been to eliminate government-provided risk protection. This, too, would have induced increased investment in new risk management tools, but not at a cost to U.S. taxpayers. ♦