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Abstract

We develop a principal agent model to examine how the optimal contract between a farmer and an external equity investor is altered by the presence of crop insurance. The contract uses both fixed compensation and variable compensation varying with realized revenue to induce high farmer effort. All remaining surplus is divided between the farmer and investor. The optimal contract with crop insurance relies more on the variable compensation and less on the fixed compensation than when crop insurance is unavailable. This compensation scheme requires the investor to share more risk with the farmer to induce higher effort while still enticing the farmer’s participation in the contract. Empirical analysis finds that the variable compensation increase is not substantial, but the fixed compensation decrease ranges 1% to 73% depending on the acreage allocation between crops.

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