SUBSIDIZED CROP INSURANCE AND THE EXTENSIVE MARGIN

A partial equilibrium model of stochastic crop production is used to analyze the influence of subsidized crop insurance on the extensive margin. The addition of a crop insurance program that is characterized by a perfectly separating equilibrium and an actuarially fair premium for each quality does not change input use or land allocation. However, Risk neutral farmers facing actuarially fair premiums are indifferent between the purchase and not purchase decision. risk averse farmers all will purchase actuarially fair crop insurance. Premium subsidies create incentives for the extensive margin to expand at the lower end of the quality spectrum leading to adverse selection. Land in production without crop insurance remains in production with subsidized crop insurance. An actuarially fair pooling equilibrium creates incentives for the extensive margin to expand at the lower end of the quality spectrum, again leading to adverse selection. In the short-run, owners of high quality land do not insure their crops, while owners of the lowest quality land purchase insurance, exacerbating adverse selection. In the long-run, the pooling equilibrium premium rate increases until a limiting solution is obtained in which risk neutral owners of only one land quality type are indifferent between insuring and not insuring a quality of land. For risk averse farmers there will be a nondegenerate long-run pooling equilibrium. Premium subsidies mitigate the disincentive for higher quality landowners to purchase insurance, but exacerbate the incentive to expand the extensive margin