Agriculture Reference
In-Depth Information
A Two-Period Model of Farmland Contracts with Ratchet Effects
We slightly modify the principal-agent model from chapter 6 to create a two-period
principal-agent model of farmland contracting to clarify the ratchet effect and demonstrate
its testable implications. 8 We assume that the landowner is risk neutral and the farmer is risk
averse, all cost and revenue functions are the same each period, there are no wealth effects,
there is no discounting, and nature draws from the same distribution in both periods. These
are the standard assumptions made in a dynamic principal-agent model in order to focus
on the ratchet effect. The no wealth effect assumption implies that the coefficient of risk
aversion is constant and that the optimal contract maximizes the total certainty equivalent
income, subject to any incentive constraints. We make these assumptions to focus on the
ratchet effect. 9
Furthermore, we assume there is a pool of homogeneous (equal ability) farmers, which
rules out adverse selection and leaves only moral hazard. 10 Farmer moral hazard, as always,
exists because nature plays a large role in agricultural production and because farmer effort
is costly to observe. Over time, however, landowners become more knowledgeable about
nature, and they use this information to alter the contract in their favor.
Since two forms of incentive contracts dominate—cropshare and cash rent contracts,
a ratchet effect might manifest itself in two potential ways. First, there may be a ratchet
effect in the choice of one type of contract versus another. Second, the ratchet effect might
arise within share contracts. We search for ratchet effects in both contexts and begin with
the choice between cash rent and cropshare contracts, and then examine the ratchet effect
within cropshare contracts alone.
Cash Rent versus Cropshare Contracts
In agricultural land leasing where farmers and landowners contract over the use of land
and where the choice is between share contracts and cash rent contracts, the principal-
agent model with ratchet effects suggests that new farmers are more likely to lease land
with cash rent contracts, since cash rent contracts have stronger farmer incentives or are
“higher-powered.” When cash rent contracts are used with new farmers, landowners can
exploit the information obtained over past seasons with previous renters and still maintain
the reservation income of those who currently work the land. 11
To show this, assume the contract between the farmer and landowner generates the
following income for the farmer in each period:
Y = sQ β C(e) Y
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