Abstract
Smallholder farmers in emerging economies are vital to the global food supply, yet they remain highly vulnerable to yield risks such as extreme weather. Whereas government subsidies that compensate farmers in low-yield scenarios are common in developed countries, such policies are often impractical in emerging economies because of the high cost of assessing yields on small farms. To address this, an innovative index-based approach has gained traction, under which payments are triggered when a predetermined index (e.g., rainfall) predicts a low yield. Yet the inevitable inaccuracy of indices in reflecting actual yields weakens the alignment between payments and actual yields, reducing risk protection for farmers. This paper analyzes how governments should design yield protection subsidies under index inaccuracy. Our analysis reveals several insights. First, unlike actual yield–based policies, higher subsidies under index-based policies can inadvertently increase farmers’ income variability. Building on this, we identify a nonmonotonic relationship between the optimal subsidy and index accuracy: as accuracy improves, subsidies should initially increase but then decrease once accuracy becomes sufficiently high. Second, whereas price protection subsidies (which compensate for low prices) are often viewed as strategic substitutes for yield protection as both can increase income and incentivize planting, we show that they act as strategic complements when index accuracy is low, meaning the presence of price protection warrants a higher index-based yield protection subsidy and vice versa. Finally, when governments allocate budgets between subsidy payments and improving index accuracy, we find that tighter budgets can make it especially important to prioritize index accuracy.
This paper was accepted by Christoph H. Loch, operations management.
Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2024.05008 .