Optimal Decisions for Contract Farming under Weather Risk

Abstract

Weather risk causes uncertain crop yield and price and further influences the willingness of farmers to participate in contract farming and honour the contract. In this study, we investigate the optimal decisions for contract farming between a profit-maximizing manufacturer and multiple identical farmers under weather risk, using a game-theoretical approach. We discuss two different cases. In the first case, the manufacturer sets a contract price to ensure farmers to honour the contract under any weather condition. While in the second case, the manufacturer sets a lower contract price only to guarantee that farmers will not renege under certain weather condition but has a second chance to purchase products from the reneged farmers at a renegotiated price. We derive the optimal decisions of the manufacturer in both cases and show that the manufacturer gains much more profits in the second case, and therefore, the decisions in the second case are optimal. Moreover, we numerically investigate the sensitivity of the effectiveness of contract farming and the manufacturer's optimal decisions to model parameters and get more managerial implications.