Risk Management Externalities in Agrifood Supply Chains
Firms may under- or over-invest in risk management from the social planner’s perspective, resulting in a negative externality on other economic agents in the supply chain. The externality of risk management is particularly relevant for agrifood supply chains, which frequently experience shocks and play a primary role in preventing major social losses from food insecurity. The magnitude of the externality depends on the structure of the supply chain. We build a theoretical model to characterize such externalities in US food supply chains where intermediary firms choose output quantities and investments in managing risks. The model allows for flexible market structures and interdependence of risk management among firms. Risk interdependence captures the unique feature of biotic hazards (e.g., animal and plant diseases) in agrifood supply chains, where the effectiveness of a firm’s risk management depends on peer firms’ behavior. We offer novel insights on the role of risk interdependence in driving the externality in risk management under different market structures. We show that private firms invest less than the socially optimal level under perfect competition, but risk interdependence and market power introduce complex incentives in risk-reducing investment that shape the externality. In particular, when investments are complements across firms, and firms possess strong market power in production but limited coordination in risk management, private investment may equal or even exceed the socially optimal level.
Status: Accepted at American Journal of Agricultural Economics