Incentives, Information & Drought Policy

Australia is subject to widespread droughts, with significant financial implications for agricultural producers, regional, state and national economies. Most economic assessments conclude there is no economic efficiency case for governments to provide drought assistance. However, significant public funds are allocated to farmers during droughts and there is a second-best case to improve drought policy design. In the paper it is argued that the National Drought Policy suffers from adverse selection, moral hazard, incentive compatibility and government commitment problems. The key reason this approach is ineffective is that it is very difficult if not impossible to design an efficient and fair drought policy that relies on ex post revelation of information. An alternative approach is investigated where incentives are designed so that farmers self-select into one of a number of drought policy agreements or contracts. Under this approach, farmers would be offered either a subsidy on risk management actions, such as privately provided rainfall insurance/weather derivatives and self-insurance, thereby forgoing other forms of drought assistance; or assistance to adjust out of the sector. Although there are dead weight losses associated with these forms of assistance, there are likely to be offsetting efficiency gains if adverse selection and moral hazard can be reduced. The government commitment problem also needs to be addressed through better institutional design.