CHAPTER ONE

DEFINITION, SCOPE, AND ROLE OF AGRICULTURE IN ECONOMIC

DEVELOPMENT
Introduction: Definition of Agricultural Economics
To make it simple, before we attempt to define the term agricultural economics, let us begin with
splitting the two words ‘Agriculture’ and ‘Economics’ and then attach specific definition for
each.

We hope that every one of you is well familiar with the word agriculture. Agriculture is the
purposeful tending of crop(s) and livestock. It includes group of interrelated activities that
encompasses the planting, raising, subsequent care and final disposition of a wide range of crops
and livestock. Alternatively, we can define agriculture as the production, processing, marketing,
and distribution of crop and livestock.

What is economics? The modern definition of Economics, like other science, is brought
evolutionary from the earlier definition of Adam Smith “economics as the study of wealth” to the
modern Keynesian definition “as the study of administration of scarce resources and of the
determinants of income and employment.” In your microeconomics course you had been
acquainted to different ways of defining economics. This means there is no single definition for
the word economics. But for our purpose let us define economics as a science of analyzing the
use of limited resources to achieve the desired wants/satisfy human wants.

Now bringing both definitions, we can define Agricultural Economics as a discipline that adopts
the principle of economics to the problems of agricultural production and people engaged in
agriculture and allied activities. Thus, Agricultural Economics is an applied science dealing with
how humans choose to use scarce productive resources and technical knowledge to produce
agricultural output and to distribute these for consumption to various members of society over
time.

Agricultural production has several general characteristics that distinguish it from other forms of
production. These are:

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 The existence of many small production units (despite differences among countries,
agriculture employs by far the largest share of the world population)
 The plurality of products from one producing unit (individual producing unit or farm
typically engage in production of several different types of commodities)
 The biological nature of the production process (production processes are geared to the life
cycle of the particular plant or animal that is involved requiring considerable quantities of
heat, moisture, and soil nutrients)
 The nature of location decision (decision is how best to use the land)
 The existence of considerable degree of production for self-sufficiency (majority of farmers
in the world plan their activities in terms of production for home consumption rather than for
the market. In other words, it does not enter commercial channels)
 Its sensitivity to natural forces such as rainfall intensity, climate, drought, temperature and
the like.

Because agriculture is special (almost unique) in a number of ways, a specialized branch of

economics called Agricultural Economics has developed to address the problems associated with
it. And agricultural economists make extensive use of microeconomics or price theory in which
propositions on the functioning of markets in terms of production, consumption, and exchange
are developed from hypothesis about the behaviors of individual producers and consumers. In
contrast, macroeconomics utilizes highly aggregated concepts such as total consumption,
national output, investment etc, which are closely linked with agriculture. Recently some studies
(e.g. Trimmer et al, 1985) have noted that macroeconomic policies and adjustments can have a
major impact on the agricultural sector.

The central theme in studying agricultural economics is that resources - land, labor, capital, time,
etc. are limited or too few to satisfy all human wants and that as a consequence of this scarcity
choice must be made.

The problems with which we will study are ones of "constrained choice" (socio-economic
influences-land tenure, farm size, market system, infrastructure, government actions, cultural
influence); that is how limited quantities of inputs are allocated between alternative production

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uses of agricultural as well as non-agricultural activities, and of how limited income are allocated
between the many products consumers may buy.

Evolution of the Subject Matter

The application of economic theory to agricultural problems has gone through a process of slow
acceptance. The origin of the field, now known as Agricultural Economics reach back in many
directions and over a long period of time. The filed came from two separate sources: - from the
physical sciences, and later, from economic theorists. Since agriculture and its production
systems are influenced by physical (topography, climate), social (tradition, culture) and
economic (market, infrastructure) factors, a comprehensive body of science, which includes
physical science, social science, and economic theory, is fundamental.

The severity and length of the agricultural depression beginning in the 1880s caused increasing
attention to be devoted to its causes and possible solutions. Primarily agronomists and
horticulturalists made the most notable early efforts. They recognized that the ability to grow
plants and animals was not sufficient to make farmers succeed. Agricultural Economics is an
important subject area because it is concerned with society's basic needs. Getting food and other
agricultural products to all people in the world in the right form at the right time is an extremely
complex process.

Role of Agriculture in Economic Development: The contribution of agriculture to economic

development is crucial. The contributions lie in:
1. Providing food to the rapidly expanding population: In less developed countries, food
production dominates the agriculture sector. When output expands with increased
productivity it increases the incomes of the farmers. Rise in per capita income leads to
substantial rise in the demand for food. In such economies, the income elasticity of demand
for food is very high. Moreover, the increase in the growth rate of population due to a rapid
decline in the mortality rates and slow reduction in fertility rates tends to raise further the
demand for food. Besides, the process of industrialization and urbanization is more efficient
when food is more affordable for the growing industrial labor force. In general, agricultural
sector plays a great role in providing food for the increasing populations.

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2. Supplying raw materials to the growing and diversifying domestic
industrial sectors.
3. Releasing labor for the growing industrial sector: The idea is to have as much rural
employment as possible at lower stages of industrialization. As an economy industrializes,
the countryside can efficiently release more labor to urban industrial complexes.
4. Providing employment for a large percentage of the rural population: Evidence shows
that it is as important to create rural jobs as urban ones in poor nations. Rural jobs are vital to
slow down premature urban migration, propelled by rural poverty and lack of economic
opportunity. Agriculture sector can play this vital role when the agricultural productivity and
farm income increases. When this is realized, non-farm rural employment expands and
diversifies. It includes textiles, furniture, tools, handicrafts, leather and metal working,
transport, repair works, construction, etc.
5. Increasing the demand for industrial products and thus necessitating the expansion of the
secondary and tertiary sectors, i.e. Market Contribution.
6. Providing additional foreign exchange earnings for the import of capital goods for
development through increased agriculture exports, i.e. Product Contribution
7. Increasing rural incomes to be mobilized by the state, i.e. Factor Contribution
8. Improving the welfare of the rural people:
One of the goals of economic policy of a given country is improving the welfare of the society.
And the welfare of the rural people can be improved when the agricultural sector develops. In
other words, increase in rural incomes as a result of the agricultural surplus tends to improve
rural welfare. Peasants start consuming more food especially of a higher nutritional value and
they build better houses fitted with modern amenities. They also set the services of schools,
health centers, irrigation, banking, transport and communication, etc.

According to Kuznet (1960), the contribution of the agricultural sector to economic development
constitutes three elements:
A) Product contribution
B) Market contribution
C) Factor contribution
A. The product contribution:

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developing countries mostly specialize in the production of a few agricultural goods for exports.
As output and productivity of exportable goods expand, their exports increased and result in
large export earnings.

Thus agricultural surplus leads to capital formation when capital goods are imported with foreign
exchange. Foreign exchange earnings can be used to build the efficiency of other industries and
help the establishment of new industries by importing scarce raw materials, machines, capital
equipment and technical know-how. This is what is called the product contribution of
agriculture, which first augments the growth of net output of the economy, and then the growth
of per capita output.

B. The market contribution:

As rise in rural purchasing power, as a result of the increased agricultural surplus there is a great
stimulus to increased development. The market for manufactured goods is very small in
developing countries where peasants, farm laborers and their families are too poor to buy factory
goods. Increased rural purchasing power caused by expansion of agricultural output and
productivity will tend to raise the demand for manufactured goods and extend the size of the
market. This will lead to the expansion of the industrial sector. Moreover, the demand for such
inputs as fertilizers, better tools, implements, tractors, irrigated facilities in the agricultural
sectors will lead to the expansion of the industrial sector. Besides, transport and communications
will expand. The long-run effect of these expansions will be higher profits, which tend to
increase the rate of capital formation through their investment.

C. The factor contribution:

A developing country needs large amount of capital to finance the creation and expansion of the
infrastructure and for the development of basic and heavy industries. In the early stages of
development, increasing the marketable surplus from the rural sector without reducing the
consumption levels of farm population can provide capital. Labor as the principal input can be a
source of capital formation when it is reduced on the farm and employed in other productive
works. One major possibility of increasing farm receipts and thus capital formation is by
mobilizing increased farm incomes through agricultural taxation, land taxes, agricultural income

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 tax, land registration charges, school fees, fee for providing agricultural technical services and
other types that cover the cost of services provided to the farm population.

In general, the agriculture sector occupies a central place in the national economy. The manner in
which it contributes to the economic development can be depicted in the chart below:
Agriculture

National Trade Foreign

Food income A way of
exchange
Rural life
Industry development Vocation
Employment

Interdependence of agriculture and industry

The interdependence of agriculture and industry helps the development of both the sectors. The
most important aspect of this inter dependence is that the products of one serve as important
inputs for the other. Growth of one sector thus means ample supply of inputs for the other. The
situation is such that a greater flow of products from one sector to other simultaneously ensures a
greater return flow of inputs itself, though with some time lag. Help others to help you in brief,
sums up, development.
Limits of Interdependence:

The account of the contribution of each sector to the other should not lead one to conclude that
this interdependence is competing. This is not the case. Each sector uses some inputs which are
not supplied by the other sector. For instance, industrial sector does not depend upon the
agricultural sector for supply of minerals and salts as raw materials. Much of its capital is now
supplied from its own sources. It itself supplies machinery to it. Similarly, agricultural sector will
continue to depend upon nature for certain inputs like water supply even after industrial sector
has provided it with canals and modern irrigation facilities. As use of machinery is limited in
agriculture, human and animal power will continue to be important inputs for the sector. For
these inputs, the agricultural sector will again depend upon itself.

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Further, there are some problems which are specific to a particular sector and the development of
the other sector will leave these problems untouched. What all this implies for the policy-makers
is that development of one sector say, the industrial sector, will surely remove some hindrances
in the way of further development of the agricultural sector. But at the same time, it should not
be overlooked that there are other hindrances too which emanate from within the agricultural
sector itself. These too have to be attended to. Same is the case with the industrial sector.
Development of agricultural sector will not remove all the hindrances inhibiting the development
of the industrial sector.

Contributions of Agriculture to Industries:

(i) Supply of raw materials to industries:

Many industries look to the agricultural sector for supply of raw material.
(ii) Agriculture and foreign trade:
This is one of agriculture’s most important roles in developing countries. It is evident that, the
majority of the developing countries are largely dependent on primary exports as their major
source of foreign exchange. In other words, the import capacity of the typical developing country
is based, to a large extent, on the flow of agricultural exports that it can sell to the rest of the
world. Since the balance of payments is generally the binding constraint to further growth,
especially to build the efficiency of the existing industries and to help the establishment of new
industries, the role of the agricultural sector as a provider of foreign exchange through exports or
as a saver of foreign exchange through import substitution (particularly through increased
domestic production of foodstuffs) is a crucial one.
(iii) Provision of market for the industrial sector:

The increasing income of the farm sector leads to an expanded demand for the consumer’s goods
produced in the industrial sector. Though no enquiry directly pertaining to this issue has been
conducted in Ethiopia, the data collected by the National Sample Survey organization does
indicate that the goods produced in the industrial sector are finding their way into the
consumption schedule of the rural people.
(iv) Provision of capital and labor to the non-agricultural sector:

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No data are available about the supply of these to inputs by the agricultural sector to the
industrial sector. Since it is the agriculture which is the custodian of capital and labor in the
initial stages of economic development, it can be positively asserted that, these factors have
moved to the industrial sector, mainly from the agricultural sector, in initial stages of economic
development in most of the countries.

The contribution of the agriculturists in setting up of various industries in England, of textile

industry in India and of some important industries in Japan is quite known. The statement about
Indian labor that it was migratory in character and that this was because of its nexus with
agriculture shows that it was agricultural sector which provided labor to the industrial sector in
the initial stages of the development of the latter.

Contributions of the Industrial Sector to the Agricultural Sector:

(i) Provision of modern inputs to the agricultural sector:
One of the major contributions of the industrial sector is to provide modern input to agriculture.
The inputs are in the form of fertilizers, pesticides, machinery etc.
(ii) Reduction of population pressure on land:
Data regarding transfer of population from agricultural to non-agricultural sector in India does
not yield an encouraging picture. Dependence of population on agriculture during the last 50
years or so has not declined to any significant extent.

Growing population and a slow progress of the industrial sector are responsible for this static
situation. However, the population data concerning some developed countries of Europe & that
of the U.S.A. are quite illuminating in this regard.
(iii) Provision of infrastructure:
No doubt, many of the items included infrastructure serve the agricultural sector as well as the
industrial sector but these are provided mainly by the industrial sector. Transport, electricity,
financial institutions, health services, educational and research institutions, all owe their
existence mainly to the facilities provided by the industrial sector.

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1.3. Theories of Role of Agriculture in Economic Development
To begin with, the history of agricultural development ideas can be divided roughly in to three
periods:

i) The Economic Growth and Modernization Era (1950-1960s)

ii) The Growth-with-Equity Period (1970s)
iii) The Economic Growth and Policy Reform Period (1980s)

I. The Economic Growth and Modernization Era

Economists traditionally have analyzed agricultural development in terms of its relationship to
the growth of the overall economy. The first notable Physiocrats viewed agriculture as the
engine of economic growth, arguing that agriculture was the only activity capable of generating a
surplus large enough to stimulate growth in other sectors of the economy. Classical economists,
on the other hand, believed that diminishing marginal returns to agricultural land would
eventually lead to overall economic stagnation.

Most Western Development Economists of the 1950s did not view agriculture as an important
contributor to economic growth, and assigned passive role of agriculture to economic
development. Those economists of course knew little about tropical agriculture or rural life, and
thus equated development with the structural transformation of the economy, i.e., with the
decline of agriculture’s relative share of the national product and of the labor force and the
dominance of the industrial modern sector.

Many development economists of 1950s and 1960s concluded that since economic growth
facilitated the structural transformation of the economy in the long run, the rapid transfer of
resources (especially surplus labor) from agriculture to industry was an appropriate short-run
economic development strategy.

Box 1: Arthur Lewis

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The first important event affecting development economics throughout the 1950s and 1960s was
by W. Arthur Lewis’s 1954 article “Economic Development with Unlimited Supplies of
Labour.” In the article Lewis presented a general equilibrium model of expansion in an economy
with two sectors - a modern capitalist exchange sector and an indigenous non-capitalist sector,
which was dominated by subsistence farming. The capitalist sector is characterized by its use of
reproducible capital, hiring of labour, and its sale of output for profit. The subsistence sector was
pictured as the ‘self-employment sector’. Lewis’s model focused on how the transfer of labour
from the subsistence sector (where the marginal productivity of a laborer approaches zero as a
limiting case) to the modern sector facilitated capitalist expansion through reinvestment of
profits. The labour supply facing the capitalist sector was ‘unlimited’ in the sense that when the
capitalist sector offers additional employment opportunities at the existing wage rate, the
numbers willing to work at the existing wage rate will be greater than the demand. Then
expansion in the capitalist sector continued until earnings in the two sectors were equated, at
which a point dual-sector model was no longer relevant.

Box 2: Hirschman
The second important event affecting development economists’ view of agriculture was the
publication of Albert Hirschman’s influential book The Strategy of Economic Development
(1958). Hirschman introduced the concept of linkages as a tool of investigating how, during the
course of development, investment in one type of economic activity induced subsequent
investment in other income-generating activities. Hirschman defined the linkage effects of a
given product line as the investment-generating forces that are set in motion through input-output
relations, when productive facilities that supply inputs to that line or utilize its outputs are
inadequate or non-existent. According to Hirschman, investment should be concentrated in
activities where the linkage effects were greatest, since this would maximize indigenous
investment in related or linked activities. So Hirschman asserted that agriculture lacks direct
stimulus in the setting up of new activities through linkage effects-and he concluded the
superiority of manufacturing. He argues investment in industry would generally lead to a more
broadly based economic growth than would investment in agriculture.

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In an article entitled "The role of agriculture in economic development" (1981) Johnston and
Mellor drew on insights from the Lewis model to stress the importance of agriculture as a motive
force in economic growth. They argued that far from playing a passive role in development,
agriculture could make five important contributions to the structural transformation of third word
economies: Thus, agriculture
 Provide labor, capital, foreign exchange, food to growing industrial sector, and
 Supplies a market for domestically produced industrial goods.
Johnston and Mellor's article and William H. Nicholl's influential article "The place of
agriculture in economic development" (1964) were instrumental in encouraging economists to
view agriculture as a potential positive force in development, and they helped to stimulate debate
on the interdependence of agriculture and industrial growth.

In addition, Western development economics was challenged (1960-70s) by the emergence and
rapid growth of Radical Political Economy and Dependency Models of Development and
Underdevelopment.

The radical political economy models have their roots in the writings of Lenin (on imperialism),
Kautsky (on agriculture), Paul Baran and other Marxist economists.

Box 3: Baran
Baran argued that in most low-income countries it would be impossible to bring about broad-
based capitalist development without violent changes in social and political institutions.
Accordingly, small-scale agriculture is incapable of making major contributions to economic
growth and he stressed on the need for farm consolidation. Baran Identified institutional and
structural barriers to development and stressed on the need to put effective demand at the centre
of development programs. Baran also accepted the view that the marginal product of labour often
approached to zero in agriculture and that therefore there is no way of employing it usefully in
agriculture.

The dependency interpretation of underdevelopment was first proposed in 1950s by economic

commission for Latin America under the leadership of Raul Prebisch. The basic hypothesis of

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this perspective is that underdevelopment is not a stage of development but the result of the
expansion of the world capitalist system. It is a condition of impoverishment brought about by
the integration of the Third World economies in to the world capitalist system. Dependency
theorists implicitly argued that low-income countries were pauperized through both a process of
unequal exchange with the industrialized world and repatriation of profits from foreign owned
businesses. Capitalist growth in Third World countries was stunted by policies favoring import
substitution of luxury goods and export of agro-industrial products often

produced on large estate farms. These policies limited the internal market for consumer goods
(including food and other agricultural products) and led to impoverishment of the mass of small
farmers.

To sum up, radical political economists made several important contributions to the
understanding of agricultural and rural development. First, they stressed on the importance of
understanding each country’s economic development in the context of that country’s historical
experience. Second, in arguing that rural poverty in the third world resulted from the functioning
of the global capitalist economy, they focused attention on the relationships between villagers
and the wider economic system. Third, they attacked the ‘mutual benefit claim’ of international
trade by development economists - the assertion that economic relations between high and low-
income countries could be shaped in a way to yield benefits for all.

Both the western dual-sector model economics and the radical analysis of the 1960s suffered
from the following shortcomings:-
 Inadequate attention to the need for technical change in agriculture.
 Lack of attention to the biological and location-specific nature of agricultural production
process.
 Lack of a solid micro foundation based on empirical research at the farm and village
level.
? Analytical thinking

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Dear distance learners, taking the realities of agricultural production system of your Wereda,
Tabia, or country, attempt to criticize the Western dual-sector model and the radical political
economy and dependency perspectives________________________.

II. The Growth-with-Equity Period (since 1970s)

Dear distance learners, recognition of some of the shortcomings of the above model were
important elements leading to a reevaluation of the goals and approaches of development
economics and of the role of agriculture in reaching those goals in the period following 1970.
Then around 1970 mainstream Western Economics began to give greater attention to
employment and the distribution of real income. This shift in emphasis spills over from three
reasons:-

a) The goal of economic growth for Third Word countries was seriously questioned and the
need to redefine the goal of development more broadly was required.
b) From the 1960s onwards it became apparent that rapid economic growth in some
countries (Pakistan, Nigeria and lran) had harmful and in some cases disastrous results.
The development disasters ranged from civil war to the establishment of murderous
authoritarian regimes.
c) Though in countries were rapid economic growth had not contributed to social turmoil,
the benefits of economic growth were not trickling down to the poor and the income gap
between rich and poor was widening.

Thus growth-with-equity concerns stimulated a number of important theoretical and policy

debates.
 The first concerned the interactions between income distribution and rates of economic
growth. The analysis focused on changes not only in the size of distribution of income
during the course of development but in the functional distribution as well (for example
impact of economic growth on small farmers, on women…).

 The second centered on employment generation and the possible existence of employment-
output trade-offs in industry and agriculture (for example population growth, rural-urban

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 migration and its impact on agricultural production and output; urban industry and its
capacity to employ new entrants to the labour force…).

Taking these and other issues, new concern was raised about creating rural jobs in agriculture
and industry, and in the relative output and employment generation capacities of large and small
enterprises. In agriculture debate centered on how much emphasis should be given to improving
small farms as opposed to creating large and more capital-intensive farms and plantations. In
industry, the small-versus-large debate led to empirical studies of rural small-scale enterprises.

IMPLICATIONS FOR AGRICULTURE

The change in orientation of development economics implied much greater role for agriculture
in development programs because:
i) The majority of the poor in most developing countries live in rural areas and because
food prices are a major determinant of the real income of both for rural and urban poor,
the low productivity of agriculture was seen as a major cause of poverty.
ii) Urban industry had generally provided few jobs for the rapidly growing labor force;
development planners increasingly concentrated on ways to create productive
employment in rural areas, if only as a holding action until the rate of population growth
declined and urban industry could create more jobs.

It becomes apparent that if agriculture were to play a more important role in development
programs, policy makers would need a more detailed understanding of economics. That is why
there was a rapid expansion of micro-level research on agricultural production and marketing,
farmer decision-making, the performance of rural factor markets, and rural non-farm
employment in 1960s and 1970s.

III. The Economic Growth and Policy Reform Period of 1980s

Distance learners, we have so far discussed two views concerning the role of agriculture in
economic development: The Economic Growth with Modernization Era, and the Growth-with-

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Equity Period. We are now remaining with the third view. Let us dwell on it and have a clear
picture.

This period witnessed a major shift in development economics towards economic growth, policy
reform and market liberalization. The shift from microeconomic analysis of agricultural projects
to macro policies was considered as a cutting edge of development in food policy analysis, and it
was the dominant development theme of the 1980s. In Africa, policy reform was strongly
advocated in the Word Bank's report, and structural adjustment programs were launched or in
underway in the mid of 1980s. In Asia, agricultural development proceeded more rapidly than
expected and can be considered as major success story of the 1980s. For example, India achieved
food self-sufficiency in grain production in the mid 1980s.

In the policy reform era, a major analytical advance in the way economists viewed policy was
the development of the Food Policy Analysis Approach. The approach synthesized work in a
number of areas, outlining how to trace the effects of macroeconomic adjustments as well as
sectoral level policies on food production, income generation, and consumption patterns of the
poor. The food policy analysis approach has set two distinguishing characteristics apart from the
production incentive school, and the basic needs school

The production incentive school emphasizes the need to get prices high, i.e. raising agricultural
price in order to increase farmers’ incentive to produce. The basic needs school stressed the need
to keep price low in order to ensure that the poor could afford an adequate diet.

The Food Policy Analysis Approach recognized that the production concerns of the production
incentive school and the consumption concerns of the basic needs school were both legitimate,
and it showed how they will be linked through food prices. Food policy analysis hence forms a
bridge between the two approaches. In addition it recognized in a more explicit manner that
policy formation takes place in an open economy where the financial and commodity markets are
increasingly integrated; thus calls for the integration of food and agricultural policy with macro
policies such as the exchange rate and interest rates, in a world economy framework.

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In the mid 1980, policy makers in many countries become interestingly concerned about Food
Security. Despite the achievement of national food self-sufficiency in major Asian countries, it
was apparent that a large percentage of people neither had the access to resources (land, credit)
nor the purchasing power to secure their food needs. Thus many works stressed that food
security should involve assuring both an adequate supply of food (through own production and
trade) and access by the population to that supply.

Tips!!! Food Security can be defined as access by all people at all times to enough food for an
active and healthy life. Similarly, it could be defined as the absence of hunger and malnutrition.
The basic concepts are:
 Sufficiency of food (calorie requirement)
 Access to food (produce, purchase, gift)
 Security (vulnerability, risk)
 Time (chronic, transitory)

Acid rain, pollution, environmental degradation, and sustainable agriculture also emerged as
central issues in the 1980s, especially following the release of the influential Bruntland Report,
‘Our Common Future’. Concerns about sustainability were raised at several levels: local,
institutional, national, and global. Increasing population pressure on fragile environments led to
worries that existing farming systems in many parts of the world were no longer sustainable.

CHAPTER 2

ECONOMICS OF AGRICULTURAL DEVELOPMENT

2.1 Structure of Agricultural System in Developing and Developed World

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 Some of economic and demographic facts of LDCs in the second half of the twentieth century,

adopted from Hayami and Ruttan, are presented below.

As provided in the following table, the growth rate of total agricultural output in the LDCs

between the periods 1960-80 was fair, even better than the performance of the DCs - on average

1 percentage point above the DCs. But average population growth rate of 2.5 % per year in the

LDCs partially offset the benefit obtained in total output, leading to a much lower rate of growth

in the average agricultural output per capita in contrast to that of the DCs. This slow growth rate

in relation to the high growth of food demand, resulting from high income elasticity of demand

for food, leads to food import burden.

Table [Link] Economic-Demographic Conditions of LDCs in the Period 1960-80 (percent

per year)

Agricul Popul Agricult Agricult Labor Agricu Land Land-man Ratio

Countries tural ation ural ural produc ltural Produc Per Per
output (N) output labor tivity land tivity capita work
(Y) per force ( L (A) (A/N) er
capita ) (A/L)

Developed
Countries 1.9 0.8 1.1 -3.8 5.7 -0.3 2.2 -1.1 3.5

Middle 3.4 2.1 1.3 -1.5 4.9 0.3 3.1 -1.8 1.8
stage
Countries
Less 2.9 2.5 0.4 1.2 1.7 0.4 2.5 -2.1 -0.8
Developed
Countries
Source: Hayami and Ruttan P. 418

Another important variable is the growth rate of the agricultural labor force measured by the
number of male workers in agriculture. In LDCs the supply of labor in the agricultural sector was
increasing at an average rate of 1.2 percent per year reflecting a slow growth rate in labor
productivity in the LDCs – less than one third of that in DCs. Two reasons underlie the

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accelerated growth of the agricultural labor forces. The first reason is that the total population
and thus the total labor force grew at a higher rate after the 1940s. The second reason was that
because of imperfections in input markets and of unfair trade policies, the industrial sector was
not capable of providing better job opportunities for the progressively increasing labor force.

The last variable that remains to be explained is the agricultural land. Comparison between DCs
and LDCs reflects that the size of arable land was declining over the given period in DCs and
only slowly grew in the LDCs at 0.4 percent per year. The related concept of land-man ratio,
particularly the ratio of agricultural land to agricultural worker, showed a marked contrast
between DCs and LDCs. Due to high growth rate in the agricultural labor force, the land-man
ratio per worker was declining implying that the land holding per worker has progressively
become smaller and smaller. This smaller land holding, coupled with the high population growth
and lower employment absorption rate of the nonagricultural sector, continues to exert further
pressure on the declining land-labor ratio, there by depressing the labor productivity and labor
income in agriculture.

Even if the preceding explanation centered on the facts of the periods between 1960 and 1980,
no dramatic change could happen to this time and it will continue to characterize part of the
twenty-first century. It means that the LDCs will remain in the Ricardian trap in which “the
increase in the demand for food, resulting from population growth, and the growth in the supply
of labor combine to bring about a rise in both food prices, and land rents and a decline in wage
rates,” so the means by which these countries can get rid of the poverty trap and stagnation is
developing and diffusing an appropriate technology. And the relevant technology for these
nations should depend on their cheap and abundant resource, namely, using labor- and land-
saving technology.

It is also important to emphasize that in the near future the rates of growth in labor force,
resulting from today’s high rate of population growth, will be too high to be observed in the
nonagricultural sector employment. The appropriate technology thus mentioned should be
accompanied by the expansion of the nonagricultural sector only then will labor productivity and
labor income rise. Apart from that it is worth noting that the opportunities of growth from this

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technology will be realized when agricultural researches are carried out in a highly location-
specific and suitable environment and when the critical factors, scientific and technical
manpower, are effectively used.

2.2. The Concept of Structural Transformation

Structural Transformation includes virtually all economic functions, but primarily involves the
transformation of production. In other `words, it entails a decline in the relative importance of
agriculture and an increase in that of the industrial and the service sectors of an economy
accompanied by a shift in resources, particularly that of labor in the same direction. Secondly, it
involves the change in the composition of consumer demand. Demand for food declines relative
to the demand for non-food consumption. At the aggregate level, the relative importance of
investment, government expenditure and international trade (export of manufactured goods and
services) increase. Furthermore, changes occur with regard to socioeconomic factors such as
urbanization and the demographic structure.

The production component of structural transformation is the driving force behind other changes.
To put it more specifically, the economy becomes relatively less agriculturally oriented, although
agriculture and, more broadly, the food system continue to grow in absolute terms and generate
important growth linkage to the rest of the economy. Structural transformation thus involves a
net resource transfer from agriculture to other sectors of the economy, over the long term.
Therefore, the focus is on the mechanism by which underdeveloped economies transfer their
domestic economic structure from predominantly rural and traditional subsistence agriculture
into a more modern, more urbanized and more industrially diverse manufacturing and service
economy. This structural transformation has involved expansion of non-farm employment,
increased integration of agriculture with the rest of the economy, and expansion of off-farm
elements of the food system.

In Lewis’s model, the underdeveloped economy consists of two sectors: a traditional,

overpopulated rural subsistence agricultural sector, characterized by zero marginal labor
productivity that can be withdrawn and transferred to the modern sector without any loss of
output in the agricultural sector; and a high productivity of modern industrial sector into which

19
labor from the subsistence sector is gradually transferred. The structural transformation of the
economy takes place with the balance of economic activity shifting from traditional rural
agriculture to the modern urban industry.

The following figure shows the process of Structural Transformation of an Agrarian Economy.

From both historical and contemporary cross section perspectives, agricultural transformation
seems to endure at least four phases that are roughly definable according to C.P. Timmer. The
process starts when agricultural productivity per worker rises. The increased productivity creates
surplus, which in the second phase can be tapped directly, through taxation and factor flows, or
indirectly, through government intervention into the rural-urban terms of trade. The surplus can
be utilized to develop the non-agricultural sector, and this phase has been the focus of most dual
economy models of development. The progressive integration of the agricultural sector into the

20
macro economy, via improved infrastructure and market equilibrium linkages, represents a third
phase in agricultural development. When this phase is successfully completed the fourth phase is
barely noticeable; the role of agriculture in industrialized economies is little different from the
role of steel, housing and insurance sectors.

2.2.1. Agricultural Transformation in Historical Perspectives

Agricultural development, which is also referred to be agricultural transformation or agricultural
modernization, is the gradual and sustainable transition of individual farms from subsistence
oriented to diversify and then more specialized market oriented production.

The subsistence-oriented agriculture is characterized by:

 Low Productivity and Minimal Capital investment
 Use of simple traditional methods and tools
 Labor and land as the principal factors of production (Seasonal employment of Labor)
 Presence of disguised unemployment
 Production for household’s own consumption
 Dominance of staple foods in production

Subsistence agriculture is highly risky and the main motivating factor/force in this type of
agriculture is to maximize their family’s chance of survival, not profit. That means agriculture in
this case is a mode of life, not a mode of making money.

On the other hand, diversification in agriculture refers to the stage where part of the produce is
grown for own consumption and part for sale to the commercial sector. And in this form of
agriculture, the production is no more dominated by staple food crops, but includes animal
husbandry and cash crops that take up the idle labor.

2.2.2. STAGES OF AGRICULTURAL TRANSFORMATION

[Link]. The Need for agricultural Transformation
Based on the historical perspectives, economists identified four evolutionary stages of
agricultural transformation that calls for different policy approaches.
Stage One: The Economic Growth and Modernization Era of the 1950s and 1960s.

21
This stage is about “getting agriculture moving” and this is the period where development was
defined largely in terms of growth in average per capita output (growth was defined only as
quantitative increase). Although, the growth of agricultural surplus was acknowledged at the first
stage of agricultural transformation, in 1950s most development economists did not view
agriculture as an important contributor sector to economic growth, by raising the following
arguments:
 The income elasticity of demand for unprocessed food is less than unity; hence, the
demand for agricultural products grows more slowly than consumption of non-
agricultural products. Because agriculture’s share in the economy was assumed to be
declining. Economists of that time neglect the need to invest in agricultural sector.
 Others also argues that the scope of growth through agriculture and other primary
exports were very limited since the terms of trade turn against countries that export
primary products and import manufactured goods. These economists advocate that
priority be given to import substitution of manufactured goods rather than to production
of agricultural export products.

However, in1960s, other scholars argued the need to invest in agricultural sector since
agriculture has a potential positive force in development and agriculture and industry are
interdependentfor economic growth and development. The analysis given by those economists
showed that:
 Food shortage could chock-off the growth in the non-farm sector, by making its labor
supply infinitely elastic. In the early stages of development, a country needs to make
some investment in agriculture to accelerate the growth of agricultural surplus.
 Agriculture could provide labor, capital and foreign exchange to the developing
economy and specifically to the industrial sector.
 It could also supply market for domestically produced industrial goods.

The “Green Revolution Model” was instrumental in convincing policy makers and international
donors to devote more resources to the development of new inputs for Third World Farmers,
such as high yielding and fertilizers responsive grain varieties. Intensification of agricultural
production based on high yielding cereal varieties offered the opportunities to provide productive

22
employment and outputs for the rapidly growing rural labor force. During this phase, agriculture
becomes a key contributor to growth. Thus, the policy interventions focused on establishing
market links with industry, technology and incentives to create a healthy agricultural sector, and
improving factor markets to mobilize rural resources.

Stage Two: The Growth-With-Equity Era of the 1970s

This stage is concerned with the interaction between income distribution and rate of economic
growth. The attention was given to income growth, income distribution and health and education
services. It was also concerned with employment generation and possible existence of
employment. It had become apparent that urban industry in most developing countries could not
expand quickly enough in the short run to provide employment for the expanding rural labor
force. Hence, the concern of development economics and planners shifted to finding ways to
hold labor force in the countryside.

The surplus generated in agriculture can be utilized to develop the non-agricultural sector
through a combination of factor inputs. For this matter, rural factor and product markets must
become better integrated with those in the rest of the economy. This is because improved
functioning of labor markets speeds up the process of extracting labor and capital from
agriculture, where returns are low and shifting to industry or service with higher productivity.
Therefore, in the early 1970s, rather than simply waiting for increase in average per capita
income to solve the problem of poverty and malnutrition, the greater attention has been paid to
employment, income distribution and basic needs such as nutrition and housing.

Stage Three: The Economic Growth and Policy Reform Era of the 1980s
In the third stage, agriculture is progressively integrated with the macro-economy through
improved infrastructure. At this stage, the relative importance of agriculture in the economy
substantially declines and economic dualism disappears. More attention was given to
macroeconomic policies related to income generation, agricultural sustainability and market
liberalization. The policy synthesized how to trace effects of macroeconomic adjustments as well

23
as sectoral level policies on food production, income generation and the consumption patterns of
the poor.

Stage Four: The Policy Role in Agriculture and Rural Development Period since 1990
The fourth stage of agricultural transformation was the immediate result of the third stage in
which serious attention was given to macroeconomic and agricultural policies. For
macroeconomic and agricultural policies to succeed it requires:
 Sufficient domestic and international effective demand
 Public investment in research and rural development/Infrastructural facilities
 Stable political environment, peace, security, etc., which was the focus areas of this stage.

Generally, it was aimed at building a more dynamic and integrated rural economy, through
attaining more rapid, broad based agricultural growth and sustainable rural development. The
following few points are the focus areas of the coming decades which are required to attain
sustainable agricultural and rural development:
1. Agriculture and rural development require strong rural institutions and well trained
individuals, to relate smallholder agricultural farmers with research, training and extension.
2. Public and private investment policies should be in such a way that promote and accelerate
agriculture and rural growth.
3. Agricultural development must satisfy the food requirement of rapidly growing population to
achieve food self-sufficiency.
4. Government should invest in expansion of public services to the rural economy such as road
construction, irrigation, water supply, etc.
5. Improved management and governance can also use economic resources economically,
effectively and efficiently.

[Link]. PEASANT CHARACTERISTICS

Peasants are farm households who derive their livelihoods mainly from agriculture, utilize
mainly family labor in the farm production and are characterized by partial engagement
(integration) in input and output markets, which are often imperfect or incomplete.

24
 Distinguishing features of peasants:
1. Land: a peasant without land is no more a peasant. Land is, therefore, the distinguishing feature
of peasants from landless laborers, urban workers, plantation workers and nomads. Since
peasants obtain their livelihood from the land by crop cultivation and livestock rearing, they have
access to the resources of land as a base for their livelihood.
2. Family labor: it is widely agreed that reliance on family labor is a defining economic
characteristics of peasants. In case of capitalists, production is run by employment of worker.
Thus, family labor utilization is another distinguishing feature of peasants from other social
groups like capitalists and commercial farmers. But peasants may hire labor in peak period of
harvesting and may engage in off-farm activities in the off season.
3. Capital: command over capital and its accumulation is a central attribute of capitalist production.
Peasants do not have access to capital and the main objective of their farm business is to get
appropriate returns that satisfy/maximize the household utility.
4. Consumption: the majority of the production of peasants is for self-consumption. Perhaps the
most popular defining feature of peasants is their subsistence way of life. Subsistence refers to
the proportion of peasants' output which goes for self-consumption rather than for profit making
activities.
For peasant Farm Family:
1. Capital markets are fragmented or non-existent so that credit is obtained mainly from merchants
or local money lenders at high rate of interest.
2. Variable production inputs like fertilizer, seed and chemicals are erratically available or
unavailable. Their quality may vary or access to them may involve formal and informal way of
rationing.
3. Up-to-date technology is not available or costly if available.
4. Land is not easily available for sale, but may be on rent.
5. Market information is poor, erratic, fragmented and incomplete. Depending on place and
infrastructure factors, there are varying degrees of association between social communities,
regions and the more developed segment of the national economy.

In the Ethiopian context, the inherent weakness of peasant agriculture flows from the interplay of
the following factors:

25
 i. Smallholder agriculture is oriented towards self-consumption, and this, more than the
market, largely determines land use and cropping patterns.
ii. The standard of technology is poor or of limited potential. Improved technology is, for
most peasants, either too costly to acquire, too complicated to operate, or too dependent
on external economies.
iii. Most peasants are plagued by inadequate holdings; their plots are too often fragmented,
and soil and water erosion are frequent hazards. Compared with family based peasant
production, producer cooperatives are fragile institutions. Cooperatives rate of success in
developing countries–measured by the ability to be self-supporting–has been very
disappointing.

RISK AND UNCERTAINTY

Unlike uncertainty, risk is restricted to situations where probabilities can be attached to the
occurrence of events which influence the outcome of decision making process. For example, if
drought occurs, on average, in two years out of five, the probability of drought occurrence is 0.4.
On the other hand, uncertainty refers to a situation where it is not possible to attach probability to
the occurrence of events as it is not known by the decision maker or by anyone else.

Risk is an objective matter i.e. it assumes that provided enough information is available, it should
always be possible to forecast about the incidence of events. Thus, it might be argued that
historical patterns of rainfall are known from weather stations records permitting the calculation
of an objective probability for the incidence of drought. However, current practices in the
economic analysis of risk are not based on this notion of objective risk. It is pointed out that in
most decision making what is relevant is not the assumption of super human knowledge
concerning the likelihood of uncertain events but rather the decision maker’s personal degree of
belief about the occurrence of events. Hence in the example of patterns of rainfall, what is
important is not the known past average occurrence of drought rather the farmer’s personal view
which determines the course of action taken by him/her to cope up with the incidence of drought.
This changes the analysis of risk from objective to subjective matter. With the following changes
in the definition of risk and uncertainty, risk still refers to probabilities. But these are now the
subjective probabilities attached by the farm decision makers to the likelihood of occurrence of

26
different events. The analysis of risk involves not just these probabilities but also the way they
enter into economic decisions. Hence, the term risk is used to describe the entire mechanism by
which farmers make decisions with respect to the uncertain events.

Uncertainty does not refer to probabilities or their absence at all. It refers in a descriptive sense to
the character of the economic environment confronting peasant farm household, an event which
will contain a wide variety of uncertain events to which farmers will attach various degrees of
risk according to their subjective beliefs of the occurrence of such events.

[Link]. Mixed farming

Mixed farming includes agriculture and allied sectors that include crop production, livestock,
forestry, and fisheries.
I. Crop production:
In Ethiopia crop production is estimated to contribute on the average around 60 percent;
livestock accounts for about 27 percent and forestry and other sub-sectors around 13 percent of
the total agricultural value added in 1980s. Furthermore, even though the farming system in
Ethiopia can be classified into the small holder farming system, the pastoral-nomadic system,
and the modern commercial farming system; the sector is dominated by small scale farmers who
have been adopting rain fed mixed farming with traditional technologies. Small scale farmers on
the average accounts for 95 percent of the total area under crop production and for more than 90
percent of the total agriculture output. Moreover, 94 percent of food crops and 98 percent of
coffee are produced by small scale farmers while the remaining 6 percent of food crops and 2
percent of coffee are generated from commercial farms.

While about 51 percent of the Ethiopian land is used for grazing, only about 14.8 percent of it is
used for cultivation. This means that assuming most of the grassland is suitable for cultivation,
land devoted to crop production is relatively low. The three major crop categories are – cereals,
pulses, and oilseeds. The principal cereal crops are teff, barley, wheat, maize, sorghum, millet,
and oats. Pulses include horse beans, chick peas, haricot beans, field peas, lentils and vetch. And
oilseeds include nug, linseed, fenugreek, rapeseed, sunflower, groundnuts, and sesame. The
cultivated area of land and total crop output vary from year to year.

27
ii. Livestock

Livestock is the integral part of nearly all farming systems in Ethiopia. It serves as source of
draught power and cash income for the large majority of the rural population which is engaged in
farming. Livestock also provides milk and meat to both rural and urban population. Manure from
livestock is an important fuel and fertilizer while hides and skins are important for local leather-
based industries as well as export. In terms of livestock possession Ethiopia stands first in Africa
and 10th in the world. However, the numerous livestock in the country lack high quality and
productivity.

[Link]. Modern Commercial Farming

The economic situation of modern commercial farmers includes:
1. Credit is abundantly available at competitive rate of interest for commercial farmers.
2. Variable production inputs like fertilizers, seeds and chemicals are available up to any
quantity that an individual farmer might wish to purchase.
3. Knowledge of latest available technology is widely spread and distributed to all farm
magazines.
4. There is a free hold market in land, so that the potentials exist for new entrants to begin
farming and the unsuccessful ones to exit from the activity.
5. Information on the prices of both inputs and outputs is available typically on a nationwide
base. This reflects the high degree of integration of markets and communication.

2.3. CONDITIONS FOR AGRICULTURAL DEVELOPMENT

The following are the conditions that need to be fulfilled for agricultural development:
 Academic Foundations; Communications; Problem Solving and Critical Thinking;
Information Technology Systems; Knowledge of Safety, Health and Environment;
Leadership and Teamwork Skills; Ethics and Legal Responsibilities; Employability and
Career Development; Technical Skills; Invention; Innovation; Education.

28
 Innovation is one of the several strategies through which a farmer could change its situation in
the market in pursuit of its objectives. It is an instrument, which the farmer uses to enhance its
competitive power in the market. It provides a basis for greater degree of diversification and
hence growth of the farmer. The major elements of innovation or technological change are:
New agricultural products,
New methods of production,
New markets and
 New forms of agricultural organization, etc.
An invention is the creation of the new technology. By 'technology' we mean any tool or
technique, any product or process, any physical equipment or method of doing or making, by
which human capability is extended. It is an intellectual act which involves a perception of a new
image, of a new connection between old conditions, or of a new area for action. All inventions,
big or little, are made for some practical uses.

The process of adopting an invention in a practical use is called innovation. It is the

implementation of a new or significantly improved idea, good, service, process or practice that is
intended to be useful.

If the existing product line is changed by a firm, i.e. it introduces a new product with or without
displacement of the old ones, and then it is defined as product-innovation. If a new method is
initiated to produce existing products, then it is process innovation. Both of these are the
elements of 'technological innovation'. When a firm makes changes in its marketing strategy we
define that as 'market-innovation'.

In case of agricultural development, the contribution of education is the following:

1. It will directly improve the productivity of agriculture
2. It will improve the probability of getting off-farm employment
3. It will lead to improved family planning
4. It can improve the health and nutrition of the people and its impact is felt over generation
5. By widening the horizons of knowledge; it can enable them to overcome ignorance and
superstitions

29
6. It can improve the risk taking and managerial capacity of the farmer
CHAPTER THREE

ECONOMICS OF AGRICULTURAL PRODUCTION

3.1. Introduction
In this chapter we present the main elements of the theory of agricultural production, which is
concerned, with the allocation of scarce resources to alternative uses. Here the decision-making
unit is either the firm in commercialized agricultural production or the peasant in non-
commercialized peasant agriculture.

Microeconomics provides few basic principles, laws and relationships applicable to agricultural
production and resource use. The following table summarizes these fundamental relationships in
agricultural production economics.
Principles of Economics Explaining Management decision

1 Principles of Diminishing Returns or Factor-Product How much to produce? [optimal

Increasing costs relationship level of resource use]
2 Principle of substitution or least cost Factor-Factor How to produce? [Least-cost
combination relationship method]
3 Principle of opportunity cost or equi- Product–Product What to produce? [Enterprise
marginal returns relationship Selection]

Physical and Economic Relationships of Agricultural production

Production in agriculture can be defined as the process of combining resources (labor, fertilizer,
mechanical implements….) in the creation of agricultural products. Producing a ton of wheat, for
example requires in addition to suitable climatic conditions, some amount of arable land, seed,
fertilizer, equipment such as ploughs, and human labor. From this, we can understand that
production varies in a systematic way with the level of input usage, and economists call this
relationship as production function, which mathematically can be expressed as:
Q = f (x1, x2,…, xn)
Where, Q = quantity of specific product
x1,…,xn = quantities of n inputs used in the production process

The function purely states that output is related to the levels of input usage. The production
function is purely physical concept: it depicts the maximum output in physical terms for each

30
combination of specified input in physical terms. It relates to a given state of technology. The
technical aspects of production are discussed in terms of:
1. Factor- product relationships
2. Factor- Factor relationships
3. Product - product relationship

3.2. Production with single variable input, Factor-Product Relationship

Qty of output
TPP

A
Q0
Stage 2 Stage 3
Stage 1

X1/x2…xn Fertilizer input

X’1 X01 X’’1
APP and MPP

Stage III
Stage I
Stage II

APP

X01 X1/x2…xn
X’1 X’’1
If it is assumed that all inputs except one (fertilizer denoted as x1) are held
MPPfixed, the relationship
between output and single variable factor can be denoted as:
Q = f (x1 / x2,…, xn )

31
For inputs like fertilizer, irrigation water, weedicides, etc., one would expect some level of
output even if there were zero application of input and the graph starts at some level above the
horizontal axis. For other inputs like seed, labor or land, a zero input would cause zero output
and the production function begin at the origin of the graph.
The relationship states that as more of fertilizer (x 1) is applied, output (Q) increases until
maximum, associated with input usage (x’’1) is reached. Further application of fertilizer will only
serve to reduce the total output.
Three aspects of factor-product relationship will be of interest:
i) Marginal physical product (MPP)

ii) Average physical product (APP)

iii) Input elasticity (partial elasticity of production)

I. Marginal Physical Product (MPP) of the variable input

From the very beginning we have noted that our production function is constructed keeping other
resources such as land, labor, and production technology constant. Under such conditions though
output grows with successive increases in fertilizer application, the amount by which it grows
changes because of the existence of fixed quantities of resources.

The concept, which measures the quantity of additional output obtained for each successive
additional input is called the Marginal Physical Product (MPP). It is defined as the change in
output resulting from a small change in the variable input expressed per unit of the input;
alternatively, it is the slope of the total product curve at any point.

For a discrete change:

∆Q
MPPx1 = where, ∆ signifies “change in”
∆ x1
For an infinitesimal change:
dQ
MPPx1 = where d signifies “derivative of” dx1
dx 1
The slope of the TPP curve, i.e. MPP first increases and is maximum (the slope of TPP is at
greatest) at the point of inflection of the curve (x’ 1), it is zero at the point of maximum TPP

32
(x’’1) and becomes negative at input levels beyond x’’1. MPP curve slopes continuously
downward reflecting lower and lower additional output for each successive unit of input.
II. Average Physical Product (APP) of the variable input
There is a very important measure of productivity of factors of production the average
productivity. It is defined as total product divided by the total amount of the variable input
(fertilizer) used in production.
Q
APPx 1=
x1
The APP is the slope of the line from the origin to the relevant point on the TPP curve (A) at
input level x01, where APPx1 = MPPx1, i.e., the slope of the TP curve equals to the slope of a line
from the origin at x01.
III. Input elasticity
Another important measure of the physical relationship between an output and a single variable
input is the input elasticity (partial elasticity of production). It is defined as the percentage
change of output resulting from a given percentage change in the variable input.

% change ∈output
E=
% change ∈input
dQ /Q dQ∗x 1
E= =
dx 1/ x 1 dx 1∗Q

MPP∗1 MPP
E= =
APP APP
The relationship between E, MPP and APP can be summarized as:
 The area of diminishing marginal returns on production function occurs When MPP< APP,
but it is not negative, i.e., 0< E< 1.

 E > 1 and E < 0 define areas of the production function in which it would not be
economically logical for the farmer to operate.

- The first case (E >1) is because output grows more than proportionately with any increase in
input, which means the farmer could always gain by using more of the input.

33
- The second case (E<0) is because output decreased as a consequence of using more input and
the farmer clearly does better by reducing input use.

When summarized, the discussion on the physical relationship of factors and products, all
production functions must satisfy two conditions to make economic justification acceptable:
a. The MPP should be positive and declining, i.e. the equation should have a positive first
derivative [dQ/dx > 0]

b. The equation should have a negative second derivative [d 2Q /dx2< 0], i.e. the response of
output to increasing level of input must be rising but at a decreasing rate.

Notice that the TPP, MPP and APP curves have been divided into three stages. Since you are
very well familiar with these stages, let us remind you with the following summary:
 Stage 1 is defined to be that in which APP of x1 is rising, and MPP is above APP. With
each additional units of fertilizer, more is not utilized efficiently.

 In stage 2 both APP and MPP of x1 are falling but are positive

 In stage 3 MPP of x1 is actually negative. In this stage additional units of fertilizer reduce
total product i.e. the marginal product of fertilizer is negative. The fixed inputs are
overloaded and the producer’s interest would be better served by using less fertilizer
(moving back out of stage 3).

It would therefore be predicted that the optimum position in terms of variable input usage will lie
somewhere in stage 2.
Exercise: Given the production function Q = 2200 + 25x 1 - 0.10x12, where x1 is the
variable input, fill in the TPP. After constructing the APP and MPP equations, compute and fill
the corresponding values in the blank columns.
Units of Fertilizer (x1) TPP (tones) APP MPP
A 0
B 25
C 50
D 75
E 100
F 125

34
G 150

3.3. Economic Optimum level of resource use

The most efficient level of variable input depends on the relationship between the price of the
input and the price of output. Then in deciding the economically optimal usage of a single
variable input, the farmer requires three pieces of information: (i) the MPPx 1, which indicates the
contribution of the variable input to total output; (ii) the price per unit of the final product (Py);
and (iii) the price per unit of the variable input (Px 1). The value of an additional unit of the
output to the producer is the extra revenue, which will be forthcoming as a result of greater input
usage. This is measured by the value of marginal product (VMPx1) where:
VMPx1 = MPPx1*Py [When the farmer is price taker in competitive market]

Economic Optimum yielding maximum profit will be attained where the value of the marginal
product of the variable input is equated to its price:
Px 1
VMPx1 = Px1; or MPP x 1 =
Py

At the particular level of input usage associated with the optimal condition, the farmer is said to
be in equilibrium (no incentive to alter the production plan).
 When VMPx1 > Px1, an additional unit of the input would yield more to the producer in
terms of extra revenue than it would cost, thus more profit would be obtained if an extra
unit were employed

 When VMPx1 < Px1, the last unit of the input employed contribute less to revenue than it
added to cost, hence less of the input should be used.

3.4. Production with two variable inputs (Factor-Factor relationship)

Do you think that farmers use only one variable productive resource in one season?
3.4.1. The physical interaction between inputs

Typically, in a given production period, there would be more than one variable factor of
production. For example, in the production of wheat, fertilizer, seed, and labor services may be

35
variable, while land and mechanical implements may remain fixed. Now our main interest is in
the relationship between output and the set of variable inputs and the extent to which one
variable factor may be substituted for another.
In this case, the idea that two or more variable inputs may be combined in different quantities to
produce the same output is called the principle of factor substitution (or the law of variable
factor proportion). It applies whenever alternative combinations of input can produce the same
level of output.

Assuming two variable inputs, the production function is defined as:

Q = f (x1, x2 / x3…xn)
This relationship will be illustrated by an isoquant map (or iso-product curve). It is a contour line
or locus of different combination of the two inputs, which yield the same level of output.

Qty of x1
X10 A

X11 B
Q = 15

Q = 10

Qty of x2
X20 X21

From the above figure one can easily understand that both the input combination at point A and
that at point B can produce ten units of output. In moving from A to B, the amount of x 1
decreased from x10 to x11 and that of x2 increased from x20 to x21, i.e., x2 substitute for x1.
The rate at which one input substitutes for another at any point on the isoquant is called
Marginal Rate of Substitution (MRS) and it can be measured as the slope of the isoquant curve.
MRS measures the rate at which one input must be substituted for the other if output is to remain
constant.
Numerically,

36
 ∆ x1 d x 1
-MRS of x2 for x 1= ∨
∆ x2 d x 2
MRS is negative since more usage of one input is associated with less of another, i.e., the
isoquant is downward sloping. However, the negative sign is often omitted.
Isoquants are convex to the origin. This means that MRS tends to diminish as more of one factor
is used to replace the other. The Diminishing Marginal Rate of Substitution (DMRS) results from
the principle of Diminishing Marginal Returns (DMR) which states as substitution proceeds it
requires more and more of input x2, to replace a single unit of x1 in order to maintain the same
level of output.
There are different rates of substitution between inputs:
I. Decreasing Rate of Substitution, the input being increased substitutes for successively
smaller amount of the input being replaced. MRS of x2 for x1 at A is greater than at B

X1

A
B
Q

X2
II. Constant Rate of Substitution, the amount of x2 required to replace a unit of x 1 remains
the same. MRS is constant

X1

=∞

X2
Q

III. Complementary Substitutes, there are no substitution possibilities since the inputs must
be used in fixed proportions.

X1 37

=0
 Q
X2

However, the MRS as a measure of the degree of substitutability of inputs has a serious defect
in that it depends on the units of measurements of the inputs.

A better measure is provided by the elasticity of substitution () which is defined as:-
Percentage change∈ x 1/ x 2
¿
Percentage change ∈MRS
This is a pure number, which is independent of units of measurement. The numerator is the
percentage change in input, the input ratio, or factor intensity
In the decreasing rate of substitution, the factor intensity at A in the figure above is given by the
slope of the ray (OA) from the origin to the isoquant. In the above diagram, when we move from
A to B, the ratio of x1/x2 falls and as x1 intensive production is replaced by an x 2 intensive
production. Similarly, the denominator is the percentage change in MRS as we move along the
Isoquant.
In constant rate of substitution, where inputs are perfect substitutes, the denominate for MRS is
zero, hence  = ∞. In complementary input, since inputs are in fixed proportion, numerator is
zero, hence = 0

3.5. Economic Optimum Level of Resource Combination

To determine the appropriate level of input use when there are two variable factors of
production, a producer must know the rates at which input are exchanged in the market [their
relative prices] as well as the rates at which they can be exchanged in production [their MRS].
To illustrate the former, we introduce isocost line, which is the locus of all combinations of two
variable inputs, which the producer can purchase with a given cost outlay.

X1
Co 38
Px1

Co = PX1X2 + PX2X2
 X2
Co
Px2

The slope of the isocost line is the ratio of input prices

= ¿¿
The least cost combination of the two inputs occurs at a point of tangency between isocost line
(C0) and an isoquant line (Q).
At this point the slope of the isocost line is equal to the slope of isoquant.

X1

X2

At point A, MRS of x2 for x 1=¿ ¿

Mathematical implications, in summary, on the factor-factor relationships can be looked as:

Y = f (X1, X2)
dy dy
MPPx 1= and MPPx 2=
dx 1 dx 2
Inverse ratios of MPP = MRS
MPPx 1 dy . dx 2 dx 2
= = = = MRSx1,x2
MPPx 2 dx 1. dy dx 1
The inverse ratio of MPP of each input equals the inverse ratios of their prices. Therefore,

MPPx 1 p 1
= by cross-multiplying
MPPx 2 p 2

39
 MPPx 1 MPPx 2
=
p1 p2
Critical thinking
Dear learners assuming the reality in your locality, how do peasants choose the type of crops
when there is differences in soil type or differences in season (short or long rain) or when there
will be shortage or excess labor supply?
_______________________________________________________

3.6. The Product-Product Relationship (Enterprise choice or physical interaction between

outputs)

Dear learners, now our analysis is extended to the multi- product firm, since most farmers have a
range of alternative crops they could grow for a given availability of input. As an example we
can take the following:
 Growing two different successive crops with short growing seasons on the same land.

 Utilizing different kind of land for the crops most suitable to the different soils.

 The practice of mixed cropping which permits a fixed labor resource to cultivate
simultaneously several different crops.

It is assumed that the producer can produce two products, Wheat and Maize, each output being
produced by a set of n inputs.

Production function for wheat and maize can be specified as:

QW = f1 (X1, X2, ……..,Xn)
QM =f2 (X1, X2 ……….Xn)

A Production Possibility Frontier (PPF) or [transformation curve] can illustrate the production
options, which are technically feasible for the above two production functions. This curve is the

40

Qty of W0 PPF
 C b
locus of combination of outputs [wheat and maize], which canofbe
Qtity M0produced with a set of given
inputs and assuming a particular state of technology.

The slope of the PPF represents the Marginal Rate of Transformation (MRT) of Maize for wheat

QW
MRT MW =
QM

It is the amount of wheat on the vertical axis (dy1), which can be obtained by giving up one unit
of Maize on the horizontal axis (dy2). In other words, MRT measures the increase in y1 (wheat),
which results from a small decrease in y2 (Maize).

It should be noted that an efficient farmer would chose to operate at some point on the PPF. A
point inside the PPF would mean an inefficient use of resources, since with the same level of
inputs, more of at least one of the product could be forthcoming specially in the ab segment of
the curve.

3.6.1. Economic Choice of Enterprises

41
 W Iso-revenue lines

W0

W*A

M
500 birr 1000 birr 1500 birr
M* M0

Iso-revenue lines are different combination of outputs (wheat and maize) which yield a given
levels of total revenue. The slope of the Iso- revenue lines equals the inverse ratio of output
prices. The slope is negative because for total revenue to remain constant increased income from
one output is associated with decreased income from the other. The optimum combination of
enterprise occurs at the point of tangency of an iso- revenue line with the PPF, since any iso-
revenue lines to the left of this point would represent lower returns. Therefore, the optimal
allocation point is at: W*. Pw + M*. Pw = 1500 birr

In General
Taking Y1 = f(X1) the single variable input, x, has two
Y2 = f(X1) MPPs, one for each function
dy 1 dy 2
MPP (y1) = and MPP (y2) =
dx 1 dx 1
dy 1
MPPy 1 ∗dx 1 dy 1
The MRT of output y1 into output y2 is MRT12 that is equal to = dx 1 =
MPPy 2 dy 2
dy 2
The MRT equals the ratio of MPPs for a given resource between the two enterprises.
P ( y 2)
MRT12 =
P ( y 1)

42
 MPPy 1 P ( y 2)
Therefore at the optimum point, =¿
MPPy 2 P ( y 1)
= MPP (y1)*P(y1) = MPP(y2) *P(y2)
MVP (y 1 )= MVP (y2)

When the above mathematical applications are summarized, the optimum choice of enterprise
occurs when the Marginal Value Product (MVP) per unit of a variable resource is equal in both
enterprises. This is called the principle of Equal-Marginal Returns. It says that a variable input
should be transformed from one enterprise to another up to the point where the MVP of each unit
of the input is equal for both enterprises. The two concepts mostly associated with the economic
choice of enterprises are Opportunity cost and Comparative advantage

A. Opportunity Cost: Opportunity cost of any resource may be defined as the maximum income
that the resource could have obtained in an alternative use. For example, if farmland could earn
more by turning into a holiday resort then the opportunity cost of continuing to use it in farming
is the income, which could have been obtained by leasing it to a hotel resort.

B. Comparative Advantage: It refers to the physical resources best suited to the production of
different crops/livestock which exist in different locations e.g. at the level of a single farm which
has land of difference qualities, it makes sense to grow alternative crops on the land
economically best suited to each crop.

Both on-farm and off-farm sector comparative advantage may change over time due to:
a) Change in technology (new variety, equipment, etc)
b) Land improvement (drainage, irrigation, etc)
c) Change in relative input costs or output prices in different location
d) Changes in transport cost (opening of new roads)
e) Development of substitute outputs (synthetic fibers)

43
CHAPTER 4: AGRICULTURAL MARKETING

4.1. MARKETING CHARACTERISTICS

Marketing can be defined in various ways as many writers have used their own way of defining
it. In fact, there are almost as many definitions as to the number of marketing specialists. As
such, there cannot be a universally accepted definition. The definitions depend upon the role
marketing is expected to play and the perspective from which it is viewed. Generally, Marketing
is a total system of business activities designed to plan, price, promote and distribute want-
satisfying products to target markets and to achieve organizational objectives.

Like marketing, there are many ways of defining agricultural marketing; some writers have used
the “economists” definition of production as a basis for the term agricultural marketing. The
economists’ reason states that man cannot create matters; he produces by changing matters in
form, place, and possession so that it might better suit his wants. Other writers have limited their
definition to include only the sale of the product. This concept probably originated from the word
market is a place where the ownership of a product changes hands where goods are bought and
sold. Here the producer may sell directly to the consumer, but to do so, he may have to pack,
store and transport and advertise his product. Note that, selling is not marketing; it is one
component/function/ of marketing. Based on the above concept agricultural marketing can be
defined as follows:
Agricultural marketing is the study of all activities, agencies, and policy involved in the
procurement of farm inputs and the movement of agricultural product from the farms to the
consumer.

Thus agricultural marketing is the link between the farm and nonfarm sectors. It includes
organization of agricultural and material supply, processing industries, the assessment of demand
for farm inputs and raw materials and the policy related to the marketing of farm products to the
consumer. Therefore, the term "agricultural marketing” as used in this learning task describes
nothing more than a series of services involved in getting goods from the point of production to
the point of consumption.

44
With specialization in production on the rise, agricultural marketing systems have increasingly
become more complex. Today, most producers and consumers of agricultural products live far
apart meaning that a number of middlemen are involved in the provision of crucial services to
bring the product from the producer to the final consumer.

Difference in Marketing of Agricultural and Manufactured Goods:

The marketing of agricultural commodities is different from the marketing of manufactured
commodities because of the special characteristics. The special characteristics which the
agricultural sector possesses, and which are different from those of the manufactured sector, are:
1. Perishability of the Product: Most farm products are perishable in nature; but the period of
their perishability varies from a few hours to a few months.
2. Seasonality of Production: Farm products are produced in a particular season; they cannot be
produced throughout the year. In the harvest season, prices fall. But the supply of manufactured
products can be adjusted or made uniform throughout the year. Their prices therefore remain
almost the same throughout the year.
3. Bulkiness of Products: The characteristic of bulkiness of most farm products makes their
transportation and storage difficult and expensive. This fact also restricts the location of
production to somewhere near the place of consumption or processing. The price spread in bulky
products is higher because of the higher costs of transportation and storage.
4. Variation in Quality of Products: There is a large variation in the quality of agricultural
products, which makes their grading and standardization somewhat difficult. There is no such
problem in manufactured goods, for they are products of uniform quality.
5. Irregular Supply of Agricultural Products: The supply of agricultural products is uncertain
and irregular because of the dependence of agricultural production on natural conditions. With
the varying supply, the demand remaining almost constant, the prices of agricultural products
fluctuate substantially.
6. Small Size of Holdings and Scattered Production: Farm products are produced throughout
the length and breadth of the country and most of the producers are of small size. This makes the
estimation of supply difficult and creates problems in marketing.

45
7. Processing: Most of the farm products have to be processed before their consumption by the
ultimate consumers. This processing function increases the price spread of agricultural
commodities.

IMPORTANCE OF AGRICULTURAL AND FOOD MARKETING

The basis of all marketing is man’s effort to satisfy his wants. These include the basic items such
as food, clothing and shelter. The desire to cultivate material goods, the mental and spiritual
wants have led to both acceleration and maintaining tradition of man’s progress. The marketing
economy has developed much more rapidly. Here freedom to do as one wish was greatest, and
with the individual reaping the rewards of his own work, the standard of living of the people has
reached the highest level in the world.

Agricultural marketing plays an important role not only in stimulating production but also in
accelerating the pace of economic development. Agricultural marketing is important in economic
development. Effective agricultural and food marketing is important to developing countries for
the following reasons:
o Agriculture is the biggest single industry in developing countries
 Largest employer
 Source of raw materials
 Market for manufactured goods

o Economic growth and development in developing countries

 Increasing urbanization
 Increasing incomes
 Increasing employment of women

o Improvement of rural incomes in developing countries

 Reduce income inequality between the rural and urban areas
 Decrease rural-urban migration

46
o Adoption of market liberalization and privatization policies
 Decreased participation of the public sector in marketing
 Increased participation of the private sector in marketing

4.2. FUNCTIONS AND MIX OF AGRICULTURAL MARKETING

Marketing functions are classified into three groups:
1. Exchange functions
 Buying and Selling: They are directly associated with negotiating an exchange of ownership
– or flow of title – between a seller and a prospective buyer. Buying activities include
searching for, gathering information about, evaluating alternative products and suppliers, and
negotiating a purchase agreement. The selling function involves identifying and seeking out
potential buyers, determining an asking price, negotiating terms of sale, and similar activities.
The ultimate aim for any seller is to meet its consumer (buyer’s) needs.

2. Physical functions
 Storage: Balances supply of and demand for agricultural and food products. Agricultural
production in developing countries is usually seasonal whilst demand is generally
continuous throughout the year. Hence, the need for storage to allow a smooth, and as far as
possible, uninterrupted flow of product into the market.
 Transportation: Making the product available where it is needed, without adding
unreasonably to the overall cost of the produce. Adequate performance of this function
requires consideration of alternative routes and types of transportation, with a view to
achieving timeliness, maintaining produce quality and minimizing shipping costs.
 Processing: Most agricultural produce is not in a form suitable for direct delivery to the
consumer when it is first harvested. Rather it needs to be changed in some way before it can
be used. The form changing activity is one that adds value to the product.

3. Facilitating functions
 Standardization: concerned with the establishment and maintenance of uniform
measurements of produce quality and/or quantity. This function simplifies buying and selling
as well as reducing marketing costs by enabling buyers to specify precisely what they want

47
 and suppliers to communicate what they are able and willing to supply with respect to both
quantity and quality of product. In the absence of standard weights and measures trade either
becomes more expensive to conduct or impossible altogether.

Quality differences in agricultural products may be due to production methods and/or because of
the quality of inputs used. Technological innovation can also give rise to quality differences. In
addition, a buyer’s assessment of a product’s quality is often an expression of personal
preference. Thus, for example, in some markets a small banana is judged to be in some sense
‘better’ than a large banana; and white maize is ‘easier to digest’ than yellow maize.

 Financing: In almost any production system there are inevitable lags between investing in
the necessary raw materials (e.g. machinery, seeds, fertilizers, packaging, flavorings, stocks,
etc.) and receiving the payment for the sale of produce. During these lag periods some
individual or institution must finance the investment.
 Risk bearing: In both the production and marketing of produce the possibility of incurring
losses is always present. Physical risks include the destruction or deterioration of the produce
through fire, excessive heat or cold, pests, floods, earthquakes, etc. Market risks are those of
adverse changes in the value of the produce between the processes of production and
consumption. A change in consumer tastes can reduce the attractiveness of the produce and
is, therefore, also a risk. All of these risks are borne by those organizations, companies and
individuals.
 Market intelligence: It is the process of collecting, interpreting, and disseminating
information relevant to marketing decisions. The role of market intelligence is to reduce the
level of risk in decision making. Through market intelligence the seller finds out what the
customer needs and wants. Marketing research helps establish what products are right for the
market, which channels of distribution are most appropriate, how best to promote products
and what prices are acceptable to the market.

Note: Each of these functions adds value to the product and they require inputs, so they incur
costs. As long as the value added to the product is positive, most firms or entrepreneurs will find
it profitable to compete to supply the service.

48
MARKETING MIX
The marketing mix is probably the most famous marketing term. Its elements are the basic,
tactical components of a marketing plan. Also known as the Four P’s, the marketing mix
elements are: product, promotion, place and price.

No Customers! = No Business!

Marketing goes well beyond selling and is often described in terms of the 4 P's. The 4 P's affect
every decision made within a business from production to the final product delivery.
Product ⇨ what you make!
Pricing ⇨ what you charge for it!
Promotion ⇨ how you let people know about it!
Place ⇨ where and how you distribute!

The concept is simple. Think about another common mix– a fertilizer mix (composite/compound
fertilizer), all mix of fertilizers will contain Nitrogen, Phosphorus and Potassium along with
various micro nutrients. However, depending on the crop, the soil condition and the stage of the
crop, one can alter the final composition of the mix by altering the amounts of mix elements
contained in it. For soils deficient in potassium, add more of potash based fertilizer.

It is the same with the marketing mix. The offer you make to your customer can be altered by
varying the mix elements. So for a high profile brand, increase the focus on promotion and
reduce the weight given to price. Some commentators will increase the marketing mix to the Five
P’s, to include people. Others will increase the mix to Seven P’s, to include physical evidence
(such as uniforms, facilities, office/branch ambience and printed cheque book, etc.) and process
(i.e. the whole customer experience e.g. a visit to the modern retail store). The term was coined
by Neil H. Borden in his article The Concept of the Marketing Mix in 1965.

A. Product

49
For many people, a product simply means the tangible, physical entity that they may be buying
or selling. A farmer buys a new tractor and that's the product - simple! In formal marketing, the
product may not be as simple as it may appear at first. For example, when a farmer buys a
tractor, the product is more complex than he first thought? Like an onion, the ‘Product’ has many
levels. A tractor comes bundled with spares and accessories, after-sales service warranty and a
network of support and supplementary services. Without all of that, the tractor ownership would
be such a difficult task.

 PRODUCT – what is it that you are going to sell

 Product Mix – range of PRODUCTS or SERVICES offered for sale
 Product Features – color, packaging, quality, brand name
 Product Support – maintenance, after-sales Service, pre-sale like advice and quotations

B. Promotion
Another one of the 4Ps is promotion. This includes all of the tools available to the marketer for
'marketing communication'. As with Neil [Link]'s marketing mix, marketing communications
has its own 'promotions mix.' Think of it like the mix of fertilizers, the basic ingredients are
always the same. However, if you vary the amounts of one of the ingredients, the final outcome
is different. The different elements of promotion mix are: Advertisement, Sales promotion,
Events and Public Relations, Direct Marketing, Personal Selling and Internet marketing.
Therefore, our promotions are designed to create demand. Public Relations, Online Marketing,
Advertising, Direct Marketing and Event Marketing are different Methods of promoting your
product or service:
- Public Relations – establishing a favorable image
- Publicity – feeding media of information that is of public interest (free advertisement)
- Sales Promotions
- Merchandising – point-of-sale display

C. Place

50
Another element of Neil H. Borden's Marketing Mix is Place. Place is also known as channel,
distribution, or intermediary. It is the mechanism through which goods and/or services are
moved from the manufacturer/ service provider to the user or consumer.

 The 3rd "P" of the marketing mix deals with product placement – the width of distribution.
 Distribution - how your products or services reach your customers
 Distribution Methods:
o Customers come to you
o You take the product/service direct to the customer
o You use an agent merchant franchise etc. to reach your customer
 LOCATION - the place of the business "locate your business where the market is".
 Factors in Selecting an area:
o Customer accessibility
o Adequacy of transport/communication facilities
o Supply of skilled labor
o Population Trends

D. Price
 Price acts as a primary cue for the customer. It helps the customer to evaluate the worth of
the offer that the marketer is making. There are many ways to price a product depending on
the situation faced by the marketer vis-à-vis his customer or the competition.
 There are several options to consider regarding price:
1) Price matching, 2) price making, 3) introductory penetration pricing, and 4) a competitive
upgrade price strategy

 Pricing - not just how much you charge for a product but how the price fits your target
market and the image you wish to develop.
 Pricing methods you choose depends on:
o competition in the market and your marketing strategies
o controlled pricing

51
 o your costs
o demand for your product
o perceived value

4.3. AGRICULTURAL MARKETING AGENTS AND ENTERPRISES

As defined earlier, marketing is management orientation focusing all the activities of the
organization on satisfying customer needs and wants, thereby helping achieve the organization’s
long-range objectives.

Agricultural and food marketing system comprises all functions, and agencies that perform those
activities, which are necessary in order to profitably exploit opportunities in the marketplace.
Agricultural and food marketing system consists of the following sub-systems: input, production,
distribution, consumption and regulatory as given below.

The marketing concept must therefore, be adopted throughout not only the entire organization,
but also the entire marketing system. A system is a complex of interrelated component parts or
sub-systems, which have a defined common goal. Thus, an agricultural and food marketing
system comprises all of the functions, and agencies who perform those activities, that are
necessary in order to profitably exploit opportunities in the marketplace. Each of the components
or sub-systems is independent of one another but a change in any one of them impacts on the
others as well as upon the system as a whole.

4.4. INTEGRATION AND DIVERSIFICATION OF MARKETING

Integration can be:
o Backward integration- instead of buying from farmers, the agro-industrial enterprise should
consider integrating backward to produce some or all of its raw material, which converts raw
material pricing to an internal accounting process.
o Backward Vertical Integration- it implies whether the agro-industry should use the existing
suppliers or assume some production, assembly, or transport functions. Be aware of the
following possible effects of integration.

52
Stages in a commodity marketing system (marketing system integration)
 A commodity marketing system encompasses all the participants or actors in the production,
processing and marketing of an undifferentiated or unbranded farm product (such as cereals),
including farm input suppliers, farmers, storage operators, processors, wholesalers and
retailers involved in the flow of the commodity from initial inputs to the final consumer.
 The commodity marketing system also includes all the institutions and arrangements that
effect and coordinate the successive stages of a commodity flow such as the government and
its parastatals, trade associations, cooperatives, financial partners, transport groups and
educational organizations related to the commodity.
 The commodity system framework includes the major linkages that hold the system together
such as transportation, contractual coordination, vertical integration, joint ventures, tripartite
marketing arrangements, and financial arrangements.
 The systems approach emphasizes the interdependence and interrelatedness of all aspects of
agribusiness, namely: from farm input supply to the growing, assembling, storage,
processing, distribution and ultimate consumption of the product.

Table: Stages of agricultural marketing (integration of agricultural marketing)

Stage Examples
Stage 1: Assembly Commodity buyers specializing in specific agricultural products, such
commodities as grain, cattle, beef, oil palm, cotton, poultry and eggs, milk.
Stage 2: Independent truckers, trucking companies, railroads, airlines, etc.
Transportation
Stage 3: Storage Grain elevators, public refrigerated warehouses, controlled
atmosphere warehouses, heated warehouses, freezer warehouses.
Stage 4: Grading Commodity merchants or government grading officials
and classification
Stage 5: Processing Food and fiber processing plants such as flour mills, oil mills, rice mills,
cotton mills, wool mills, and fruit and vegetable canning or freezing plants
Stage 6: Packaging Makers of tin cans, cardboard boxes, film bags, and bottles for food
packaging or fiber products
Stage 7: Independent wholesalers marketing products for various processing plants
Distribution and to retailers (chain retail stores sometimes have their own separate
Retailing warehouse distribution centers)

53
Diversification
This is where we market completely new products to new customers. There are two types of
diversification, namely related and unrelated diversification. Related diversification means that
we remain in a market or industry with which we are familiar. For example, a soup manufacturer
diversifies into cake manufacture (i.e. the food industry). Unrelated diversification is where we
have neither previous industry nor market experience. For example, a soup manufacturer invests
in the rail business.

Bases for market segmentation (Diversification)

Market segments are based on customer or product characteristics. Typical product
characteristics are different sizes, prices and colors whereas customer characteristics may be age,
sex, income, social class, geographical location, personality, product usage rate, degree of brand
loyalty, occasions of product usage.

Strategic approaches to market segmentation

Once the market has been segmented an agribusiness must decide which of these segments it can
profitably serve. The main strategic approaches which may be adopted in this regard are:

Concentrated marketing: The organization concentrates on serving a single market segment.

This is also known as niche marketing. This can be a high risk strategy since the organization is
vulnerable without some degree of diversification as niche markets can quickly disappear.

Differentiated marketing: Here the organization elects to serve two or more of the market
segments identified. A distinct marketing mix is employed for each market segment which the
organization is seeking to penetrate.

Undifferentiated marketing: This is the antithesis of market segmentation in that the

organization seeks to attract as many buyers as possible with a single marketing mix. Some

54
organizations have been very successful with this simple formula but it becomes increasingly
difficult to sustain market position and share as the level of competition becomes more intense.

4.5. Transaction Costs and Marketing Efficiency (Marketing Costs and Margins)

Marketing efficiency
Marketing efficiency is the ratio of inputs to outputs. Marketing efficiency is principally
comprised of operational efficiency and pricing efficiency.
 Operational efficiency is increased when marketing costs are reduced whilst outputs are
either maintained or expanded.
 Pricing efficiency is concerned with the efficient allocation of resources by a marketing
system.

Marketing costs
To begin with, can you identify the probable costs of marketing of agricultural commodities or
products? Marketing costs include labour, transport, packaging, containers, rent, utilities (water
and energy), advertising, selling expenses, depreciation allowances and interest charges.
Marketing costs vary from commodity to commodity and product to product. There are several
factors that individually or collectively account for these differences. These include:
 The more wastage, the greater the proportion of customers’ expenditure which goes on
marketing costs
 The more perishable the product, the greater the marketing costs
 The more processing of the commodity, the greater the marketing costs
 The greater the amount of produce handling and transportation, the greater the marketing
costs.

Marketing margins

A marketing margin is the percentage of the final weighted average selling price taken by each
stage of the marketing chain. The margin must cover the costs involved in transferring produce
from one stage to the next and provide a reasonable return to those doing the marketing.

55
Table: Example of Margins, shares and costs and marketing efficiency
Raw Milk Processed Milk
Retail price 1000 1200
Marketing margin 600 800
Farmer’s return 400 400
Farmer’s share 40% 33%

Though margins are often used in the analysis of the efficiency of marketing systems they have
to be interpreted cautiously. Why should we be cautious when interpreting marketing margins?
While higher marketing margins might reflect inefficiency of the marketing system it is not
always the case. As economies develop, consumers tend to demand for more services, such as
processing, cold transportation and storage, and these usually lead to higher margins even though
the marketing system may be efficient. In the example provided in table above, you will see that
the marketing margin (farmers’ share) is higher (lower) for processed milk than raw milk. This
implies that the marketing system for processed milk is less efficient than that for raw milk.

Note: When calculating marketing margins, it is advisable to employ the reference product
concept. The reference product concept is important for purposes of comparing the performance
of market participants who may be operating at different stages of the marketing channel from
one another. The finished product as delivered to the end user can serve as the reference point.
The reference product concept also takes into account product losses, the creation of by-
products, transport, storage, handling, packaging and capital costs.

CHAPTER 5: AGRICULTURAL FINANCE

MEANING AND SCOPE OF AGRICULTURAL FINANCE AND CREDIT

Finance can be defined as the art and science of managing money. Finance is concerned with the
process, institutions, markets involved in the transfer of money among and between individuals,
businesses and governments.

56
Not all rural finance is agricultural or microfinance and not all agricultural finance are rural.
Yet financial service providers offer:
 rural finance (financial services used in rural areas by people of all income levels),
 microfinance (financial services for poor and low-income people), and
 agricultural finance (financing of agriculture-related activities, from production to market)
often have overlapping objectives and opportunities.

The clients served by microfinance are often the same clients or households that would benefit
from increased rural or agricultural finance. The financial systems approach in micro and rural
finance—which emphasizes a favorable policy environment and institution-building—has
improved the overall effectiveness of rural finance interventions. But numerous challenges
remain, especially in financing agribusiness.

Suppliers of rural and agricultural finance can be broadly categorized as:

 Value Chain Actors: exporters/wholesalers; processors; local traders; producer groups;
farmers; and input suppliers.
 Financial Institutions:
o banks (commercial, agricultural banks, state development banks)
o non-bank financial institutions
o not-for-profit MFIs, which tend to work with poorer clients' credit unions and agricultural
cooperatives

DEFINITION: AGRICULTURAL FINANCE AND CREDIT

Loans, notes, bills of exchange, and bankers' acceptances are some of the credit instruments
financing agricultural transactions. Banks lend to farmers for a variety of purposes, including:
1. Short-term credit to cover operating expenses;
2. Intermediate credit for investment in farm equipment and real estate improvements;
3. Long-term credit for acquisition of farm real estate and construction financing; and
4. Debt repayment and refinancing.

57
 Commercial banks are the largest source of agricultural credit, followed by the Farm Credit
Banks. Nationwide cooperative system of banks and associations are providing credit to farmers,
agricultural concerns, and related businesses. The system is comprised of the Banks for
Cooperatives; which makes loans to farmer-owned marketing, supply, and service cooperatives,
and rural utilities.

5.1. SOURCES OF AGRICULTURAL FINANCE

Finance is essential for a business’s operation, development and expansion. Finance is the core
limiting factor for most businesses and therefore, it is crucial for businesses to manage their
financial resources properly. The main source of credit for many farmers and agribusinesses is
other agribusinesses along the value chain including input suppliers, traders, and processors.
Moreover, the clients’ own savings and credit from financial institutions continues to play a role
in agricultural production.

Finance is available to a business from a variety of sources both internal and external. It is also
crucial for businesses to choose the most appropriate source of finance for its several needs as
different sources have their own benefits and costs. Sources of finance can be classified based on
a number of factors. They can be classified as Internal and External, Short-term and Long-term
or Equity and Debt. It would be uncomplicated to classify the sources as internal and external.

I. Internal sources of finance: Internal sources of finance are the funds readily available
within the organization. Internal sources of finance consist of:
 Personal savings
 Working capital
 Retained profits
 Sale of fixed assets
II. External sources of finance: External sources of finance are from sources that are outside
the business. External sources of finance can either be:
o Ownership capital or Non-ownership capital
a) Ownership capital: Ownership capital is the money invested in the business by the
owners themselves. It can be the capital funding by owners and partners or it can also

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 be share bought by the shareholders of a company. There are mainly two main types
of shares. They are:
 Ordinary shares
 Preference shares
b) Non-ownership capital: Unlike ownership capital, non-ownership capital does not allow the
lender to participate in profit-sharing or to influence how the business is run. The main
obligations of non-ownership capital are to pay back the borrowed sum of money and
interest. Different types of non-ownership capital:
o Debentures
o Grant
o Bank overdraft
o Venture capital
o Loan
o Factoring
o Hire-purchase
o Invoice discounting
o Lease

5.2. ECONOMIC FEASIBILITY TEST OF A CREDIT PROPOSAL (CREDIT

WORTHINESS ANALYSIS)
The technological advancement achieved in agriculture made the agriculture capital intensive.
The farmers need credit at right time, through right agency and in adequate quantity to realize
maximum productivity. This is from farmer’s point of view. In contrast to the farmer’s point of
view, when a farmer approaches a lending agency with a loan proposal, the lender should be
convinced about the economic viability of the proposed investments.

Credit proposal is one of the main steps in credit processing, which include all the track records
and information of the customer. When the economic feasibility of the credit is being observed,
three basic financial aspects are to be assessed by the creditor. If the loan is advanced, will it
generate returns more than costs? Will the returns have surplus, to repay the loan when it falls
due? Will the farmer stand up to the risk and uncertainty in farming? These three financial

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aspects are known as 3 Rs of credit, which are: returns from the proposed investment, repayment
capacity the investment generates, and risk- bearing ability of the farmer-borrower. The 3 Rs of
credit are sound indicators of credit worthiness of the farmers.

1. Loan Appraisal: This is about analysis of repayment capacity and how to appraise
information collected about an applicant's character, capital and collateral position. The
process of cash flow and balance sheet analysis is examined and key interpretation ratios are
introduced. The key elements of loan appraisal are an assessment of the applicant's:
 repayment capacity, which can be done through cash flow analysis, Repayment capacity is
the ability of the farmer to repay the loan obtained for the productive purpose within a
stipulated period as fixed by the lending agency. At times, the loan may be productive
enough to generate additional income but may not be productive enough to repay the loan
amount. Hence, the necessary condition here is that the loan amount should not only
profitable but also have potential for repayment of the loan amount. Under such conditions,
only the farmer will get the loan amount.

The repayment capacity not only depends on returns, but also on other quantitative and
qualitative factors as given below:
Y= f ( X1 , X 2 , X 3 , X 4 ___ X 5 , X 6 , X 7 ...)
Where, Y is the dependent variable i.e., the repayment capacity. The independent variables, X1 to
X 4 are considered as quantitative factors while X 5 to X 7 are considered as qualitative factors.
X1 = Gross returns from the enterprise for which the loan was taken during a season in ETB,
X 2 = Working expenses in ETB,
X 3 = Family consumption expenditure in ETB,
X 4 = Other loans due in ETB,
X 5 = Literacy,
X 6 = Managerial skill,
X 7 = Moral characters (honesty, integrity etc.).
 character or personal creditworthiness,
 Capital and collateral, which can be determined through a balance sheet.

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2. Cash Flow Analysis: All the income and expenditure information that has been collected
during the field trip is now consolidated in a cash flow projection. The exact period of the
projection depends on the envisaged loan term. In agricultural households, one year
projections are common because they encompass the majority of crop growing seasons. Once
a cash-flow projection has been prepared for all the economic activities of all household
members, and all the family expenditure has been incorporated, it needs to be assessed in
relation to the loan proposal. The most commonly used indicators for doing this are:

 the accumulated repayment capacity; and

 net cash flow after loan repayment or "free net cash flow"
3. Sensitivity and Risk Analysis (Risk bearing ability): It is the ability of a farmer to
withstand the risk, which arises due to financial loss. Risk can be quantified by statistical
techniques such as coefficient of variation, standard deviation, and other programming
models.

In order to find out how a cash flow might be affected by adverse factors, the loan assessment
may include a sensitivity and risk analysis. The objective is to know whether adverse
circumstances would undermine the repayment capacity to such a degree that the loan repayment
will be at risk. Factors to be considered in the sensitivity analysis of cash-flow projections could
include:
 Reduced yields due to bad weather conditions, diseases or pests;
 Delays in payments, e.g. delays in payments for crops after harvest;
 Lower than expected sale prices;
 Higher input costs;
 Additional labor costs, e.g. replacing a sick family member with hired labor.

When analyzing a cash-flow, these risk mitigating techniques must be taken into account as part
of the risk profile of a farm household. Here are some examples:
 Diversification of income sources

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  Family safety networks
 Liquidation of assets

The measures that can be taken to strengthen the risk bearing ability of the farmer include
increasing the owner’s equity/net worth, reducing the farm and family expenditure, developing
the moral character (i.e. honesty, integrity, dependability and feeling the responsibility etc. all
these qualities put together are also called as credit rating), Undertaking the reliable and stable
enterprises (enterprises giving the guaranteed and steady income), improving the ability to
borrow funds during good and bad times of crop production, improving the ability to earn and
save money (a part of the farm earnings should be saved by the farmer so as to meet the
uncertainty in future) and taking up of crop, livestock and machinery insurance.

4. Character Assessment: The information obtained during the field visit, the results of the
careful review of the client history and the cross-checking with other information sources
must now be combined in a final assessment of the personal creditworthiness of the loan
applicant. These include:
a. Disclosure of required information
b. Reputation within the community
c. Good credit history
5. Capital: As the next step of the loan appraisal, a brief analysis of the balance sheet should be
carried out to assess the applicant's capital position. It is not as critical as the cash flow
projection but we can gain some useful insights into a business, even that of a small farmer,
from a balance sheet. Here is a reminder of the balance sheet layout, followed by examples of
things you could look out for:
1. Large amounts of cash
2. The existence of savings
3. Accounts receivable
4. The amount of total assets
5. Accounts payable
6. The value of the existing agricultural stocks
7. The composition of fixed assets

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 8. Level of indebtedness – expressing liabilities as a percentage of total assets indicate what
proportion of the farm’s assets has been financed through borrowing.

9. Equity percentage – it is the mirror image of the level of indebtedness. It is the equity or
owner's capital expressed as a percentage of total assets.

6. Collateral: Another purpose of examining the asset and liability structure in the balance sheet
is to identify appropriate collateral. The following conditions need to be fulfilled for any asset
that would be accepted as collateral:
1. Importance to the borrower 3. Marketability
2. Value

5.3. LOAN TERMS AND REPAYMENT PLANS

Methods and Mechanics of Processing Loan Application

The financing bank is vested with the full powers to either accept or reject the loan application of
a farmer. This is nothing but the appraisal of farm credit proposals or procedures and formalities
followed in the processing of loans. The processing procedure of a loan application can be dealt
under the following ten steps.
a) Interview with the farmer;
b) Submission of loan application by the farmer;
c) Scrutiny of records;
d) Visit to the farmer’s field before sanction of loan;
e) Criteria for loan eligibility;
f) Sanction of loan;
g) Submission of requisite documents;
h) Disbursement of loan;
i) Post-credit follow-up measures; and

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j) Recovery of loan

Loan Approval and Follow-up

In this part we will examine the steps that follow loan appraisal, including the approval process,
setting loan terms and conditions, loan disbursement and loan monitoring. Let us now have a
closer look at the various steps that follow loan appraisal.
1. The Loan file: As a first step, the loan officer prepares a loan file in accordance with a pre-
defined structure. It is useful to have a standard checklist of the information and documents that
are needed for a complete loan file. The following five key aspects of this step:
1. Brief description of the economic activities of the farm household (main crops, livestock
etc.);
2. Brief risk profile of the farm household and details of risk-mitigating strategies that are used;
3. Characteristics of the loan applied for and the recommendation from the loan officer;
4. Financial indicators:
i. accumulated repayment capacity indicator, ii. Free net cash-flow indicator, iii.
Indebtedness ratio;
5. Rating results as regards personal creditworthiness.
2. Loan Terms and Conditions: A very important part of preparing the loan file that will be
presented is determining the most appropriate loan terms and conditions. Repayment schedules
must be in line with the cash-flow patterns of the farmer. Depending on the household situation,
different options exist for appropriate repayment plans in agricultural households:
1. Equal (monthly) installments of loan principal and interest;
2. Regular monthly interest payments and a bulk payment of loan principal at maturity;
3. Regular monthly interest payments and irregular intermediate loan principal payments
when cash is available.

The repayment of medium and long-term loans is different from that of short-term loans because
they are characterized by their partially liquidating nature. These loans are recovered by a given
number of installments depending up on the nature of the asset and the amount advanced for the
asset under consideration. There are six types of repayment plans:
a) Straight-end repayment plan or single repayment plan or lump sum repayment plan

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 b) Partial repayment plan or Balloon repayment plan
c) Amortized repayment plan
a. Amortized decreasing repayment plan
b. Amortized even repayment plan or Equated annual installment method
d) Variable repayment plan (or) Quasi-variable repayment plan
e) Optional repayment plan
f) Reserve repayment plan (or) Future repayment plan

3. Lending Decision
Lending decisions are normally taken by a credit committee. Decision-making should be
decentralized, i.e. take place as close to the relevant customers and loan officers as possible. This
is essential if large distances exist between branches and district, regional or head offices.
Another reason for decentralizing credit decision-making is that a good loan decision depends on
having good knowledge of the specific economic situation of the client group, the agricultural
activities and the regional context.

A credit committee should consist of at least one person in addition to the loan officer. Loan
officers should not vote on the credit committee but should rather present the information and
provide a clear recommendation for loan approval or rejection.

4. Disbursement Programs
Once the loan decision has been made, clients should be informed immediately. Since farmers
generally live far away from the central office, it is important to let them know the date on which
the application will be presented to the credit committee, and when a decision can be expected.
Reducing useless travel time for loan applicants is good client service and reduces the transaction
costs of the borrower. There are various methods that can be used for loan disbursement:
 Cash disbursement. Many lending institutions disburse loans in cash. They either do these
themselves through their own cashiers or by handing out a cheque that can be cashed at a
partner-bank.

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 Money transfer to supplier. Some organizations prefer to transfer the approved loan
amount directly to suppliers. This can increase the level of control over how the loan amount
is being spent.
 Supplying inputs in-kind. This method was common in the 1970’s and 1980’s. Many
agricultural lending institutions bought agricultural inputs and then disbursed them as credit
in kind. In-kind loans, however, have the severe disadvantage that the lender becomes
directly connected to the economic success of the investment. If the investment fails, farmers
are then more likely to refuse to repay.

Whatever disbursement method is chosen, however, it is imperative that the loan is available to
the farmer at the moment when it is needed. Late disbursement can undermine the entire
investment, put the income flows at risk and, hence, endanger the loan repayment. The cash flow
budget should indicate clearly when disbursement is required.

5. Loan Monitoring
The success or failure of any financial institution is closely tied to the quality of its loan portfolio
and its loan monitoring system. The assessment of repayment capacity and the creditworthiness
of an applicant provide the basis for good loan decisions and thus, portfolio quality. There are
some key requirements for an appropriate monitoring system for agricultural loans:
a. Open communication between the lender and the borrower is essential for effective loan
monitoring.
b. Loan files must contain all the documents (loan application, loan assessment, collateral
records, memos, loan agreement, etc.) which provide a loan officer and other interested
parties with a complete historical and on-going record of the relationship between the lender
and the borrower. These files are the backbone of a loan monitoring system.
c. Computerization should be introduced, if it is not already in place.

Various strategies can be employed to monitor loan performance:

I. Periodic direct monitoring of clients
 Client visits
II. Indirect monitoring of clients

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  Attending local markets, cattle auctions, agricultural fairs
 Meetings with extension officers
 Meetings with veterinary officers
 Contacts with agricultural input suppliers, traders, slaughter houses, etc.
 Other client records in the financial institution
III. Monitoring actual loan repayment performance

5.4. THE OLD AND NEW AGRICULTURAL CREDIT POLICIES IN ETHIOPIA:

AFTER FINANCIAL LIBERALIZATION
The development of the financial sector in Ethiopia has a long history and included an array of
banking and non-banking institutions. The financial system comprised of commercial banks,
development banks, specialized financial institutions, cooperatives, insurance companies, etc.
The organizational structure, management and ownership of these financial institutions as well as
their performance have been changing under the different regimes. Ethiopia should give priority
to the peasant agriculture in its national development efforts since development cannot take place
without giving special considerations to the majority of the rural population.

Financial liberalization is an extremely important component of a successful development

strategy. Both economic theory and practical experience suggest that financial liberalization can
stimulate economic development. It is advocated that financially repressed systems should
abolish or relax interest rate controls; eliminate or greatly reduce controls on allocation of credit;
switch to market based indirect methods of money supply control; and develop money and
capital markets.

Following financial liberalization, market determination of the interest rates is expected to result
in positive real interest rates. These in turn will increase the resources available to the financial
system, since bank deposits offering competitive return will attract savings that were previously
held outside the formal financial sector. Moreover, positive real interest rates will provide an
incentive for borrowers to invest in more productive activities, thereby improving the

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productivity of the economy as a whole. Consequently, financial liberalization should lead to an
increase in both the quantity and the quality of financial intermediation by the banking system.

Following the overthrow of the Derge regime, changes in economic policies as well as political,
administrative and institutional structures began to be introduced by the new government. Hence,
several policies, legal, regulatory, supervisory and institutional reforms have been undertaken by
the new government. The government adopted a World Bank/IMF supported structural
Adjustment Programmes (SAP). The policy reforms involved among other things, reducing
budget deficits and government reliance on domestic bank borrowing, developing more flexible
monetary policy instruments, liberalizing interest rates, and improving efficiency of financial
intermediation by removing distortions in financial resources mobilization and allocation.

Financial liberalization in Ethiopia began at the end of 1992. The financial reform undertaken in
Ethiopia include elimination of priority access to credit, interest rate liberalization, restructuring
and introduction of profitability criteria, reduced direct government control on financial
intermediaries and limits bank loans to the government, enhancement of the supervisory,
regulatory and legal infrastructure of the NBE, allowing private financial intermediaries through
new entry of domestic private intermediaries (rather than privatization of the existing ones) and
introduction of treasury bills auction markets. As a result of the liberalization, nominal interest
rates on deposits and loans were raised by 60 – 90% and 58-144% in 1992, respectively. Prior to
1992, the interest rate charged to farmers’ cooperatives was 5 percent which is below the rate of
savings deposit (6 percent). Financial institutions were obliged to pay interest margin on deposits
from their own sources. Lending rates which were between 4.5 and 9.5 % were raised to 11-15%
depending on the sector until September 1994. Deposit rates which ranged between 1 & 7.5% for
time deposit, and 6% for savings deposits were raised to 10-12%. Discrimination of credit access
and interest rates by type of ownership (i.e. between state owned enterprises, cooperatives and
private firms) were eliminated. Sectoral interest rates discrimination was reduced, and domestic
establishment of private financial institutions was allowed and encouraged through proclamation
number 29/1992 (NBE, 1992).

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Further liberalization eliminated sectoral discrimination of lending rates, which had continued
(favoring agriculture and housing construction with reduced rates). Since January 1995, the NBE
switched to a policy of floors on deposits and ceilings on lending rates, allowing banks to set
interest rates (NBE, 1995). These rates combined with low inflation resulted in positive real
rates. Further interest rates liberalization was taken in 2001/02. The government saw the need to
review the interest rates to encourage savings through the banks and to create a disincentive to
forestall speculation and uneconomic use of savings by borrowers. The interest rate policy was
reviewed with the following objectives: (1) to keep the general level of interest rates positive in
real terms in order to encourage savings and to contribute to the maintenance of financial
stability; (2) to allow greater flexibility and encourage greater competition among the banks and
non-bank financial institutions to enhance efficient allocation of financial resources – in
particular, the policy strove to ensure that funds flowed into those areas that are most productive.
Hence, the NBE revised the floor for saving deposits downwards to 3% from 6% in 2001/02 with
an intention of encouraging investment and boost economic activity. Lending rates quickly
followed suit as the minimum lending rate charged by commercial banks went down from 10.5%
to 7.5% in the same period.

The liberalization also raised nominal yields on treasury bills and bonds to 12% and 13%
respectively, since 1992. Later a government securities market was established in January 1995
through the introduction of monthly (later biweekly) auction of 91 days' treasury bills with 28
days and 182 days bills added in 1996. Treasury bills are now on offer to financial institution,
business firms as well as the general public. Interest rate liberalization was accompanied by other
reforms including the floating of the exchange rate and trade liberalization. The government also
sought to strengthen the legal and technical capacity of the central bank to carry out its
regulatory and supervisory functions. The 1960 Civil Code with respect to sale of bank collateral
has also been amended in 1997 by proclamation (FDRE, 1997). This amendment provides for an
agreement with the borrower authorizing lending banks to sell directly and quickly collateral
from delinquent borrowers. This contributed to the effectiveness of enforcement of credit
contracts. In addition, restructuring of the financial institutions was felt necessary to promote
competition, reduce government ownership and control, balance the type of institutions
(commercial banks, development and household savings banks), and upgrade services. The state

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owned banks were restructured financially and operationally. Changes in corporate governance
have been introduced: banks have management autonomy and their own boards; management
have been replaced and reorganized; new incentive schemes have been introduced; and banks are
to operate in a competitive environment using commercial criteria. Banks are no longer required
to specialize their credit services to certain sectors of the economy. They also no longer face
restrictions on the types and sources of deposits they accept. Banks are also decentralizing loan
decision making in order to reduce transaction costs of borrowing and reducing screening hence
transaction costs of lending. Entry restrictions into banking were lifted for domestic banks. Entry
rules and guidelines have been drawn.

The lending approaches of banks to target beneficiaries could be both a direct type and a two tier
system. The direct type is in which the Bank extends credit directly to the end user. This could be
an individual person or organization such as cooperatives, government or private enterprises
which have legal entity. In the two tier approach, the Bank transfers its financial resources to end
users through other bodies such as cooperatives and peasant associations. In the case of the first
type, the credit beneficiaries enter loan agreements with the bank and are responsible for
repayment of the borrowed loan, whereas in the case of the latter other intermediaries such as
cooperatives or associations sign a loan contract with the bank and channel the borrowed fund to
their members or end users.

In the case of rural Ethiopia, regional governments act as intermediaries between banks and
farmers. These governments use their federally allocated budget as collateral to borrow from
banks and on lend these funds to farmers for the purchase of agricultural inputs. This procedure
has enabled banks to lend a great deal of money to farmers. Nevertheless, there have been cases
of default, which have necessitated repayment out of the budget allocations of the regional
administrations.

However, the inability of the formal financial sector to provide adequate financial services to
small farmers and the poor in general continued even after the reform. A study by the National
Bank of Ethiopia (1996) concluded that CBE and DBE have only catered for insignificant
demand for credit of small farmers. The bulk of financial services provided to small and micro

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enterprises in rural and urban areas, therefore, mostly originated from the informal sector such as
Iqqub, money lenders and friends” (NBE, 1996).

CHAPTER 6: UNCERTAINTY AND FARM DECISION MAKING

UNCERTAINTY IN AGRICULTURE

Farmers must make decisions on crops to be planted, seeding rates, fertilizer levels and other
input levels early in the cropping season. The crop yield obtained as a result of these decisions
will not be known with certainty for several months or even several years in the case of perennial
crops. Changes in weather, prices and other factors between the time the decision is made and
the final outcome is known can make previously good decision very bad.

Because of time lag in agricultural production and our inability to predict the future accurately,
there are varying amounts of risk and uncertainty in all farm management decisions. If
everything was known with certainty, decision would be relatively easy. However, in the real
world more successful managers are the ones with the ability to make the best possible decisions,
and courage to make them when surrounded by risk and uncertainty.

DEFINITIONS

Risk is a situation in which all possible outcomes (results) of an activity are not certain (not
known), but the probabilities of alternative outcomes (results) are known or can be estimated.
The probability may be estimation based on past experience or data. Example, if a farmer know
that his maize crop is likely to fail in one of the four years of consecutive production period by
25% then this is a risk because even if he doesn’t know the exact year he is expecting failure in
one the four years of production period.

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Uncertainty is a situation where all possible outcomes and the probability of the outcomes are
unknown or neither the outcome nor the probability is known. Uncertainty is not insurable. It is a
situation where an action has got a set of possible outcomes the probability of which is
completely unknown. For example, no one can assign probability to how many times he will fall
sick within a year. Farmer normally calculates his labor requirements on the ground that his
workers will be healthy throughout the year and that each labor will supply at least eight working
hours per day. Similarly, no one can precisely predict when he is going to die. Farm manager
may project his activity for the whole year and he may not reach the end of that year before he
dies. Any situation where one cannot predict what can happen is normally regarded as uncertain
situation.

Profit maximization as a goal: Profit maximization is usually assumed to be the overriding goal
of management. However, this assumption has two shortcomings: it fails to account for the
timing of earnings, and risk and uncertainty. Although the terms "risk" and "uncertainty" are
frequently used interchangeably, there is a classical distinction between them. Both define a
situation in which a number of outcomes are possible. Risk describes a situation in which these
outcomes follow a known probability distribution, while uncertainty refers to cases where the
probabilities of different outcomes are unknown. The two major sources of risk are business risk
and financial risk.

Business risk is the variation in net earnings arising from the nature of the kinds of enterprises in
which the firm is engaged, including weather, disease, and price changes. The profit
maximization rule, which compares mean or average returns, could be used to select superior
projects with more profit, while standard deviation is used to select projects with less risk. A
project with higher return and low risk can be considered as a profitable project. However, the
choice is largely subjective depending on personal preference for risk versus returns as well as
on financial ability to carry the greater degree of risk involved.

Financial risk determines how much capital should be acquired. Financial mangers really have
only two basic capital sources: their own equity capital and non-equity capital. However, the use
of non-equity capital creates a fixed financial commitment in the form of principal, interest, rent,

72
or other obligations. This commitment to the supplier of non-equity capital results in financial
risk. As leverage, the amount of non-equity capital relative to equity capital, increases, the
financial commitment increases, so that the risk increases also.

6.1. SOURCES OF UNCERTAINTY

There are different types of uncertainties which arise when the producer commits his resources to
production in the present and then waits for the outcome till sometime in the future: These are:

a) Yield uncertainty: refers to uncertainty related to the output level of the products from
agriculture. Since agricultural activities are highly influenced by nature (weather condition),
it is not possible to guess the output for certain product. The degree of uncertainty may differ
from product to product, crop to crop, on season to season or place to place. Therefore, it is
not possible to exactly produce the output level as determined by the principles of resource
allocation.
b) Price uncertainty: refers to change in price due to either one or all of the following factors:
 Actions of farmers’ cooperatives against price
 Change in the total supply of agricultural products in the market
 Discontinuous production cycles etc (Seasonality of the business/production)
c) Tenure Uncertainty: refers to the uncertain ownership of land by tenants. If they did not
own their agricultural land by themselves i.e. if they are provided the land by someone else
(for example, the government), they will not be encouraged to make some type of long-term
investment or improvement or development on the land to increase their productivity.
d) Uncertainty related to the prices or qualities of inputs: again there is uncertainty with
regard to the prices of inputs in the factor market and the qualities of such inputs.
If this is so it is not possible to produce again the decided level of output for the selected product
at the estimated cost and then be in equilibrium.
e) Political Uncertainty: refers to the uncertain political condition in a country. Example,
political instability of the country to perform economic activities related to agriculture,
change in government policies related to land reforms.
f) Personal Uncertainty - refers to the uncertainty about the welfare of farmer’s family – for
example, the health or productivity of farmer’s family.

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g) People’s Uncertainty- refers to the relationships of the farmer with persons he deals with
like laborers, bankers, landowners etc.

Types of risk and uncertainty in agriculture

The more common sources of risk can be summarized into the general types as:
production risk, marketing risk, financial risk and technological risk.

Production or yield risk: refers to the unpredictable impact of climate, crop and livestock
diseases and pests, and other natural and manmade calamities on outcome (output).
Price or marketing risk: are risk associated with the variability of output of price and its effect
on the farm income. Commodity prices vary from year to year and may have substantial seasonal
variation within a year.
Financial risk: a risk incurred when money is borrowed to finance the operation of the business.
That is, any time money is borrowed there is some chance that future income will not be
sufficient to repay the debt without using equity capital.
Technological risk: Another source of production risk is new technology. Will the new
technology perform as expected? Will it actually reduce costs and increase yields? These
questions must be answered before adopting new technology.

6.2. MEASURES TO DEAL WITH UNCERTAINTY

A. Measures at Farm level: price and yield uncertainty have an important bearing on the
decisions taken by farmers in regard to the conduct of the farm business. They take the following
important measures to reduce the uncertainty even though the measures may involve some cost.

I. Diversification: means that the farmer carries on several farm products simultaneously in
order to avoid the dangers of having all his eggs in one basket. This implies that even in a
situation where the marginal rate of product transformation and the expected price-ratios suggest
production of only a few products, the farmer, as a precaution against uncertainty, doesn’t do so
and instead, diversifies his production by producing several products. Because if he loses the
price or yield of some, he will get from the other products. But this is true as long as the
correlations between prices and yields of different products are negative. i.e., if they move in

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opposite direction. If prices or yield correlations are positive, the method cannot reduce
uncertainty or income variability.

II. Flexibility: means that the farming system is so arranged that the farmer can move out of one
product in to another without much cost if economic conditions make this shift desirable. It
involves the avoidance of rigid production method or production pattern. Flexibility may be in
terms of:
 Product i.e. product flexibility -– to shift among two or more types of products.
 Time i.e. time flexibility -– to shift the amount of different activities in different times.
 Cost/factor i.e. cost or factor flexibility -– to shift among different types of factors of
productions by considering their cost.

Compared to diversification, flexibility is not intended to prevent the happening of the uncertain
event. It is a method only to reduce the impact of such an event. The former, on the other hand,
in some cases, also prevents the occurrence of the uncertain event itself, e.g. production or
drought or disease resistant crops. However, both methods work against specialization in
product.

III. Liquidity: refers to a condition where the farmer holds a reasonable proportion of his assets
in the form of near money or money. This enable the farmer to either produce more by
purchasing resources if the prices of his products go up or to abstain from selling his products till
their prices go up if they go down.

In general, the above three measures result in a pattern of resource use which is less efficient and
therefore less profitable when compared with the general condition given above. As such the
resultant input structure does not ensure a minimum cost of production and the resultant output
mix does not ensure the maximum revenue as given by the principles of resource allocation
(factor-factor relationship and product-product relationship, respectively)
IV. Capital Rationing is a general term which means a restricted flow of capital to an enterprise
even when the return to it is quite high. Capital rationing may be.

75
 Internal capital rationing: the farmer invests a sufficient amount of his own resources to
ensure equality of marginal return to the amount invested with its marginal cost.
 External capital rationing: means that private money lenders and financial institutions are
reluctant to advance loans to the farmer on account of uncertainty.

In short, capital rationing is not a method of reducing uncertainty rather a method that avoids
uncertainty by running away from the uncertain thing/event.
V. Contract Farming: involves contractual agreements in money terms between the farmer,
manufacturing firms and input suppliers – this is to guarantee the farmer a certain price for a
given grade of product at a given time.
VI. Choice of Reliable Products: the farmers should produce those products whose yield
variability or uncertainty is less, for example, cereal crops instead of root crops.

VII. Stick to Traditional Crops: the farmers have to rely on those crops which they know well
instead of on new innovative crops in order to avoid yield uncertainty.
VIII. Discontinuing for risk: this implies that the farmers use insufficient inputs and produces at
less than the optimum level of output – this is, in order to reduce losses under unfavorable
circumstances. Smaller production will reduce the losses if the situation turns out to be
unfavorable.

IX. Maintaining Reserves: refers to maintenance of extra multipurpose equipment and labor
forces larger than what is normally necessary to meet some types of uncertainty for example
floods.

B. Possible Measures by Government

I. Guaranteed Agricultural Prices: involves enactment of legislation giving the farmer more or
less prices guarantee of the price level or the minimum price he may expect some time ahead.
II. Buffer Stock Scheme: refers to the purchase of stocks of agricultural commodities in years of
bumper crops and unloads them into the market in years of crop shortages with a view to raising
price in times of glut and lowering them in times of shortage. It brings about greater regularity in

76
the year to year availability of crops and at the same time promotes rational economic decisions
on the part of farmers by reducing price uncertainty.
III. Crop Insurance: refers to the chance of reducing uncertainty (especially yield uncertainty)
by incurring insurance premium or cost. Crop insurance can be:
 Insurance for specific crops
 Insurance for all crops taken together
 Voluntary crop insurance, or
 Compulsion crop insurance
6.3. DECISION MAKING UNDER RISK AND UNCERTAINTY
6.3.1. Risk and Return as Goals
The primary objective of a farm business may be profit maximization. However, profit
maximization is associated with a variety of risks involved in every business. While we are
planning to maximize our returns from a farm business activity, we are planning to face risk and
uncertainty. How can we measure risk and uncertainty in agriculture? What are the major
decision rules applicable to select an optimal portfolio of enterprises? The major problem of
agricultural investment is the high variability in returns associated with various factors and
constraints prevalent in the sector. It is also difficult to measure the risk associated with the
environment and individual enterprises. In this section, returns and risk are set as goals of a
business, and the principles of diversification to maximize returns and to minimize risk from an
investment are introduced with relevant applicability in agriculture.

Risk can be defined in terms of variability of returns. It is the potential for variability in returns.
Risk refers to the chance that some unfavorable event will occur. An investment whose returns
are stable is considered a low-risk investment, whereas an investment whose returns fluctuate
significantly is considered to be a high-risk investment. The measures of profitability and risk
can be used in two cases of analyses.

a) On a stand-alone basis, where the enterprise is considered in isolation to estimate the

expected return and risk involved in a single business; and
b) On portfolio basis, where the enterprise is held as one of a number of enterprises in
a portfolio to select among alternative enterprises or investments.

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In financial management, the profit maximization goal can be modified to account for the fact
that decision makers actually consider both expected return and risk. The financial manager is
assumed to have a goal of maximizing the utility of the owner of the business, where utility is a
function of both risk and expected returns. In this case, utility is the capacity of the business to
satisfy the profit wants of the owner, i.e. maximum return and minimum risk. It is generally
assumed that the manager prefers a higher return to a lower value. It is also assumed that the
manager is risk-avert in which case lower amount of risk is preferred. The general utility
function for a profit-maximizing, risk-averse decision maker is given by:
U =f ( E , V ) ; ...................................................................................6.1
Where: U = Utility,
E = Expected return, and
V = Risk
∂U
Profit-maximizing: >0 ;.....................................................................6.2
∂E
∂U
Risk aversion : <0 .....................................................................6.3
∂V

The position of the manager can be represented on a two-dimensional graph such as Figure 6.1,
which characterizes the risk-return utility function as a pair of indifference curves I1 and I2.
These curves indicate that the decision maker is indifferent to (or derives the same utility from)
all combinations of risk and return along any given indifference curve. Along curve I1, for
example, the decision maker is assumed to be indifferent to combinations of risk and expected
returns denoted by e1v1, e2v2, e3v3, and e4v4. To assume more risk (e.g., 0v2 instead of 0v1),
the decision maker must be compensated by higher expected returns, in this case 0e2 instead of
0e1.
expected return I2 I1

e4

e3
78
 e2
e1
0 Risk
v1 v2 v3 v4

Figure
Figure 6.1 6.1: Indifference
also illustrates curves
the utility describing
increases themovements
with risk-return utility
up andfunction
to the left to higher
indifference curves. Such a shift represents less risk for any amount of expected return or greater
expected return for any given amount of risk.

Expected Return I

I’
e2
e1

0 v1 v2 v3 Risk
Figure 6.2: Illustration of varying degrees of risk aversion

Decision makers will vary in their willingness to accept risk. In Figure 6.2, risk-return preference
function I illustrate more risk aversion than I’. For a given increase in expected returns e1e2, the
decision maker whose risk-return preference function is I is willing to assume v1v2 units of
additional risk. For the same increase in expected return the decision maker represented by I’ is
willing to assume v1v3 units of additional risk. However, even though I’ illustrates less risk
aversion than I, both indifference curves illustrate the general rule of risk-averse behavior.

[Link]. Measuring expected return and risk

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Thus far, the analysis of the risk-return or E-V trade-off has been in terms of undefined units.
The basic issue in analyzing the benefit of investments is how to measure the expected returns
and the risk associated with returns.

Expected return: The expected return of an investment is the probability-weighted average of

all the possible returns. The concept of return provides operators with a convenient way of
expressing the financial performance of an investment or business. There are two measures of
returns: monetary terms and rate of return. The monetary return is the amount received less the
amount invested. Although expressing return in monetary terms is easy, two problems arise:
a. To make a meaningful judgment about the adequacy of the return, you need to know the scale
(size) of the investment; and
b. You also need to know the timing problems of monetary returns. A $100 return on a $110
investment is a very good return if it occurs after one year, but the same return after 20 years
would not be very good.

The solution to the problems of monetary returns is to express investment results as rates of
return, or percentage returns. The rate of return is the monetary returns per unit of investment.
The rate of return standardizes the return by considering the return per unit of investment.

The expected return for a possible return is estimated as:

i=n
E=∑ Ei P ( E i )...................................................................6.4
i=1

Where: E = Expected return;

Ei =¿ Possible outcome of return in period (or situation) i;
P( Ei ) = Probability of occurrence of return Ei ; and i = 1,2,...n
The mean or average value of returns is used as a measure of expected returns estimated as:
i=n

E=
(∑ )
i=1
Ei
...........................................................................6.5
n
Ei =return∈ year i ; and n = Number of observations

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Risk: It can be measured in different ways, and different conditions about an asset’s riskiness
depending on the measure used. Remembering the following five issues will be helpful:

1. Cash flow risk: All financial assets are expected to produce cash flow, and the riskiness of an
asset is judged in term of the riskiness of its cash flow;
2. Stand-alone risk versus Portfolio risk: The riskiness of an asset can be considered in two
ways: on a stand-alone basis, where the asset’s cash flows are analyzed by themselves, or in a
portfolio context, where the cash flows from a number of assets are combined and then the
consolidated cash flows are analyzed;
3. Diversifiable risk versus market risk: In a portfolio context, an asset’s risk can be divided into
two components. A diversifiable risk component, which can be diversified way and hence is of
little concern to diversified investors and a market risk component, which reflects the risk of a
general asset market decline and which cannot be eliminated by diversification, hence does
concern investors;
4. High risk and high return: An asset with a high degree of relevant risk must provide a
relatively high expected rate of return to attract investors. Investors in general are averse to risk,
so they will not own risky assets unless those assets have high expected returns;
5. Financial assets and physical assets: Financial assets such are stocks and bonds, are different
from physical assets such as machines, crops, land, and livestock.

The variance and the standard deviation measure the extent of variability of possible returns from
the expected return. The variance is computed as:
i=n
2
σ 2=∑ [ ( E i−E ) P ( E i ) ]..........................................................6.6
i=1

where: σ 2=the variance of thereturn ;∧¿ 𝞂 = the standard deviation

E.g.: Assume a single crop A and its hypothetical possible returns (in monetary terms) and the
associated probability of occurrence of these returns as indicated in the first two columns of
Table 6.1. Compute the expected return, standard deviation, and variance of the returns.

Table 6.1: Estimation of expected return (pay-off matrix) and risk for a single enterprise
Possible returns, Ei Probability, (%) Deviation, (ETB) (Ei - E)2 Product

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 (ETB) P(Ei) (Ei-E) (Ei- E )2P(Ei)
30 0.10 -18 324 32.4
40 0.30 -8 64 19.2
50 0.40 2 4 1.6
60 0.10 12 144 14.4
70 0.10 22 484 48.4

Solution: Here, the sum and the mean of the returns are 250 and 50, respectively. The expected
return from the business is estimated to be 48. However, expected return will not indicate the
variability of the return or the risk associated to the expected return. The expected returns, the
variance, and the standard deviation are 48, 116, and 10.8, respectively. These figures will enable
to know the absolute magnitude of returns and variability for a single business.

This widely used approach for assessing risk is known as mean-variance approach. However,
variance or standard deviation provides a measure of the total risk associated with an enterprise
or business. The total risk comprises two components, namely systematic risk and unsystematic
risk. Systematic risk is the variability in business returns caused by changes in the economy or
the market, whereas unsystematic risk is the risk, which is specific or unique to a business firm.
Unsystematic risk associated with an enterprise can be reduced by combining it with another
enterprise having opposite characteristics. This process is kwon as diversification.

E.g.: Assume further, in addition to crop A, that there is a second crop B with possible returns
and the probability of occurrence of the returns. A reasonable basis for measuring expected
return is past performance. For the two cropping alternatives, hypothetical data on 10 years of
past performance are given in Table 6.2.

Table 6.2: Selection of alternative enterprises (portfolio selection) using expected returns and
standard deviation
Year Net returns above fixed costs (ETB per acre)
Return from crop A Return from crop B
1 136 86
2 88 64
3 104 92
4 148 102
5 62 82

82
6 176 78
7 192 62
8 142 90
9 48 94
10 34 60
Mean return (E) 113 81
Variance ( 𝞂2 ) 2953.11 215.33
Standard deviation ( 𝞂 ) 54.34 14.67

Solution: This example illustrates the general problem of selecting a portfolio of risky assets
when resources are limited. The limited resource is land, and the risky assets are crops A and B.
As shown in the table, the mean annual returns are 113 for crop A and 81 for crop B. Using this
measure, crop A is more profitable on average. However, the standard deviation is 54.34 for crop
A and 14.67 for crop B indicating that crop A is riskier business with a greater degree of year-to-
year variability.

[Link]. Decision Rules for Risk-Return Trade-Off

There are several decision rules to follow when choosing between A and B based on expected
return and risk. However, if a choice must be done between two investments which have the
same expected rate of return but different standard deviation, most people would choose the one
with lower standard deviation, and therefore, the lower risk. Similarly, given a choice between
two investments with the same risk (standard deviation) but different expected rates of returns,
investors would generally prefer the investment with the higher expected return. However, how
do we choose between two investments when one has the higher expected rate of return but the
other has the lower standard deviation? In this event, we use coefficient of variation and highest
lower bound.

Coefficient of variation: It may be desirable to select the alternative that offers the least amount
of risk per ETB of net return. The measure for this decision rule is given by the coefficient of
variation. The coefficient of variation shows the risk per unit of return, and it provides a more
meaningful basis for comparison when the expected returns on two alternatives are not the same
and computed as:
σ
CV = x 100.............................................................6.7
E

83
Where: CV = Coefficient of Variation
The CV is 48% for crop A and 18% for crop B indicating that crop B offers less risk per ETB of
expected return and would be preferred over A.

Highest lower bound: Another decision rule would involve selecting the alternative with the
highest lower bound. This rule is useful in a situation where the decision maker feels that net
return below a certain level would be insufficient to meet financial obligations and computed as:
L=E−2 σ..................................................................6.8
Where L =The highest lower bound
For our hypothetical crops data the lower bounds (in ETB) are:
 For crop A: 113-2(54.34) = 4.32; and for crop B: 81-2(14.67) = 51.66.
According to the highest lower bound rule, the decision maker would select crop B because its
lower bound is ETB 51.66 compared with ETB 4.32 for crop A. Both the coefficient of variation
and the highest lower bound have resulted in selection of the same crop B. It is also sometimes
possible that the two measures will end with different results. However, neither rule accounts for
the risk-return trade-off shown by the decision maker's risk-return utility function, because it is
difficult to get numerical estimates of utility functions. Nevertheless, the concept of risk-return
indifference curves is useful for explaining why some decision makers would rationally choose
to grow crop A while other would prefer crop B.

Diversification: In our analysis in the previous subsection, it was suggested that the choices
were limited to crop A or crop B, a conservative decision maker would choose B, while a
decision maker who displays comparatively less risk aversion would choose A. Both decisions
would be rational according to the utility-maximizing approach using the standard deviation as
the measure of risk. There is a possibility that some combination of crops A and B can be grown,
known as portfolio.

Portfolio, in financial context, can be defined as a combination of different enterprises,

investments, or assets held by an owner, which can be evaluated in terms of their combined risks
and returns. Observation of the data in Table 6.2 suggests that some diversification between

84
crops A and B might be a useful risk-reducing strategy because there is no apparent tendency for
the net returns from A and B both to be below average in the same years, and vice versa.

Diversification among two or more enterprises will generally be desirable if returns tend to be
independent, or negatively correlated. The covariance and the coefficient of correlation between
two random variables such as net returns of two crops provide statistical measures of the degree
of independence if it is less significant, and the degree of interdependence if it is more
significant.
6.3.2. The Theory of Expected Utility
Generally, in uncertain environment where there are a number of possible outcomes, each with a
probability of occurrence, the producer seeks to minimize risk. The objective would be to
maximize expected utility. The production decision rule depends on the farmer’s attitude towards
risk. Rationality in pure neoclassical sense demand that the producer should operate at the point
where E (MVP) = MFC. That is the expected marginal value product of the factor should equal
the price of the input. This is the profit maximizing position taking good years with bad ones
over a long period of season. The risk-averse farmer operates at the position where MVP1=MFC
which means E(MVP) > MFC. This implies that the household profit is not maximized though
consumer needs are covered except in bad season.

Output

E1 E2 MFC

E (MVP)
MVP1
0 X1 XE Input X
Figure 6.3: MVP and MFC curves indicating theory of Expected utility

But this does not mean that peasants are irrational in making decisions. Rather the objective of
peasants in such uncertain environment in agriculture would be to minimize risk. This

85
minimization of risk maximizes expected utility. The theory of expected utility states that in a
condition of uncertainty, individuals maximize their expected utility not expected income and
should not be blamed if income/profit is not maximized at equilibrium.

A risk-averse individual maximizes expected utility E (U), given the belief about events and
outcomes. At the core of decision theory there is a concept called certainty equivalence. This is
what enables less and riskier alternatives to be compared and placed in a scale of personal
preferences by the decision maker. It refers to the amount that would make us just as happy, or
indifferent, to taking the chance on two widely differing outcomes.

6.4. MECHANISMS OF MITIGATING RISK AND UNCERTAINTY

1. Risk-Averse Peasant: prefers a lower level of certain income to a higher level of risky
income [IA < EMV] which yields the same utility or happiness. She or he is prepared to forgo
EMV [Yc] - IA [Yr] = r (known as risk/insurance premium) in order to achieve certainty. Risk
premium is the amount of income required to make the individual indifferent between a risky
outcome and a certain outcome. If the value for r is positive, it means the individual is risk
aversive. If it is negative, it means the individual is risk loving. If it is zero, it means the
individual is risk neutral. The income that results from the expected utility is known as certainty
equivalent.
The utility function shows diminishing marginal utility of income.
E.g. U (w) =w1/2
−1 Utility
MU = 1/2W 2 I
A

EMV
r

0 Yr Yc Income
Figure 6.4: Certain income (IA) and risky income (EMV) of a risk averse peasant

2. Drudgery-Averse Peasant (Peasants as consumers and producers)

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The theories of peasant farm household behavior examined so far, profit-maximizing and risk
aversion, take no account of the consumption side of peasant decision making. The fact here is
the peasant is both a household and a business concern. The dual character of the peasant
household family and enterprise, consumer and producer is stated to be the most important
aspect of the definition of the peasant. Moreover, there exists the situation that the interaction of
consumption and production within the household causes a unique form of decision making
which sets peasants apart from any other kind of production unit under capitalism.

A central consideration in the construction of more complete theories of household behavior is to

achieve a more accurate representation of the multiple goals, and the impact these have on the
response of the household to changing circumstances. In the profit maximization theory, there is
a single goal, and economic responses are predictable provided that the assumptions of the
theory are roughly made. In the risk-averse theory, this single goal is modified but not
abandoned and responses are predictable subject to the impact on them of subjective response to
uncertainty. In the full household theory, the pursuit of various different goals in consumption
may result in variable or unpredictable response to different kinds of economic and social
changes. Hence the major aim of this theory is to clarify as far as possible the links between
goals, actions and the outcomes of such [Link] theory of drudgery-averse peasant is related
to the Chayanov model which emphasizes the influence of family size and structure on
household economic behavior via the subjective valuation of labor within the household. This
theory has crucial implications for the concept of peasant household production which go beyond
the mere mechanics of its working as a microeconomic model.

In the consumption side, equilibrium is determined as follows.

Leisure
At point E, slope of IC = slope of BL
A MU Y dH OA
MRS YH = = =
MU H dY OB
OA
E MRS YH =
OA .W
I 1
MRS YH =
BL W
Income(
0 B

87
 Figure 6.4: Household’s utility

In the production side, the Chayanov farm household model is used. It refers to a theory of
household utility maximization which focuses especially on the subjective decision making by
the household with respect to the amount of family labor to commit to farm production in order
to satisfy its consumption needs. It involves a tradeoff between the drudgery or irksomeness of
farm work (disutility of work) and the income required to meet the consumption needs of the
household (utility of income). In this model, the household has two opposing objectives, namely:
 An income objective which requires work on the farm and
 A work avoidance objective – which conflicts with the income generation

The main factor influencing the tradeoff between leisure and income (work) is the size of the
peasant household and its composition between working and non-working members i.e. the
demographic structure of the household. This factor is summarized by the ratio of consumers to
workers. For example, if a household consists of 2 adults with no children its c/w ratio is 1:1 but
two adults with an elderly peasant and four children say two of which each makes half an adult’s
work contribution would have a c/w ratio of 7/3.

output/income
output/income

A
Ye TVP
d
I1 Y
I dH
Ymi Ymi
n n
0 L
L Lma
Leisure days
Labor days(H)

Figure 6.5: Chayanov model of peasant household behavior

88
The predictive power of the model almost entirely rests on its demographic structure. This
implies that the model is a demographic model of household decision making. The following
points are the key assumptions of the model as microeconomic theory of peasant household
model.
 There is no market for labor (neither hiring of labor by the household nor wage work by
family workers outside the household). In effect, this means that there is subjective rate
which depends on the demographic structure of the household, but there is no
objective/market determined wage rate.
 Farm output may be retained for home consumption or sold in the market and is valued at
market price.
 All peasant households have flexible access to land for cultivation.
 Each peasant community has a social norm for the minimum acceptable consumption level

The central elements of the Chayanov model or theory of peasant household behavior is depicted
graphically fig 6.5. The gross output of the peasant farm which equals gross farm income is
measured on the vertical axis. The farm income is expressed in money terms due to the presence
of output market. The horizontal axis measures the total labor time available to the household,
which is determined by its number of workers. This total time can be allocated either to farm
work or other activities like leisure. The number of days committed to farm work is measured
from left to right, OL, and the number of days engaged in other pursuits (activities) is measured
from right to left, LO. The model comprises both the production and consumption aspects of
household decision making. The production aspect is handled by a production function
describing the response of output to varying levels of labor input. This production function
(TVP) curve displays the property of DMRL. In this model, the TVP curve can be described as a
family income curve i.e. Y= Pyf (L). This means the total income of the family is a function of
only market price of the output and the labor input.

The above farm production function does not capture the flexible access to land which is an
important part of Chayanov theory. The impact of flexible access to land makes a difference on
the onset of diminishing returns as labor use increases since extra labor is combined with

89
additional rather than fixed land. In other words, the production function may have a linear
(constant marginal returns) or non–linear portion before diminishing returns sets in.

In general, the equilibrium point is found at the point of tangency of the indifference curve to the
total value product curve where utility is maximized subject to a given output, a socially
desirable minimum level of income and the maximum available labor within the household i.e.,
Max U = f (H, Y)
St. Y = f (L), Y ≥ Ymin and L ≤Lmax

3. The Share Cropping Peasant Theory

Share cropping is a type of land tenancy in which the payment for the use of the land, the rent, is
a percentage of the total physical output obtained in the crop season. Since this proportion is
fixed in advance, the absolute quantity of rent varies with the level of harvest. Share cropping
has tended to be as interesting theoretical puzzle by neoclassical economists and as an oppressive
form of exploitation by some Marxian economists. The link between these two angles on share
cropping – the economic riddle and the exploitation – is founding the concept of
interlocked/interlinked factor markets. This refers to the lack of independence (lack of arm’s
length prices) between different input markets when multiple transactions are tied together in a
single tenancy contract.

Models of Share Cropping Peasant

There are two opposing competitive models of share cropping peasant, one which views
production behavior from view point of the tenant, the other from the view point of the land lord.

a) The Tenant model

In this approach the share tenant is taken to be a profit maximizing in a competitive market
subject to the output shares being fixed in advance. Assume that the share going of the landlord

90
is “r” percent. The amount left to the tenant would be 1-r percent. The economic position of the
share tenant is shown in fig 6.6 in comparison to the land owner.

Total output in monetary terms is given by TVPo. The amount left to the tenant is given by (1-r)
TVPo. The tenant maximizes profit at point Et where she/he employees OLt units of labor and
get 0Yt level of income which results in lower profit AEt compared to EoD which would be
gained if the tenant has used TVPo. The use of the variable input, labor is at sub-optimal and
share cropping is said to be inefficient. At point Et, profit is maximum by the condition set as (1-
r) MVP=W. While it is MVP=W for the equilibrium condition at point Eo.

Output

Yo
Eo

A TVPo

TFC
Yt
Et
TVPt = (1-r)TVPo
D
C

0 labor input
Lt Lo
Figure 6.6: Profit maximization of a tenant in a competitive market
This model is based on assumptions of:
 The tenant is free to choose the level of labor input supplied.
 The same results occur for all variable inputs.
 The economic waste of the share cropping tenant is given by the area AEB but incurred by
the land lord.

91
 Land is assumed to be gained at zero cost. The rent on land is paid as part of the share that
goes to the land owner.
 The tenant gets higher income and the land lord gets lower income than would be the case
the land lord used wage labor or leased out the land for fixed cash rent. The gain for the
tenant or the loss for the land lord is equivalent to FGA.

Output MVP
G E
(1-r) MVP
F A B Wage line

0 Lt Lo Labor input
Figure 6.7: MVP and MC curves show gain and loss of a tenant

b) The land owner model

In this model, the land owner is a profit maximizing who can vary the amount of land at his/her
disposal, decide the number and size of land parcels distributed amongst share tenants, decide the
rent share, and stipulate in the share contract and the amount of tenant labor input which is
required. The only constraint on the land owner is the market wage. Since the land owner sets the
labor input of the tenant, profit maximization ensures that this occurs where the MVP = W i.e.,
point B in the figure above. Farther, the landowner will adjust the number of tenancies, tenancy
size, and the share rate so that the implicit rent per unit land is equal to the marginal product of
land. With both these conditions satisfied share cropping becomes efficient. In effect, this model
turns the landlord in to a capitalist farmer. However, the model is criticized on the following
backgrounds:
 It places the landowner in the position of a monopolist who can offer all or nothing choice of
prospective tenants.
 It is thought unlikely that the individual land owner could use the share proportion as a
variable in seeking efficient land use.

92
 The notion that the land owner can stipulate the labor intensity of the tenant is open to doubt.
It assumes a zero enforcement cost to monitoring the labor process on the tenant farm.
CHAPTER 7: FARM DECISION MAKING METHODS
7.1. INTRODUCTION
Farm management is a science which deals with the proper combination and operation of
production factors, including land, labor and capital and choices of crop and livestock enterprises
to bring about a maximum and continuous return to the farmer. Farm management therefore,
seeks to help the farmer in deciding the problems like what to produce buy or sell, how to
produce, buy or sell; and when to produce and organizational and managerial problems relating
to those decisions. These decisions are made to increase net income. The major subject matters
included are:
 Improving practices on existing enterprises
 Recognizing existing and new enterprises
 Determining time horizon of production
 Deciding the best size of the farm
 Credit requirements and sources of credit.

In general, farm management can be understood as a branch of agricultural economics, which

deal with the business principles and practices of farming with an object of obtaining the
maximum possible return from the farm as a unit under a sound farming program. In short, it is
the study of the business principles of farming.

Farm management is generally considered to be micro economic in scope. It deals with the
allocation of resource at individual farm level. It considers/focuses on the farm as a unit.
However, it covers all aspects of the farm including:
 Types of enterprises /products to be combined.
 Types of crops to be grown
 The dosage of fertilizers to be applied
 Types of implements to be used, etc.

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For analyzing such different issues in the farm, there are different tools of analysis or approaches
in the economics of agriculture. These are:
 Production function approach
 Farm Planning and budgeting approach
 Linear programming approach
7.2. FARM BUDGETING APPROACH
7.2.1. Farm Planning
A successful farm business is not a result of chance factor. Good weather and good prices help
but a profitable and growing business is the product of good planning. With recent technological
developments in agriculture, farming has become more complex business and requires careful
planning for successful farm business.

Farm Planning means the preparation of an operational program for a farm which will ensure the
conservation of land and other resources. It’s important for the efficient use of production factors
thereby increase the net income and farmer satisfaction. Farm plans are particularly required
when there are limiting factors such as land, labor and capital. This necessitates efforts to
maximize returns to the limiting factors. A farmer makes plans before starting production. For
example, in crop production, the farmer decides on the crop types (such as maize, yam, beans,
etc.) and resources to put into production (such as farmland, seed, fertilizer, labor for farm
operations, etc.). The result of crop production is the output, while the resources are the
production inputs.

Production inputs and output are measured in different units – hectares, person-days, kilograms,
liters, and so on. Aggregation of the components is possible by using a common unit of
measurement. The unit of measurement is usually monetary (currency unit). Thus, the values
(quality and quantity) of inputs and output are expressed in monetary terms in a budget. The
monetary symbol used can for instance be ETB (Ethiopian Birr) or USD (US-dollar).

Farm planning enables the farmer to achieve his objectives (e.g. profit maximization or cost
minimization) in a more organized manner. It also helps in the analysis of existing resources and
their allocation for achieving higher resource use efficiency, farm income and farm family

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welfare. Farm planning is an approach which introduces desirable changes in farm organization
and operation and makes farm a viable unit. Farm plan is a program of total farm activity of a
farmer drawn up in advance. It should show the enterprises to be taken up on the farm; the
practices to be followed in their production, use of labor and other resources, investments to be
made and similar other details. Farm planning can be done at two levels: simple farm planning
and whole/complete farm planning.
Simple farm planning: It is procedure adopted either for a part of the land or for one enterprise
or to substitute one resource to another. This is very simple and easy to implement. The process
of change should always begin with these simple plans.
Complete or whole-farm planning: This is the planning for the whole-farm. A whole-farm plan
is an outline or summary of the type and volume of production to be carried out on the entire
farm and the resources needed to do it. This planning is adopted when major changes are
contemplated in the existing organization of farm business. When the expected costs and returns
for each part of the plan are organized into a detailed projection, the result is a whole-farm
budget.

7.2.2. Farm Budgeting and Types of Budget

Farm budget is a detailed physical and financial plan for the operation of a farm and prepared for
specified period of time or season. The aim of a farm budget is to compare how profitable
different kinds of enterprises and their combinations are. Budgeting techniques can be classified
into two groups, total or complete business budgeting and partial budgeting. A total or complete
budget is prepared when contemplating a complete reorganization of the entire farm enterprise,
like introducing irrigation technology to the farm. Partial farm budget, which is more common,
is used when introducing a new enterprise or purchasing a new equipment of the farm. To
simplify the process of doing either total business budgeting or partial budgeting, enterprise
budgets are commonly employed. Furthermore, to analyze alternatives that involve purchasing
long-term assets, a special and simplified budgeting technique can be used. The aim of preparing
a farm budget is to enable the farm manager get several alternative plans for analysis so that he
would be in a position to know which of them gives the highest net farm income.

Farm Budgeting and Advantages

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Farm budgeting involves considering the resources to be used, the choice of enterprises to be
pursued and calculation of expected receipts, expenditures and net farm income. Some of the
several advantages of budgeting are:
 Budgeting assists the farm manager to select factors of production more wisely. For instance,
once some fixed resources are invested in the farm business budgeting can be used to test and
compare returns from the whole-farm and other added resources.
 As a planning tool, budgeting lets the farm manager to think more accurately, plan more
carefully and completely. Through the process of budgeting, the farm manager refines his
ideas and is better able to make more accurate decisions.
 Budgeting is money saving activity because it is cheaper to make mistake on paper than in
practice.
 Budgeting provides an excellent learning device on how to organize and reorganize farms.
 Lending agencies use budgeting process as a basis for appraising the farm business of their
clients.
 Budgeting helps a farm manager to determine when to borrow money and how much to
borrow. It can also help him in setting up repayment schedules.
 Budgeting makes early warning possible where one can discover certain items, and therefore
costs, that could easily be dropped.

Budgeting Pre-requisites/Steps in Budgeting

Information needed to prepare a farm budget, whether complete or partial must follow the
following pattern
 Stating objectives and listing of all the resources available to the farm. It is essential to list
all the resources available to the farm business – land, labor and capital. Making changes
which require more resources than the farmer can acquire could be disastrous. Hence,
objectives of making the farm plan or planned change must be carefully laid down, properly
understood and strictly operationalized within the resources listed.
 Estimate crop land size and livestock number. This helps to sketch map of available land
with crops on farm. In the case of crop enterprises, the proposed changes could be sketched
out in other map for ease of reference.

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 Estimating physical inputs and outputs. The farm manager needs to produce a list of
available labor in man-days; the quantity of hired labor, permanent labor and family labor
available should be specified by periods preferably on monthly basis. The available capital
including farmer’s savings and any amount borrowed need to be clearly indicated. Finally,
the farmer or farm manager should examine his ability in effecting any anticipated change
(partial or whole-farm).
 Estimating factors and product prices. Current market prices or a few years’ moving average
could be used as a proxy for factor and product prices.
 Decide which plan is possible. from the whole range of alternative plans available to the farm
manager he can reject outright those plans that do not interest him or those that he cannot
manage properly.
 Budget the possible alternative. The possible alternative plans are compared on the basis of
the gross margin per unit of the most limiting resources. For example, if labour is the most
limiting resource; the plan with the highest gross margin per man-day should be selected.
 Implement the best plan. Once the farmer selects the best plan; it must be put into operation.
Farm owners should be ready to accept responsibility for the outcome of its implementation.

Budget, an outcome of budgeting procedure, is a formal quantitative expression of plans on

production inputs and output. Budgets indicate the type, quality, and quantity of production
resources or inputs needed, and the type, quality, and quantity of output or product obtained.
Three types of budgets are used in agriculture: whole-farm budget, enterprise budget and partial
budget.

[Link]. Whole-Farm Budget

A whole-farm budget is a quantitative expression of the total farm plan summarizing the income,
costs, and profit (Table 7.1). Income is what a farmer realizes from farming activities, costs are
what the farmer puts into production, and profit is the difference between income and costs. In a
whole-farm budget, the unit of analysis is the entire farm. A whole-farm budget may consist of
several enterprises. Example for whole-farm budget is given in the table 7.1.

Table 7.1: A whole-farm budget showing projected income, input costs, and profits

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Nr. Income Amount Nr. Variable Input Costs (cont…) Amount
(ETB) (ETB)
1 Maize 56,000 15 Custom machine hire 9,350
2 Cassava 48,000 16 Miscellaneous 3,560
3 Beans 13,600 17 Total variable input cost (Σ7...16) 87,060
4 Yam 32,000 18 Income above variable input cost (6 – 17) 102,540
5 Poultry 40,000 Fixed Costs
6 Total income (Σ1...5) 189,600 19 Land charge 2,000
Variable Input Costs 20 Insurance 4,850
7 Fertilizers 12,900 21 Interest on loans 24,000
8 Seeds and cuttings 3,000 22 Machinery depreciation 9,200
9 Chemicals 8,900 23 Building depreciation 3,600
10 Fuel, oil, and grease 4,000 24 Total fixed costs (Σ19...23) 43,650
11 Machinery repairs 3,650 Total Costs
12 Feed 2,600 25 Total input costs (17 + 24) 130,710
13 Point-of-lay chickens 35,000 Profit
14 Labor 4,100 26 Profit (6 – 25) 58,890

Total or complete business budgeting is often used in situations where it is realized that the
proposed adjustments in the business will have an impact on several aspects of the business
operations because of inter-relationships that exist. For example, a farmer choosing to expand his
sheep operation a fairly labor intensive centerboard needs in balance in his labor resources. Total
business budgeting is a useful tool for evaluating this situation. There are three phases in the total
budgeting analysis.

The first phase is to formalize the proposed alternative to be evaluated.

The second phase evaluates the utilization of the business resources of the proposed plan. In
preparing the work sheet it is necessary to identify the main resources that will have limiting
effect on the overall business.
The third or the final phase is concerned with the economic aspects of the proposed plan.
The analysis is given below.

[Link]. Enterprise Budget

An enterprise is a single crop or livestock type produced on a farm. An enterprise budget lists all
income and costs of a specific enterprise to provide an estimate of its profit. Each enterprise
budget is developed on a single common unit, such as hectares for crops or head for livestock.

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An enterprise budget allows comparison of profitability among different enterprises on the same
farm.

Enterprise budgets are prepared by stating the income, expenses, and resource needs of a
productive activity of the farming business on a per unit basis. The income, expenses, and
resource needs are treated as a package in examining various adjustments related to the business.
Example, assume that for certain farmland, enterprise budgets are shown for three productive
activities of the farming operation; that is teff, wheat and sheep production. Each of the crop
budgets is stated on a per hectare basis. The sheep budget is stated on a per sow basis. Other
units can be used in setting up enterprise budgets (e.g. per 100 kg for grain storage and drying
facility).

Enterprise budgets, like whole-farm budgets, have three parts: income, costs, and profit. Table
7.2 gives an example of enterprise budget. The enterprise budget in Table 7.2 presents different
levels of the same single technology.

An enterprise budget is different from a whole-farm budget in aspects:

 the number of enterprises considered (only one in an enterprise budget; in a whole-farm
budget, all enterprises in the farm are included)
 the size of enterprises (a single unit for an enterprise budget, the entire farm for a whole-farm
budget)

Table 7.2: An enterprise budget for the production of an improved open-pollinated maize variety
at different N-fertilizer application levels
Nr. Item Description N-fertilizer level (kg N/ha)
0(Treatment 1) 100(Treatment 2) 200(Treatment 3)
Gross income
1 Average yield (kg/ha) 2,592 3,983 4,331
2 Adjusted yield (kg/ha) (1 x 0.9) 2,333 3,585 3,898
3 Price (ETB/kg) 2.5 2.5 2.5
4 Sale revenue (ETB/ha (2 x 3)) 5,832 8,961.75 9,744.75
Input costs (ETB/ha)
5 Land preparation 350 350 350
6 Planting

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 Materials (maize seed and seed 40 40 40
dressing)
Labor 20 20 20
7 Weed control (herbicides and 400 400 400
application costs)
8 Thinning 25 25 25
9 N-fertilizer 0 150 300
10 Other fertilizers 135 135 135
11 Miscellaneous 200 200 200
12 Harvesting (labor) 70 85 90
13 Shelling 30 32 35
14 Drying 60 64 67
15 Cost of capital 211 237 261
16 Depreciation costs (ETB/ha) 75 75 75
17 Total variable input costs 1,541 1,738 1,923
(ETB/ha)(Σ5...15)
18 Total fixed costs (ETB/ha) (16) 75 75 75
19 Total input costs (ETB/ha) (17 1,616 1,813 1,998
+ 18)
Net profit
20 Net profit (Gross Margin) 4,216 7,149 7,747
(ETB/ha) (4 – 19)
The gross margin gives an indication of how much the enterprise will contribute to paying
overhead costs and provide a profit for the operation. The gross margin of the enterprise can be
used as a guideline for making business adjustments. Making business adjustments, using gross
margins as a criterion, are commonly referred to as gross-margin planning. Enterprise budgets
often contain information on the critical resource needs. In Teff and Wheat enterprises, for
example, the critical resources needed are hectares of land and hours of labor.

[Link]. Partial Budget

A partial budget is prepared to show the effect of change(s) in farm operations. For example,
farmers know that fertilizer application will likely increase maize yield, and thus the gross
income. The use of fertilizer also results in additional costs. To decide whether to use fertilizer
for maize production or not requires a partial budget analysis. A partial budget could be prepared
to ascertain the effect on net benefit of the following possible changes:

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 Substituting one enterprise for another without any change in the entire farmland area, for
example, substituting 1 ha of soybean for 1 ha of maize
 Changing to different levels of a single technology, for example, estimating the effect on net
benefit of changing from one level of N-fertilizer application to another in maize production
 Changing to different technology(ies), for example, changing from hand weeding to
herbicide use for weed control

Partial budgeting is the process of examining only those costs, income and resource needs that
change with the proposed adjustment. The costs, returns and resource needs of the business that
are not affected by the proposed adjustments are ignored. It is a three step process. The first step
is identifying those factors that increase income, and reduce costs, the second step is concerned
with those factors that decrease income, and increase costs. Whether the adjustment is good or
not is determined by the third step that evaluates the adjustment by comparing the gains
identified in step one and the losses in step two.

Assume that the farmer wants to know if he should change the current land area mix between
Teff, and wheat. He has observed that the expected wheat price for the coming year appears to be
somewhat more favorable than the projected Teff price. Based on his information, the farmer is
considering decreasing his area of land for Teff by 40 hectares and increasing his wheat by the
same amount. To answer this question, we will use the previous enterprise budget as data source.
The following example shows all the required steps.

In Table 7.3 below, the profit will increase by 40 ha of additional wheat sales at ETB 210/ha and
having 40 fewer ha of teff expenses at ETB 113.35/ha. In addition, labor was hired at ETB 4.25
for 4.7 hrs in the 40 ha of land. This would amount to ETB 799. The total amount of increased
profits from this adjustment amounts to ETB 13,733. Similarly, the farmer has to forgone income
sales from teff and incurs additional cost for new

Table 7.3: A partial budget for wheat and teff production under same level of land (40 ha.)

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 Partial budgeting Analysis
The Small Farmland Situation
(Should he grow 40 hectares of Wheat instead of Teff?)
Step I= determine what increases profit
1) Increased income from sale of wheat
(40 ha x ETB 210/ha) = ETB 8,400
2) Reduced cost from not growing teff
(40 ha x ETB 113.35 expense/ha= 4,534)
(40 ha x 4.7 hr x ETB 4.25/hr = 799) = ETB 5,333
Total increase ETB 13,733
Step II Determine what decrease profit:
1) Reduced income from not growing teff
(Sales incomes 40 ha X 262.5/teff) = ETB 10,500
2) Increased cost from growing wheat
(40 ha x ETB 54.66 expense/ha = 2,186.4)
(40 ha x 4.1 hr x ETB 4.25/hr = 697) = ETB 83.4
Total decrease ETB 13,383.4
Step III determine net change in profit ETB 349.60

production of wheat. It is of ETB 13,383.40 in total. This items decrease the profit of the
business. However, the total increase exceeds the total decrease. Therefore, it would be favorable
for the farmer to make the adjustment analyzed.

Developing a partial budget for on-farm maize research involves collecting, organizing, and
analyzing experimental data in order to quantify the income, costs, and benefits of various
alternative maize technologies. Table 7.4 gives an example of partial budget. The partial budget
in this case shows different levels of the same single technology.
Table 7.4: A partial budget for maize production under different weed control methods
Weed control method
Nr. Item Description No Hand Boom Knapsack
weeding(1) weeding(2) spraying(3) spraying(4)
Gross farm gate benefits
1 Average yield (kg/ha) 1,266 3,986 3,797 2,833

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2 Adjusted yield (kg/ha) (1 x 0.9) 1,139 3,587 3,417 2,550
3 Farm gate price (ETB/kg) 0.75 0.75 0.75 0.75
4 Gross farm gate benefits (ETB/ha)(2 x 3) 854 2,690 2,563 1,913
Variable input costs (ETB/ha)
5 Weed control
– Labor 0 360 10 60
– Machinery 0 0 50 25
– Herbicides 0 0 160 160
6 Harvesting 42 70 70 70
7 Shelling 20 30 30 25
8 Total variable input costs (ETB/ha) 62 460 320 340
(Σ5...7)
Net benefit
9 Net benefit (ETB/ha) (4 – 8) 792 2,230 2,243 1,573
10 Changes in net benefits from 1,438 1,451 781
Treatment 1 to
Treatment 2, 3, or 4* (ETB/ha)
11 Change in total variable input costs from 398 258 278
Treatment 1 to Treatment 2, 3 or 4**
(ETB/ha)
Marginal rate of return
12 Marginal rate (%) of return (100 x 10/11) 361 562 281
*Change in net benefits between Treatments 1 and 2 is 2,230 – 792= 1,438 Change in net
benefits between Treatments 1 and 3 is 2,243– 792= 1,451 Change in net benefits between
Treatments 1 and 4 is 1,573– 792= 781
** Changes in the total variable costs calculated in similar ways

A partial budget, like an enterprise budget, is based on a unit (for example, one ha maize farm)
but it is different from an enterprise budget in the type of costs used. An enterprise budget uses
total costs (variable input costs plus fixed input costs) while only variable input costs are used in
a partial budget. In a partial budget, income is the gross farm gate benefit. The net benefit is the
difference between the gross farm gate benefit and total variable input costs.

The objective of a partial budget in maize production is to recommend technology that is

agronomically different, economically superior, and socially acceptable to farmers.

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Partial budgeting is particularly useful in evaluating the economic consequences of business
adjustments, which do not influence the entire business. Its unique advantage is in the fact that it
allows for isolating and analyzing the effects of a proposed adjustment and ignoring other
aspects of the business. It makes the analysis process simpler and tends to reduce the
computational errors that may be associated with a more involved method such as total business
budgeting.

Whole-farm planning and budgeting are used to assess the combined profitability of all
enterprises in the farming operation. Linear programming can be used to select the optimal
enterprise combination for a farm.

7.3. FARM STRATEGY DECISIONS

7.3.1. Farm Decision Making Process
As indicated before, farm management is concerned with the allocation of limited resources
among a number of alternative uses which requires a manager to make decisions. A manager,
first, must consider the resources available for attaining goals which have been set. Limits are
placed on goal attainment because most managers are faced with a limited amount of resources.
Decision-making is the most important responsibility of a manager of a farm business or other
type business. Decisions form the life-wire of the farm business. A successful manager is one
who has the skill to choose between alternatives in a constrained environment and effective at
attaining the stated objectives at best.

In a farm business, goal attainment is confined within some limits set by the amount of land,
labor and capital available. These resources may change overtime, but they are never available in
infinite amounts. The level of management skill available or the expertise of the manager may be
another limiting resource. If the limited resources could only be used one way to produce one
agricultural product, the manager’s job would be much easier. The usual situation allows the
limited resources to be used in several different ways to produce each of a number of different
products. In this case, the manager may be faced with a number of alternative uses of the limited
resources and must make decisions on how to allocate them among the alternatives to maximize
profit from the total business. This is one of the reasons why decision making is mentioned in the

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definition of farm management. Without decision nothing would happen. Even allowing things
to continue as they are implying a decision, perhaps not a good decision but a passive decision
nevertheless.

The process of making a decision can be formalized into a logical and orderly series of steps.
Following these steps will not ensure a perfect decision but ensure that the decision is made in a
logical and organized manner.
1. Identify and define the problem: A manager must constantly be alert to identify problems as
quickly as possible. Most problems will not go away by themselves and represent an opportunity
to increase the profitability of the business through wise decision making. Once identified the
problem, it should be concisely defined. Good problem definition will minimize the time
required to complete the remainder of the decision making steps. Definition of the problem
involves locating the root cause of the problem identified. This helps to identify factor
responsible for the problem identified. For the case of low yield identified as a problem, the
possible cause can include low input use such as fertilizer which may depend on several factors.
2. Collecting relevant data and information: Once a problem has been identified, the next step
should be to gather data, information and facts, and to make observations which pertain to the
specific problem.
3. Identifying and analyzing alternatives: Once the relevant information is available, the
manager can begin listing alternatives which are potential solutions to the problem. Several
alternatives may become apparent during the process of collecting data and transforming data
into information. Each alternative should be analyzed in a logical and organized manner to
ensure accuracy and to prevent something from being overlooked.
4. Making decision: Choosing the best solution to a problem is not always easy, nor is the best
solution always obvious. Sometimes the best solution is to do nothing or to go back, redefine the
problem and go through the decision-making steps again.
5. Implementing decision: Selecting the best alternative will not give the desired results unless
the decision is correctly and promptly implemented. Resources may need to be acquired and
organized. This requires some physical actions to be taken.

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6. Evaluation: This is the last step in the process of decision making. It involves comparing the
result or performance of your farming business before and after the implementation of the
solution.

7.3.2. Classifying Decision

Decision made by farm manager can be classified in a number of ways. One way of
classification system may be to consider decisions as either organizational or operational in
nature.

Organizational decisions are those decisions made in the general areas of developing plans for
the business, acquiring the necessary resources and implementing the overall plan. Some of such
decisions include: decisions regarding selection of the best size of the farm, what scale should be
the farm operation, decisions regarding (how much land to purchase or lease; how much capital
to borrow; the level of mechanization; construction of buildings and irrigation facilities, etc.).
Therefore, organizational decisions are related to planning and organization of the farm that tend
to be long run decisions which gives shape to the overall organization of the farm and are not
modified or reevaluated more than once a year. Compared to operational decisions,
organizational decisions require heavy investment and have long lasting effect.

Operational decisions are made more frequently than the organizational decisions and related to
the many details made on a daily, weekly or monthly basis and are repeated more often than the
organizational decisions as they follow the routines and cycles of agricultural production.
Operational decisions are frequent which involve relatively lower investment and their effect is
short lived. Some of such decisions include:
 Selecting fertilizer and seeding rates for a given field and year
 Making changes in livestock feed ration
 Selecting planting and harvesting dates
 Marketing decisions and daily work schedules
 What to produce (selection of enterprises)
 How much to produce (enterprise mix and production process)
 How to produce (selection of least cost method)

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 When to produce (timing of production)

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