Economics of Agriculture
(Econ-4111)
Mohammed Adem (PhD)
Department of Economics
College of Business and Economics
Bahir Dar University
Bahir Dar, Ethiopia
4/1/2024
BDU, CoBE, Dep't of Econ 1
CHAPTER SIX
UNCERTAINTY AND FARM DECISION
MAKING
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BDU, CoBE, Dep't of Econ 2
Outline
6.1 Sources of Uncertainty
6.2 Definitions of Risk and Uncertainty
6.3 Analysis of Decision Making under Risk
6.4 Mechanisms of Mitigating risk
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6.1 Sources of Uncertainty
Uncertainty is a condition in which varying degrees
surrounds all forms of activity in a market economy.
➢It is considered more of a problem for agricultural
production than for industrial production due to
▪ the influence of climate
▪ the length of production cycle
➢The different sources of uncertainty are:
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6.1 Sources of Uncertainty
Natural hazards (yield or output uncertainty)
➢This refers to the unpredictable impact on output due to
climate, pests and diseases, and other natural calamities
➢Climate may affect the outcome of planting decisions at all
stages
➢ Combating pests and diseases may depend on the ability to
purchase relevant cash inputs such as pesticides and
herbicides
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6.1 Sources of Uncertainty
Market fluctuations [price uncertainty]
➢The lengthy lag between the decision to plant crop or rear
livestock and the achievements of output
➢The problem is more severe where information is lacking
and markets are imperfect
➢ It is also severe for perennial crops, such as coffee, with a
lag of several years between planting and first harvest
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6.1 Sources of Uncertainty
Social Uncertainty
➢It refers to insecurity caused by differences of control
over resources within the agricultural sector and the
dependence for survival of farm households
Eg. crop sharing and usury
➢This occurs where there is unequal ownership of land
in peasant rural communities;
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6.1 Sources of Uncertainty
State Actions and War
➢ Peasant economies as a whole are susceptible to
unforeseen changes in decisions made by state agencies
▪which may change from time to time or
▪ from directions of external donor agencies (like IMF,
World Bank, etc).
➢Peasants are often caught up in guerilla wars, subjected to
expeditions by either side in an armed struggle
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6.2 Definitions of Risk and Uncertainty
➢Risk refers to subjective probabilities attached by farm
decision makers to the likelihood of occurrence of different
events.
➢ The analysis of risk involves not just these probabilities
but also the way they enter economic decisions
➢ Hence the term risk is used to describe the entire
mechanism by which farmers make decisions with respect
to uncertain events
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6.2 Definitions of Risk and Uncertainty
➢Uncertainty does not refer to probabilities or their absence
at all.
➢ It refers a descriptive sense to the character of the
economic environment confronting peasant farm
households
➢An environment will contain a wide variety of uncertain
events to which farmers will attach various degrees of risk,
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6.3 Analysis of Decision Making under Risk
➢There are two approaches to subjective probability.
➢The first approach is to treat probability, and hence risk, as
variance either side of the expected average outcome of
uncertain events
➢ Hence, risk treated as the ‘income variance’ which results from
uncertain events
➢Thus risk is the probability of events occurring which result in
incomes above or below the average expected income.
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6.3 Analysis of Risk Behavior
➢The second approach is to treat risk as the probability
of disaster
➢In other words, the probability that the variable
outcome of certain events will take on a value less
than some critical minimum or disaster level
➢It focuses on avoidance of disaster as possibly the
central goal of peasant families rather than the goal of
profit maximization under uncertainty
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6.3 Analysis of Decision Making under Risk
➢ Figure 6.1 plots a simple production function graph
which shows three different response curves of output
to a single variable input, say unit of purchased
fertilizer.
➢The response curves are in value terms; they are total
value product (TVP) curves, so that features of profit
and loss are shown.
➢The figure is designed to explore the income variance
approach to risk.
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6.3 Analysis of Decision Making under Risk
➢The graph explores a risk situation involving uncertainty in
weather condition.
➢ Suppose that two weather situations can occur:
1. The weather may be good (adequate rainfall and best crop
yield)
2. The weather may be bad (significant lack of rainfall and poor
crop yield)
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6.3 Analysis of Decision Making under Risk
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6.3 Analysis of Decision Making under Risk
➢ The graph contains alternative output response curves to
describe the outcome of these two events as well as the farmer’s
subjective assessment
▪ TVP1 is the total value product response to increasing level of
fertilizer input in a good year
▪ TVP2 is the total value product response to increasing level of
fertilizer input in bad year
▪ Total Factor Cost (TFC) is the cumulative cost incurred as
fertilizer use increases
▪ E(TVP) is the expected total value product given the farmer’s
subjective views about the likelihood of occurrence of good and
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6.3 Analysis of Decision Making under Risk
➢Let us assume that a farmer expects 3 years out of every 5 years
to be good, and 2 years out of 5 years to be bad.
➢Hence, the probabilities and calculation of the expected total
value product, E(TVP), are as follows:
▪ P1 = Probability of good season = 3/5 = 0.6 = 60%
▪ P2 = probability of bad season = 2/5 = 0.4 = 40%
▪ E(TVP) = P1 (TVP1) + P2 (TVP2)= E(TVP) = 0.6 (TVP1) + 0.4 (TVP2)
➢In risk analysis TVP1 and TVP2 are described as the outcomes of
events or states of nature.
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6.3 Analysis of Decision Making under Risk
➢The shapes of the curves reflect the impact of good and bad
weather conditions on the response of output to varying levels of
fertilizer use
➢Lack of rainfall results in the very poor output (depicted by
TVP2)
➢ The subjective probabilities attached by the farmer to the
occurrence of good and bad years are p1 and p2 (the sum must
sum to 1)
➢E(TVP) is a weighted or average of these two outcomes
▪ TVP1 and TVP2, where the weights are probabilities p1 and
p2
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6.3 Analysis of Decision Making under Risk
➢With the inclusion of TFC line representing the increase in total
production costs as more fertilizer is purchased,
➢ We can analyze the impact of risk on the production efficiency
and decision of the farmer.
➢Figure 6.1 displays three alternative operating positions X1, X2
and XE, each of which is allocatively rational depending on the
farmer’s subjective preferences with respect to risk.
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6.3 Analysis of Decision Making under Risk
➢Let us discuss these three inputs position further as follows:
A. Input use X1
➢This position is consistent with allocative efficiency on TVP1.
➢ It means that if TVP1 (good season) occurs, the largest possible
profit, shown by the vertical distance aa1,is obtained.
➢ If TVP2 occurs, a substantial loss equal to the vertical distance
a1a2 is obtained
➢A farmer choosing to operate at this position is described as risk-
taking.
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6.3 Analysis of Decision Making under Risk
➢This is because he/she prefers to take a chance at the largest
possible profit, even though it only has a probability of 0.60 of
happening
B. Input use X2
➢This position is consistent with allocative efficiency on TVP2.
➢ It means that if TVP1 occurs, a profit equal to cc1 is obtained.
➢ If TVP2 occurs, the farm still makes a small profit, equal to c1c2
➢A farm operating at this position is described as risk-averse.
➢This is because the farmer prefers the safety of acting as if the
worst possible outcome will happen, even though the probability
is 0.4.
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6.3 Analysis of Decision Making under Risk
C. Input use XE
➢This position represents allocative efficiency consistent with a
balanced assessment of the average outcome of good and bad
seasons.
➢ If TVP1 occurs a profit bb2 is obtained but this is not the largest
possible profit on TVP1.
➢ If TVP2 occurs a loss b2b3 is occurred and this is not the
smallest lose possible on TVP2.
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6.3 Analysis of Decision Making under Risk
➢The above analysis is based on income variance approach to risk.
➢TVP1 and TVP2 represent the variation either side of the average
response curve of output to input (fertilizer) and
➢Their position on the graph is defined in terms of the level of
subjective probability attached to each of them.
➢Risk aversion occurs here as a matter of personal choice between
several alternatives.
➢It is used to illustrate the idea of risk aversion as a response to
the problem of disaster.
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6.3 Analysis of Decision Making under Risk
➢This response for disaster avoidance is what Lipton meant by the
survival algorithm of peasant farmers.
➢Lipton’s argument is that poor small farmers are of necessity
risk-averse.
➢ This can be justified, as the poor small farmers can’t afford to
cover their household needs from one season to the next since if
they fail to do so they will starve to death.
➢In terms of figure 6.1 the occurring of a loss may be considered a
disaster; for a poor family existing as a bare subsistence level of
production a loss means starvation.
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6.3 Analysis of Decision Making under Risk
➢ In order to avoid disaster, the farmer must operate with input
use in the vicinity of X2, no other operating position will do.
➢The notion of disaster avoidance is sometimes referred to as the
safety first principle.
➢ More precisely it means that decision-making is constrained by
the farmer’s unwillingness to risk obtaining a net income below a
given level
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6.3 Analysis of Decision Making under Risk
➢The consequence of risk aversion for optimum resource use, is
illustrated in figure 6.2
➢ Economic rationality in the neoclassical sense demands that the farmer
should operate at the point where:
➢ E(MVP)=MFC That is the expected MVP (Marginal Value Product of
input used) equals the price of the input (MFC, Marginal Factor Cost).
➢This is the profit maximizing position taking good years with bad over a
run of seasons.
➢Instead the risk averse farmer operates at the position where
MVP2=MFC. This ensures that household consumption needs are
covered in all seasons, even though profit is not being maximized except
in bad season
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6.3 Analysis of Decision Making under Risk
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6.3 Analysis of Decision Making under Risk
➢The consequence is that the expected marginal value product
(MVPE) shown at point A on the E(MVP) curve, is well above
marginal cost:
➢The optimum level of resource use is not being followed and
profit is not being maximized.
➢The proposition that risk aversion causes a situation in which,
on average, MVP>MFC is in principle.
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6.3 Analysis of Decision Making under Risk
➢A device called decision tree analysis facilitates further
understanding of decision theory
➢A simple decision tree is set out in figure 6.3 and it contains
example figures, which are compatible with the earlier analysis
of a production decision
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6.3 Analysis of Decision Making under Risk
➢The components of the decision theory approach can be
interpreted to give somewhat broader understanding on the
basic terms as follows:
➢ Act: This is the set of alternative actions between which a choice
must be made. Acts a1, a2… aj should be mutually exclusive and
exhaustive of alternatives available.
➢ In figure 6.3 there are two acts: (a) apply fertilizer in full up to
the recommended agronomic practice shown by act a1 and (b)
apply a token amount of fertilizer = act a2.
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6.3 Analysis of Decision Making under Risk
➢These are the discrete equivalents of input choices of X1 and X2
➢The two acts branch off from a single decision node (a square symbol in
figure 6.3) in the decision tree.
➢ States: these are uncertain events or states of nature, which may occur,
and influence the outcome of whatever decision is taken.
➢ States S1, S2 … Si are mutually exclusive and exhaustive of events
➢ In figure 6.3 there are two states (a) good weather (S1) and (b) bad
weather (S2).
➢ These states can occur with either act, and hence they are duplicated
from the chance node of each act.
➢ They are the same as the states underlying TVP1 and TVP2 of figure 6.1
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6.3 Analysis of Decision Making under Risk
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6.3 Analysis of Decision Making under Risk
➢ Probabilities: These are the degrees of belief held by the
decision maker about the likelihood of each state occurring.
➢ They are subjective probabilities, p1, p2,…., pi.
➢ The probability of the ith state must be between 0 and 1.
➢In figure 6.3 the probabilities p1 and p2 are 0.6 and 0.4
corresponding to states S1 and S2 respectively
➢Outcomes: The decision between two or more decisions (acts)
leads to specific outcome (payoff), the level of which depend on
which of the uncertain states occurs.
➢ Outcomes are usually specified in monetary payoffs for
comparison purposes.
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6.3 Analysis of Decision Making under Risk
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6.3 Analysis of Decision Making under Risk
Choice Criterion:
➢The criterion for choosing between acts is the maximization of
expected utility.
➢This is obtained as the weighted sum of the payoffs weighted by
the subjective probability
Solution procedures:
➢ The solution method for a decision tree problem begins from the
right hand side and works backward towards the decision node.
➢ The major steps that should be followed in obtaining the
solution are as follows:
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6.3 Analysis of Decision Making under Risk
➢Calculating the EMV [expected money value] of the outcome of
each node.
➢In this example the EMVs are x
➢ Chance node A 0.6 x 2000 + 0.4 x (-375) = 1050
➢ Chance node B 0.6 x 1300 + 0.4 x 300 = 900
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6.3 Analysis of Decision Making under Risk
• Obtain the certainty equivalent net income for each act. The
certainty equivalent is guaranteed income that someone would
accept now, rather than taking a chance on a higher but
uncertain, return in the future.
• For example suppose that the certainty equivalent income for
act1(a1) is 1050 and for 2 (a2) is 900.
• Reject alternatives which has the lower certainty equivalent. In
the above example act a2 is eliminated (since 1050>900) and a
farmer would maximize utility by choosing act a1
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6.3 Analysis of Decision Making under Risk
➢In summary the outcome of risk-averse decision-making is
different from profit maximization.
➢The profit-maximizing alternative in the above problem is act a1
[Expected Money Value (EMV) came as the result of the above
calculation as 1050 birr], but risk aversion means that act a2 is
chosen using certainty equivalent calculation.
➢ Act a2, maximizes the utility of the farmer with respect to
uncertainty, it does not maximize profit.
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6.4 Mechanisms of Mitigating Risk
i. Natural hazards
A) Irrigation: the most obvious policy response to natural
uncertainty
»irrigation as an answer to rainfall variability.
➢ Irrigation can serve both
▪to alleviate the risk of drought between two seasons
▪ to smooth out within season fluctuations of water supply
➢ It can also permit higher productivity cultivation practices with
a direct impact on the volume of output and farm incomes.
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6.4 Mechanisms of Mitigating Risk
B) Crop insurance:
➢ The most theoretically consistent and comprehensive proposal
for alleviating the adverse impact of natural hazards is crop
insurance.
➢ Insurance is a method of achieving income security in the face of
potential disasters.
➢ People pay risk premiums and then protected against the
incidence of uncertain events.
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6.4 Mechanisms of Mitigating Risk
C) Resistant Varieties:
➢ More practical and relevant is plant breeding or selection
designed for resistance to pests, diseases, and drought and for
stability of yields.
➢ There are, however, trade-offs here.
➢ Stable yields may not be consistent with the highest attainable
yields.
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6.4 Mechanisms of Mitigating Risk
ii. Market risks:
A) Price stabilization:
➢ It take various forms implying varying degrees of state intervention
ranging
▪ from setting minimum floor prices for key strategic staples to fixed
producer prices across a wide range of crops.
➢Where crop yields remain highly variable, price stabilization may serve
to exacerbate rather than reduce income variance.
➢This is because prices rise in low yield years (lack of supply) and fall in
high yield years (oversupply), resulting in some smoothing out of annual
incomes.
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6.4 Mechanisms of Mitigating Risk
B) Marketing information:
➢ Where risk-aversion is attributed to inadequate information
then information provision is considered a useful component of
risk policy.
➢ Diffusion of information to peasants can take many forms
through
▪extension work
▪ training and visit programs,
▪ radio, leaflets, and
▪farmer education in schools.
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6.4 Mechanisms of Mitigating Risk
C) Provision of credit:
➢ Provision of credit for consumption is a means of reducing risk-
aversion in farm households subject to wide seasonal variations
in income.
➢ Credit has also been considered relevant on the production side,
for overcoming resistance to the adoption of new technologies.
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END OF THE COURSE
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