CHAPTER SIX

Uncertainty and Farm Decision Making

 Agriculture is highly sensitive to the uncertainty and risks

 Since it is highly biological and nature dependent.

Which is an essential feature of agricultural production.

Hence farming is a risky occupation and called games against

nature.

 “Risk” and “uncertainty” are two basic terms to any decision

making framework.

 Risk: is a situation where the outcome and probability associated

with each possible outcome are known.

 Uncertainty: is a situation where neither the outcome nor the

probability are known.
Agricultural Economics – Lecture Note 1
 6.1. Risk and Uncertainty in Agriculture
6.1.1. Sources of risk in agriculture
 Agriculture is especially exposed to risk because agriculture is
affected by many uncontrollable events related to:
 Weather including excessive or insufficient rainfall, extreme
temperatures, hail, insects, and diseases.
 Changes in the price of output or inputs
 Production generally is a lengthy process.
 Institutional risk: results from changes in policies and regulations
that affect agriculture.
 Changes in government rules may alter the cost of production and
crop price.
 Human or personal risks: resulting from such events as death,
divorce, injury, or the poor health of a principal in the firm.
 Financial risk: may be resulting from the way the firm’s capital is
obtained and financed.
 Asset risk: may be due to theft, fire, or other loss or damage to
equipment, buildings, and livestock.
Agricultural Economics – Lecture Note 2
 6.1.2. Mechanisms of Mitigating Risk and Uncertainty
 Risk management involves finding the preferred combination of
activities with uncertain outcomes and varying levels of expected
returns.

 Farmers have many options in managing agricultural risks. The

following are some of them:

a. Enterprise diversification: involves participating in more than one

activity.

 The motivation is based on the idea that returns from various

enterprises do not move up and down in lockstep.

 so that when one activity has low returns, other activities likely
would have higher returns.

i.e. why Chinese said that ‘don't put all your eggs in one basket!'
Agricultural Economics – Lecture Note 3
 Cont. ..
b. Vertical integration: vertical integration (vertical coordination)
is a strategy whereby a company owns or controls its suppliers,
distributors to control its value or supply chain.
 Vertical integration occurs when a company assumes control
over several of the production steps.
 In other words, vertical integration involves control a part of
the production or sales process that was previously outsourced
to have it done in-house.
 The incentives for vertical integration can arise either from
producers or from buyers to enhance their potential profits or
reduce their risk.
 Vertical integration benefits companies by allowing them to
control the process, reduce costs, and improve efficiencies.
 However, vertical integration has its disadvantages, including
the significant amounts of capital investment required.

Agricultural Economics – Lecture Note 4

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Types of Vertical Integration

There are two most common methods of vertical integration:

i. Backward Integration: is a type of vertical integration when a

company expands backward on the production path of its
manufacturing inputs.

ii. Forward Integration: Forward integration is a strategy that

companies use to expand by purchasing and controlling the direct
distribution of a company's products.

 Forward integration helps companies cut out the middleman by

removing distributors that would typically be paid to sell a
company's products which reduces their overall profitability .

Agricultural Economics – Lecture Note 5

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c. Production Contracts: Production contracts

typically give the contractor (the buyer of the
commodity) considerable control over the
production process.

d. Marketing Contracts: Marketing contracts are

either verbal or written agreements between a buyer
and a producer that set a price or an outlet for a
commodity before harvest or before the commodity
is ready to be marketed.
Agricultural Economics – Lecture Note 6
 Cont. ..
e. Other ways to manage the risk:
Cultural practices
Planting short-season varieties that
mature earlier in the season
use supplemental irrigation
Excess capacity
By having such resources, the farmer
can avoid delays at either planting or
harvest that may reduce yield losses.

Agricultural Economics – Lecture Note 7

 6.2. Peasant Economics
The characteristic “peasant” refers to:
 A transition between the primitive tribe and industrial
society.
 A transition from relatively dispersed, isolated, and self-
sufficient communities towards fully integrated market
economies.
 Households which derive their livelihoods mainly from
agriculture and utilize mainly family labour in farm
production
 Simultaneous engagement in both consumption and
production.
 society where land is the most important factors of production
 A household which proportion of farm output is directly
consumed by the household.

Agricultural Economics – Lecture Note 8

 6.3. Risk-aversion, Risk-neutrality, and Risk-taking
 The terms risk-aversion, risk-neutrality, and risk-taking
are defined by reference to the subjective preferences
between certain and uncertain alternatives.
A. The risk-averse peasant
 From the risk averse peasant we can infer the following
propositions:
 Peasant risk -aversion results in farming practices, such as
spatial diversification of plots and mixed cropping, which
arc designed to increase family food security rather than
to maximize profits.
 Higher income or wealthier farm households are better
able to withstand the losses which might result from
taking risky decisions.

Agricultural Economics – Lecture Note 9

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 Because higher income farmers:
 might be expected to be more efficient,
 more prepared to specialise in cash crops , and more willing
to innovate.
 better informed and have greater access to credit .
Risk aversion declines as wealth or income rises.
Note: Risk -averse behaviour results in the sub-optimal use of
variable inputs.
 Consider figure 6.1 is designed explore the ‘income variance
approach to-risk.

 The risk situation which it describes is one of uncertainty

about the weather in which there are only two events
which can occur: the weather may be ‘good’ or ‘bad’
Agricultural Economics – Lecture Note 10
 Cont. ..
 TVP1 , =the total value product
response to increasing the level
of nitrogen input in a ' good*
year;

 TVP2 = the total value product

response to increasing the level
of nitrogen input in a ‘bad year’

 E(TVP)= the expected total

value product given the farmer'
s subjective views about the
Figure 6.1: Production likelihood of occurrence of
decisions under risk *good' and *bad * seasons.
The graph contains alternative output response curves to
describe the outcome of these two events as well as the
farmer's subjective assessment of the balance between them.
Agricultural Economics – Lecture Note 11
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 Suppose the 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 a ‘good’ season) =3/5= 0.60

p2 (probability of a ‘bad’ season) =2/5= 0.40

E(TVP) = 0.60(TVP1) + 0.40(TVP 2)

Where; TVP1= total value product in good’ years
TVP2 = total value product in bad’ years
E(TVP) = expected total value product

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Figure 6.1 displays three alternative operating positions, X1,
XE and X2 each of which is allocative rational depending on
the farmer's subjective preferences with respect to risk:
(a) Input use X1. This is consistent with allocative efficiency
on TVP1. It means that if TVP1, occurs the largest
possible profit, ‘ab’ is obtained.
 On the other hand, if TVP2 occurs, a substantial loss, ‘bj’
is incurred.
 A farmer choosing to operate at this position is described
as risk -taking.
 This is because she prefers to take a chance at the largest
possible profit, even though it only has a probability in
her own mind of 0.60 of happening, then taking a safer
position with less possibility of incurring a large loss.

Agricultural Economics – Lecture Note 13

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(b) Input use X2. This is consistent with allocative efficiency on
TVP2. It means that if TVP1, occurs a profit, ‘ce’ is obtained; and if
TVP2 occurs the farm still makes a small profit, ‘de’ as shown in the
graph.
 A farmer choosing to operate at this position is described as
risk-averse.
 This is because she prefers the safety of acting as if the worst
possible outcome will happen, even though in her own mind this
only has a probability of 0.40.
(c) Input use XE: This represents allocative efficiency consistent
with a balanced assessment of the average outcome of ‘good’ and
‘bad' seasons, it means that if TVP1, occurs a profit, ‘fh’ is obtained
 but this is not the largest profit possible on TVP1.
 Similarly, if TVP2 occurs a loss, ‘hi’ is incurred, and this is not
the smallest loss possible on ’TVP2.
 A farmer choosing to operate here is described as risk-neutral.

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B. The drudgery - adverse peasant
 Describes a farm household theory which integrates the
consumption and production decisions of the peasant
family.
 The aim of such theory is to achieve a more accurate
representation of the totality of economic behaviour
encompassed in household production.
 It is due to special interest is the extent to which
consumption decisions might alter the production
responses of the household.
 The theory examined in 1920s by the Russian
agricultural economist, A.V. Chayanov.
 Chayanov assumes that peasant family farms are units
of both production and consumption.

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 He begins by assuming that the primary objective of
production in peasant society is to provide a minimum
standard of livelihood for the family.
 Peasants, Chayanov argues, are primarily interested in use
value.
 However, it doesn’t mean that all peasant households are
self-sufficient in everything they need to consume.
 but many peasant market exchanges are simply exchanges
of use values.
 Even if the exchange involves money, the peasant sells his
product for money, and later buys a another product from
someone else for money.
 This kind of exchange system is about meeting needs (for
use value), not making money as an end in itself (not for
exchange value).
Agricultural Economics – Lecture Note 16
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C. The Sharecropping peasant
 It is concerned with arrangements for exchange in the peasant
economy which substitute for imperfect or missing markets in farm
inputs or farm outputs.
 Such arrangements are referred to as agrarian institutions or
agrarian contracts.
 Under share tenancy the rental payment for the, use of land is a
percentage share of the physical output of the farm.
 Landowners can reduce these difficulties for themselves by
interlocking factor markets within the tenancy contract.
 A typical example of interlocking occurs when the landowner
advances loans to the tenant which must be repaid from the tenant’s
crop share. In this case the markets for credit, land, and labour arc
interlocked.
 According to neoclassical interpretations interlocking of markets is
the means by which profit maximising landowners overcome the
inefficiencies of incomplete markets, and reduce the transaction
costs with which they are associated.
Agricultural Economics – Lecture Note 17