Coping with Risk in Agriculture

Applied Decision Analysis

J Brian Hardaker, Ruud B M Huirne, Jock R Anderson, Gudbrand Lien

• Éditeur: CAB International
• Année: 2015
• ISBN:
  9781789243901
• Édition: 3
• Sujet: Business
• Sous-sujet: Agribusiness

Risk and uncertainty are inescapable factors in agriculture which require careful management. Farmers face production risks from the weather, crop and livestock performance, and pests and diseases, as well as institutional, personal and business risks. This revised third edition of the popular textbook includes updated chapters on theory and methods and contains a new chapter discussing the state-contingent approach to the analysis of production and the use of copulas to better model stochastic dependency. Aiming to introduce agricultural decision making, probability and risk preference, this book is an indispensable guide for students and researchers of agriculture and agribusiness management.

1 Introduction to Risk in Agriculture

Examples of Risky Decisions in Agriculture, and their Implications

The development of agriculture in early times was partly a response to the riskiness of relying on hunting and gathering for food. Since then, farmers and others have tried to find ways to make farming itself less risky by achieving better control over the production processes. As in other areas of human concern, risk remains a seemingly inevitable feature of agriculture, as the examples below illustrate.

Example of institutional risk

A dairy farmer finds that the profitability of his herd is constrained by his milk quota. He now has the opportunity to buy additional quota, using a bank loan to finance the purchase. The farmer, however, has serious doubts about the profitability of this investment because he believes that milk quotas will be removed at some time in the future. Cancellation of quota would make the purchased quota valueless from that point in time. He also thinks it is likely that milk prices will drop significantly when the quotas go. His options, therefore, are to restrict milk output to the current quota or to invest to get the benefits from increased scale and intensity of milk production. But investing means that, if the quota was to be abolished, and prices fell, he might not be able to repay the loan.

Animal welfare example

Along with a group of other interested producers, a pig farmer is considering whether to switch to a method of production that takes more account of the welfare of the animals. In addition to her personal preferences, she believes that there is a potential premium to be earned from sale of pig meat produced in a way more in tune with good standards of animal welfare. To change to the new system, considerable investment would be needed to provide better and more spacious accommodation for the pigs. Production costs would also increase owing to the need to provide larger-size housing, straw for bedding and a wider range of types of feed. However, there is considerable uncertainty about whether the new product, pig meat produced in a more welfare-sensitive way, can be marketed successfully and whether consumers will pay the premium needed to cover the extra costs.

Conversion to organic farming example

Organic farming has become more popular in response to increased consumer demand for organic produce. In addition, in several countries, conversion grants and support schemes for organic farming have been introduced to encourage organic production. There are reasons to believe that conventional and organic farming systems respond differently to variations in weather, implying different impacts on farm income risk. For example, restrictions on pesticide and fertilizer use may give rise to different production risk in organic farming than in conventional farming. Prices for organic produce may fall as more producers switch to organic production, and smaller organic markets may mean greater price fluctuations. A farmer considering switching to organic production would need to take account of the changed exposure to risk.

Insurance example

A vegetable grower farms land close to a major river and is worried about the risk of a significant flood that would destroy her crops. Her insurance company offers flood insurance to cover the potential financial loss, but the annual premium is high because of the high risk of floods at that particular location. The grower is wondering what proportion of the risk she should insure, if any.

Flower growing example

A flower grower is concerned about energy use for glasshouse heating. His current heating system is obsolete and he is considering replacing it with a new one, either a conventional design or a low-energy system. The relative profitability of the two options depends on future energy prices. If future energy prices stay as they are or rise only moderately, the conventional system will be the most profitable choice. However, if future energy prices rise substantially, the low-energy system will be best, even though it is more expensive to install.

Potato marketing example

A potato farmer is about to harvest his crop. He has to decide whether to sell the potatoes now, at the current price, or to store them for sale later in the hope of a higher price. The first option gives him a sure return for his harvest. With the second option, however, he has to face storage costs and losses, yet the future price is uncertain and depends on the market situation later in the year. If the market is in short supply, prices will rise and he will make a good profit from storage. If supply is average, prices will not rise much and he may just break even. But an over-supplied market will mean a fall in prices, causing a significant loss from a decision to store rather than sell immediately. Yet, at the time the decision to sell or store has to be made, the farmer cannot be sure what the future supply situation will be since it will depend on yields of crops yet to be harvested, grown in other areas.

Farm purchase and financing example

A dairy farmer has sold her previous farm for urban development at a good price, leaving her with funds for re-investment. She is wondering whether to invest in stocks and bonds or to buy another dairy farm, which is the business she knows best. If she buys a new farm, she has to decide how large a unit to purchase. In order to buy a farm to run of a commercial size, she will have to borrow some of the funds needed for the investment. Since she believes that scale economies in dairy farming will become more important in the future, she has to decide how much she is prepared to borrow and on what basis. Options include a loan where the future interest rate varies with economic conditions or one where at least a part of the funds is at a fixed, but initially higher, interest rate.

Disease policy example

Foot-and-mouth disease poses serious risks to farming in many countries. Outbreaks of the disease require costly control measures, including the slaughter of all animals on infected farms and bans on the movement of animals in the vicinity. A basic policy choice is between routine vaccination or not. Routine vaccination is costly and not fully effective, so that some outbreaks could still occur. In addition, because vaccinated animals show positive for the disease in immunological tests, it is not possible to certify vaccinated stock as disease-free. However, without routine vaccination most animals would have no immunity. In the event of an outbreak, therefore, there is the potential for the disease to spread freely. In reaching a policy decision, in addition to ethical issues, policy makers evidently have to weigh the fairly certain costs and losses of vaccination against the less certain consequences of no vaccination. The latter choice would save vaccination costs and preserve access to export markets, but creates the risk that future outbreaks could be serious and costly.

The need to take account of risk in agriculture

As these examples show, risk can be important in agriculture. Indeed, risk and uncertainty are inescapable in all walks of life. Because every decision has its consequences in the future, we can seldom be absolutely sure what those consequences will be. Yet risk is not something to be too afraid of. It is often said that, in business, profit is the reward for bearing risk: no risk means no gain. The task rather is to manage risk effectively, within the capacity of the individual, business or group to withstand adverse outcomes.

Of course, farmers the world over have always understood the existence of risk and have adjusted to it in their own ways in running their farms. Yet, with a few notable exceptions, rather little practical use has been made of formal methods of risk analysis in agriculture. One reason may have been the effective elimination of at least some sources of risk provided by various government schemes to support the prices of farm products, such as the Common Agricultural Policy of the European Union (EU) and farm support programmes in the USA. The fact that prices of many agricultural products have been reasonably well assured in countries where such measures of protection have been in operation no doubt reduced the need to give a lot of attention to risk management. However, trade negotiations such as those at the World Trade Organization have led to changes in agricultural policies, with obligations on member countries to reduce levels of protection, especially via price supports. Moreover, many believe that these reforms are just first steps leading to further measures towards liberalization of international trade in farm products. The outlook, therefore, may be that many farmers will face greater exposure to competitive market forces and so will enjoy less predictable consequences than has been their experience.

A further reason for the relative neglect of risk is that the methods for the analysis of risky choice, although available for many years, are a good deal more complex than the more familiar forms of analysis under assumed certainty, such as the commonly used budgeting methods. The various methods that have been developed for analysing choices involving risk are collectively called decision analysis. Advances in computer software and hardware have made application of the methods of decision analysis simpler and quicker than in the past, bringing them within ready reach of farmers, farm advisers and agricultural policy analysts. It is therefore timely to examine the scope for wider application of decision analysis in agriculture.

Risk and Uncertainty

Some definitions

The terms ‘risk’ and ‘uncertainty’ can be defined in various ways. One common distinction is to suggest that risk is imperfect knowledge where the probabilities of the possible outcomes are known, and uncertainty exists when these probabilities are not known. But this is not a useful distinction, since cases where probabilities are objectively ‘known’ are the exception rather than the rule in decision making. Instead, in line with common usage, we define >uncertainty as imperfect knowledge and risk as uncertain consequences, particularly possible exposure to unfavourable consequences. Risk is therefore not value-free, usually indicating an aversion for some of the possible consequences. To illustrate, someone might say that he or she is uncertain about what the weather will be like tomorrow – a value-free statement simply implying imperfect knowledge of the future. But the person might go on to mention that he or she is planning a picnic for the next day and there is a risk that it might rain, indicating lack of indifference as to which of the possible consequences actually eventuates.

To take a risk, then, is to expose oneself to a chance of loss or harm. For many day-to-day decisions, the risk is usually unimportant since the scope of possible loss is small or the probability of suffering that loss is judged to be low. Crossing a street carries with it the risk of death by being run over by a vehicle, yet few people would see that risk as sufficiently serious to prevent them making the crossing for quite trivial benefit, such as the pleasure of buying a newspaper or an ice cream. But, as the earlier examples show, for important business or personal decisions or for some government policy decisions, there is a good deal of uncertainty, and there are important differences between good and bad consequences. For these decisions, therefore, risk may be judged to be significant. In farming, many farm management decisions can be taken with no need to take explicit account of the risks involved. But some risky farm decisions will warrant giving more attention to the choice among the available alternatives.

Types and sources of risk in agriculture

Because agriculture is often carried out in the open air, and always entails the management of inherently variable living plants and animals, it is especially exposed to risk. Production risks come from the unpredictable nature of the weather and uncertainty about the performance of crops or livestock, for example, through the incidence of pests and diseases, or from many other unpredictable factors.

In addition, prices of farm inputs and outputs are seldom known for certain at the time that a farmer must make decisions about how much of which inputs to use or what and how much of various products to produce, so that price or market risks are often significant. Price risks include risks stemming from unpredictable currency exchange rates.

Governments are another source of risk for farmers. Changes in the rules that affect farm production can have far-reaching implications for profitability. For example, a change in the laws governing the disposal of animal manure may have significant impacts; so too may changes in income-tax provisions, or in the availability of various incentive payments. Horticultural producers may be badly affected by new restrictions on the use of pesticides, just as the owners of intensive pig or poultry operations may be affected by the introduction of restrictions on the use of drugs for disease prevention and treatment. Risks of these kinds may be called institutional risks. Institutional risks embody political risks, meaning the risk of unfavourable policy chan...