CHAPTER FIVE:

AGRICULTURAL FINANCE

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 5.1 Nature of Agricultural finance

 Murray (1953) defined as an economic study of borrowing funds by

farmers, the organization and operation of farm lending agencies and
of society‘s interest in credit for agriculture.

 Tandon and Dhondyal (1962) defined as a branch of agricultural

economics, which deals with financial resources related to individual
farm units.

 Agricultural finance can be dealt at both micro level and macro level.

 Micro-finance refers to the financial management of individual farm

business. While Macro-finance deals with the aspects relating to
total credit needs of the agricultural sector, the method of use
of total credit for the development of agriculture
2
 5.4 Significance of Agricultural Finance
Agriculture finance assumes vital and significant importance in the agro–
socioeconomic development of the country both at macro and micro level.

 It is playing a catalytic role in strengthening the farm business and

augmenting the productivity of scarce resources.

When newly developed potential seeds are combined with purchased

inputs like fertilizers and plant protection chemicals in appropriate
proportions will result in higher productivity.

 Use of new technological inputs purchased through farm finance

helps to increase the agricultural productivity.

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 Significance of Agricultural Finance …
 Farm supporting infrastructure provided by large scale financial
investment activities results in increased farm income levels leading to
increased standard of living of rural masses.

 Farm finance can also reduce the regional economic imbalances and is
equally good at reducing the inter–farm asset and wealth variations.

 Farm finance is like a lever with both forward and backward linkages
to the economic development at micro and macro level.

 Agricultural finance is needed to create the supporting infrastructure for

adoption of new technology.

4
 5.2. Sources of Agricultural Finance
Rural finance targets the rural farm and non-farm population and includes
both agricultural and rural microfinance. Rural finance covers:

RURAL FINANCE

SEMI-
INFORMAL FORMAL FORMAL

Family, Friends,
Pawnshops, Traders, Micro finance
Moneylenders and programs of  Microfinance
landlords as well as NGOs Bank
traditional savings and
lending groups.
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 1. Informal Financial Sector
A. Friends, relatives, shopkeepers, moneylenders etc.
Friends and relatives generally lend money without charging interest.
Pawnbrokers, money collectors, shopkeepers and landlords are lend money by
exploiting and charging abusively high interest rates.

Advantages:

 Easily accessible: In some regions there are no financial service providers and
borrowers have to travel to nearby towns to arrange loans. No complex loan
applications and collateral involved.

 Flexible: There are no restrictions on the way the loan can be used. While
microfinance providers are often only prepared to lend money for ―productive
purposes, many borrowers require loans to buy consumer goods, for example,
or deal with emergencies.

 Able to respond quickly. Moneylenders and pawnbrokers can pay out money
quickly and shopkeepers and traders are able to supply goods bought on credit
6
immediately.
 Informal financial sector…
B. Traditional savings and lending groups

• Have many different names depending on where they are found:

• In some countries they are known as merry-go-rounds in others as

tontines, tandas or haqbads or Iqub in Ethiopian case.

• Traditional savings and lending groups have certain basic principals in

common.
• Some examples of traditional saving and lending groups are:
 Rotating Savings and Credit Association (ROSCA)
 Accumulating Savings and Credit Association (ASCA)

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 i. Rotating Savings and Credit Association (ROSCA)
 It is the most common form of traditional savings and lending.

 Community members voluntarily come together as a group on a regular

basis and each time they meet they contribute a fixed amount of
money.

 These contributions or savings are paid out immediately to a member of

the group present at the meeting. A lottery may be held to decide who
will receive this money.

 A ROSCA cycle comes to an end once all members of the group have
received a payment.

 At this point new members can enter the group, old members can leave
and a new cycle of contributions and payments begins. 8
 Advantages of ROSCA

Members commit themselves to saving for the entire ROSCA

cycle.

Each will receive one lump-sum payment making it possible for

them to invest, buy equipment and other consumer items or pay
school fees.

The system is most popular among women, but is also

practiced by men particularly by traders and those who, like
civil servants, receive a regular income.
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 ii. Accumulating Savings and Credit Association (ASCA)
 Unlike the ROSCA system, savings collected during regular meetings are not paid
out immediately.

 They are set aside until enough money has been accumulated to provide members
with larger loans or until members need to borrow money.

 At each meeting savings are collected, loan requests discussed, money disbursed
and repayments collected.

 ASCA groups usually have a limited life cycle of about a year and at the end of
this time the money saved is distributed amongst group members.

 ASCAs are more difficult to manage than ROSCAs because money is held in cash
and records have to be kept to keep track of loans and repayments. This is probably the
reason why they are less common than ROSCAs
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 Advantages of ROSCAs and ASCAs

a) Autonomy :- They are initiated by their members and do not depend on outside
assistance. The members manage the groups themselves, decide on the amount and
frequency of saving and determine their own loan conditions and procedures.

b) Social coherence :- Group coherence is assured because members select co-members

themselves.

c) Adaptability:- The groups are generally made up of people in the same financial
position.

d) Mutual assistance :- Members also join these groups for social reasons. The group
provides them with the opportunity to meet regularly and relationships built up in
the group can be a valuable source of support in times of trouble.
 Members often assist each other in emergencies with advice as well as material and financial support
 Social capital – the status of human resources in a community, 11
 Limitations of traditional saving and lending groups:

1. Some savings and lending groups last for many years but others have a limited
life cycle. This means that they are unable to offer their members permanent
access to financial services.

2. They function well when there is good group leadership. However, there is
always the risk of fraud.

3. Members are often not capable of mobilizing sufficient funds for those
who have larger enterprises and need bigger loans.

4. ASCAs only provide short-term loans and cannot help members who
want to invest but need loans that can be repaid over a longer period of time.
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 5.5.2. Semi-Formal Sector
It is made up of NGOs and development orientated organizations that offer
financial services not covered by the legislation that regulates financial
service providers.
Community-based savings and lending groups:
The programmes all start with savings.
The amount saved is determined by the group members themselves.
Groups vary considerably in size with the smaller groups having no more
than three or four members while larger groups may have as many as 30
members.
Loans become available to members as soon as enough capital has been
generated through members‘ savings.
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Semi-formal sector…
The group is responsible for selecting beneficiaries, managing loans,
monitoring repayments and deciding the conditions (interest rate, repayment
period) under which loans can be made.

These programmes differ from the traditional ROSCA and ASCA systems
because they have been introduced by external agencies – mostly NGOs.

The NGOs promote the idea of setting up a savings and lending

programme and introduce members to the general principles of the
system.

Emphasis is placed on group formation, leadership training and the

setting up of a simple system to administer loans and financial
transactions.
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 Advantages Semi-formal sector
 They are well adapted to the financial capacity and needs of the poor.

 Group members can take loans either to invest in production and trade or
to meet the cost of emergencies and social and family obligations.

 Beneficiaries use their own savings to meet exceptional expenses.

 Operational costs are minimal because the groups manage themselves.

 An important advantage for group members is that the system is flexible

and decisions are reached through a process of group discussion.

 Loans can be issued without much delay if sufficient capital is available.

 The experience of self organization can lead to the empowerment of the

group and its individual members.
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 Disadvantages Semi-formal sector

 It can take a long time for the group to accumulate enough

capital to meet its members‘ loan requirements.

 Organizational sustainability is uncertain.

 Much depends on the quality of leadership and members‘

commitment

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 5.5.3. Formal Sector

All financial services regulated by legislation fall within the formal

sector.

While most countries have banking legislation, not all have developed
comprehensive laws and regulation to cover the field of microfinance

The formal sector consists of banks, registered microfinance

institutions and registered saving and credit associations and unions.

Within the formal microfinance sector there are many different

approaches to lending

The structure and organizations of registered organizations and

agencies vary considerable depending on location and type of client.
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 A. Agricultural and Commercial Banks
 State owned and semi-autonomous agricultural banks set up to stimulate economic
activity in less developed rural areas in the immediate post-colonial period, frequently
ran into problems.

 When loans to these areas failed to produce results and farmers and rural entrepreneurs
were unable to repay them, the banks were often forced - for political reasons - to write-off
these loans.

 Many agricultural banks were only able to operate if they had access to government or donor
support.

 Commercial banks have never been particularly active amongst vulnerable groups or in the
small-scale agricultural sector.

 Their contacts with rural communities have usually been indirect and restricted to
providing traders with credit or extending loans to the wealthier class of farmer or
shopkeeper.
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 B. Rural Microfinance Programmes

• Microfinance programmes are the main providers of financial services to poor and
marginal groups.

• They have developed a range of approaches, methods and models that include: Village
banks, Solidarity groups, and Credit unions

i. Village Banks

 The international NGO FINCA has been the main promoter of the village banking
approach.

 Village banks are found throughout South America.

 They are community run credit and savings associations managed at village level
and supervised by the external NGO responsible for initiating the association.
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 ii. Solidarity Groups
The Grameen bank in Bangladesh is often taken as a model for solidarity groups. Its
approach has been adopted in different forms by microfinance programmes all over
the world.

The Grameen bank‘s primary aim is to reach the poorest of the rural poor. Group
membership is, therefore, restricted to impoverished and vulnerable women.

The poor do not have the collateral needed to guarantee loans. To solve this problem a
solidarity group will agree to take responsibility for repaying the loan.

The other members of the group will only become eligible for a loan if the first two
borrowers pay back their loan - in instalments - over a period of six weeks.

Within the group - there will be considerable pressure to ensure that loans are repaid
on time. The collective responsibility of the group serves as collateral for the loan.
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 iii. Credit Unions
 Credit unions or Savings and Credit Cooperatives (SACCOs) are institutionalized
community based, cooperative financial institutions.

 Credit unions are officially registered although this is not everywhere the case.

 Membership is open to anyone in the community in return for the payment of a

membership fee. This fee can be seen as a share.

 Credit unions are owned and controlled by their members.

 Although paid managers may be responsible for day-to-day decisions, the ultimate
control of the organization lies with a general assembly consisting of member
owners.

 Credit unions are led by an elected management committee.

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 Advantages of Formal sector:
1. Financial service organizations in the formal sector are officially
registered. Because of this
 They have easier access to external funds
 Service providers in the formal sector have more capital at their
disposal
 Many more clients and a much broader outreach
2. Their operations in rural areas – especially in Africa – continue to be
marginal. Because they are generally

 More efficiently and professionally organized,

 Formal sector organizations can guarantee higher levels of sustainability

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 Disadvantage of Formal sector:

1. Formal sector service providers – and especially non-member organizations –

however, is the high cost of employing salaried staff to manage, execute
and monitor programmes.

 This makes it difficult for them to deliver services at affordable rates and creates
particular problems for regions and groups that are only marginally involved in
the cash economy.

 Where population density is low, service delivery is very expensive and cannot be
easily provided by organizations that have high staff costs.

2. Within the formal sector the products offered and the approach used often
fails to meet the needs and specific circumstances of the target group.
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 Disadvantage of formal sector…

2. They are not easily able to adapt their services and strategies because
they lack flexibility.

3. Many formal sector organizations focus on credit delivery even though

savings services are often more important to the poor.

4. Organizations may insist that loans are used for productive activities
but clients may need them for consumption or emergency purposes.

5. Organizations that require collateral or a co-guarantor tend to

exclude poorer groups.

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 READING ASSIGNMENT

(Slide 26- 42)

5.6. Credit Worthiness Analysis

5.7 The Old and new Agricultural Credit Policies

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 5.6. Credit Worthiness Analysis

 A creditor's measure of an individual's or company's ability to meet debt

obligations is an assessment of the likelihood that a borrower will default on
their debt obligations.

 It is based upon factors, such as their history of repayment and their

credit score.

 Lending institutions also consider the availability of assets and extent of

liabilities to determine the probability of default.

 Several firms have developed rating systems to determine an individual

or company's credit worthiness.
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 Credit Worthiness Analysis…

 Creditworthiness has to do with the ability of a borrower to pay current

debt in a timely manner.

 Within the context of the ability, several basic factors come into play.

 An evaluation of the creditworthiness of a borrower involves;-

o Identifying the presence of resources that may be used to repay debts,

o the willingness of the debtor to use those resources for repaying debt, and

o a history of choosing to repay debt obligations in a timely manner.

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 Credit Worthiness Analysis…
 The resources are normally thought of in terms of some type of cash flow.

 Once it is established that the borrower has a flow or resources that can
be used to honor the debt, it is necessary to determine if there is a
willingness to follow through and actually make the payments.

 This is where the past credit history of the individual or business

becomes important.

 When the borrower has a history of paying outstanding debt within

terms, this is a strong sign of past creditworthiness.

 Using past history as an indicator, a creditor can reasonably assume the

borrower will demonstrate a similar pattern in the future.
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 Credit Worthiness Analysis…
 Creditors will also look at the current amount of indebtedness that the individual is
carrying.

 By comparing the ratio between current debt and income, it is possible to determine
if the borrower can reasonably handle another obligation without significantly
increasing the risk of default.

 This element of the evaluation process is in the best interests of the borrower, as it
helps to prevent establishing an obligation that could have a negative impact on
overall creditworthiness.

 Proper management of available resources goes a long way toward establishing and
maintaining creditworthiness.

 By keeping debts in line with available income and paying off the debts in a timely
manner, the credit rating of the individual will be healthy and attractive.
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 5.7 The Old and new Agricultural Credit Policies
1. Objectives of old credit policy

i. To alleviate a critical constraint hampering growth in agricultural output, this constraint

being lack of cash to make needed farm investment (irrigation, drainage, pumps tractors,
buildings) and to purchase modern variable inputs (fertilizer, pesticides, fuel, feeds, etc);

ii. To replace the fragmented and incomplete rural financial market represented by private
moneylenders, these credit sources supposedly having the effect of impoverishing their
clients rather than assisting them to improve productivity;

iii.To accelerate the adoption of new technology by peasant farmers, by providing working
capital for the seasonal purchase of variable inputs,

iv.To assist small farmers to overcome their inability to borrow from commercial or informal
credit sources, due to lack of collateral and lack of information;
30
Objectives of old credit policy…
v. To provide short-term credit in order to bridge seasonal and temporal cash shortfalls of small
farmers, compared to the medium and long-term lending preferences of commercial financial
institutions;

vi. To achieve equity goals, whether these are related to intra-rural, inter-regional, or rural-
urban income distribution;

vii. To offset the disincentive effects for small farmers of policies unfavorable to them including
low output prices, over-valued exchange rates, and inefficient market interventions by state;

viii. To gain favor with farmers for political purposes, including forthcoming elections, and so on;

ix. To take advantage of the sometimes-overwhelming generosity of foreign aid donors, who
seem to be, prepared to pump large amounts of money endlessly into rural credit project.

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 2. Instruments of old credit policy

 The ways the institutions created or regulated by the state operate, and the
constraint imposed on them by government policy, also involve more specific
instruments for achieving goals such as output growth, equity, small farm coverage, and
short-term credit.

 Some main instruments of state credit policy in developing countries are:

i. Low interest rate: one of the popular instruments of credit policy in developing
countries has been to subsidize the rate of interest on loans to farmers. Small
farmers are interest sensitives, so the only way is to lower interest rates.

ii. Credit targeting: the orientation of credit policy towards small farmers involves
extensive use of targeting devices. In more general credit schemes, the target group may be
defined according to various criteria such as farm area or family income.

32
Instruments of old credit policy…

iii. Loan portfolio regulations: governments to restrict the decision-making flexibility

of financial institutions or to try to enforce compliance with state objectives may use
various devices. The devices are ;
 First to set a minimum to the proportion of agricultural sector loans out of total loans;
 Second to stipulate maximum permissible loan sizes; and
 Third to place restrictions on the term structure of the loan portfolio, such that
the major proportion of total loans are short-term loans.

iv. Miscellaneous: governments can use many other instruments in order to try to
fulfil specified goals related to the provision of credit to farmers.

 Sometimes credit is provided in kind.

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 3. Defects of old credit policy
 The central components of the critique of credit policies in developing countries are:-

(i) Fungibility: the fungibility attribute of credit invalidates state targets and
regulations for credit delivery.

 Fungibility exists in all types of the credit system, from the farmer to the farmer financial
intermediary, and to the credit banks.

 At the farmer level, fungibility means that the household for quite different ends may use loans
targeted for specific purposes.

 At the lender level, it means that cheap funds can be substituted for own funds in the preferred
loan portfolio, usually biased towards low-risk established clients.

 At the central bank level, it means donor funds for rural credit schemes mean more foreign
exchange. While the credit itself may be channeled towards small farmers, thus satisfying donor
wishes, the extra foreign exchange may be used to buy non-agricultural goods and services.
34
Defects of old credit policy…
ii. Low interest rate: subsidized interest rates create several negative effects
for the long-run viability of rural financial institutions, as well as for
borrowers and savers in the following ways:

 First, there are many recorded instances, when the real rate of interest in credit schemes was
negative. The real rate of interest refers to the actual interest rate deflated by the annual rate
of inflation.

 Second, low interest to borrowers makes it impossible to offer attractive interest rates to
savers. Saver’s r < borrower’s r.
 Third, low interest rates may mean that it is impossible for the lending institution to
cover the transaction costs of making loans within the margin between the borrower
interest rate and the rate the lender must pay for securing funds from the central bank,
or from its own savers.
 Fourth, low interest rates cause an excess of demand over supply of credit, resulting in
formal or informal credit rationing.
35
Defects of old credit policy…

iii. Transaction costs: the goals and regulations of many subsidized,

target oriented, credit schemes cause a big rise in the transaction costs
of lenders, whether these are private or state institutions.

o Lending to large numbers of small borrowers costs more per unit of

money than lending to small numbers of big borrowers.

iv. Loan recovery: loan default is typically considered to be caused by

two main factors; these are inability to repay or unwillingness to repay.

o It may also be a function of the borrower‘s perception about the penalties of

not paying, especially in terms of getting future loans.
36
Defects of old credit policy…
v. Saving failure: since rural credit agencies fail to encourage rural saving,
they also fail to possess funds that can make them independent of central or
external funding.

 Thus they are also incapable of surviving as self-sustaining financial

institutions in the long term. There are many arguments about saving:-
o First, some credit schemes are entirely supply driven and envisage no role
for savings from outset;
o Second, even those credit institutions that are permitted savings deposits do
not encourage them because they are heavily orientated to external funds;
o Third, some formal credit institutions deliberately discourage saving by
imposing high transaction costs upon savers;
o Fourth, some credit agencies may try to encourage savings deposits but are
unsuccessful due to the unrealistic levels of interest they can offer.
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 2. New Credit Policy
1. Objectives and Instruments New Credit Policy

 The redefinition of the objectives, instruments, and institutions of credit

policy means neither that the small-farm or rural-poor orientation of policy needs
to be abandoned, nor that the state has no role in the fostering and regulation of
new initiatives.

 The most important attribute of a successful credit system is that;

 it should be self-sustaining in the long run,

 not reliant on ever increasing subsidies to cover losses, and

 not dependent forever on injections of external funds from foreign aid

donors.
38
 Objectives and Instruments of New Credit Policy…

 The critical new objective of credit policy is therefore the creation of a self-
sustaining rural financial system.
 The following three important points are relevant in changing the direction of
policy instruments:
1. Savings mobilization: the generation of funds from savers is considered a key
feature of self-sustaining credit institutions.
 First, a strong savings base reduces the reliance on external funding.
 Second, savers and borrowers are often the same people at different points in time in
the community, reducing the information costs of transactions.
 Third, people to an institution for both saving and borrowing are less likely to default on loans.

 Lastly, farmers with savings can often self-finance small outlays so that loans become oriented to
bigger outlays with lower transaction costs per unit of money.
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Objectives and Instruments of New Credit Policy…

2. Interest rate level: - a self-sustaining financial system requires an interest

rate on loans sufficient to cover:
The interest rate paid to savers
The average cost of making transaction
A risk margin to cover the probability of default

3. Loan recovery: Poor loan recovery amounts to giving borrowers a gift,

o Encourages the use of credit for non-productive purposes, and

o Promotes the idea that rural development is more about cash hand-outs ( a free gift
of money) than about improved productivity and outputs.
40
Loan recovery…

• There are various reasons for default that are unavoidable, or that
require more care at the inception of a credit scheme.

1. Natural calamities such as floods or drought can make repayment

impossible in the locations and seasons where they occur.

2. When credit is earmarked (specified) for crops or enterprises that

turn out to be non-viable either due to mistakes or due to other
state policies, then responsibility for credit failure lies less with
the borrower and more with the lending agencies.

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 New Credit Policy
 The changes of emphasis with respect to these instruments lead to changes in the
criteria by which the success or failure of a credit scheme may be measured.

 Success criteria from the new objectives and instruments are:

 The number of clients reached at both savers and borrowers, with the normal
expectation for a viable institution being many small savers and fewer, large,
borrowers,
 Declining transaction cost over time,
 reflecting expansion of services and successes in attracting new clients,
 Improved loan recovery,
 Total volume of savings achieved, and significance of savings in sources of
funds for onward lending.

42
 CHAPTER SIX:

UNCERTAINTY AND FARM DECISION MAKING

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 6.1. Risk and Uncertainty
• Farmers usually face situations in which the outcomes are uncertain.

• Nature has a significant impact on farming, and farming is inherently

linked to the path of nature. For example,
• It may not rain or it may rain too much.
• Crops can get damaged by insects or a disease.
• Animals may develop diseases and die.

 The markets affect farmers to a great degree as well.

 Prices are high when they have nothing to sell and that prices
are low when crop yields are high.

44
 Risk and Uncertainty…
• Farming takes place in an environment characterized by risk and
uncertainty.

• The pervasiveness of various kinds of uncertainty like;

Natural hazards,

Market failure, and

Improper state actions in peasant production has

important implications for economic analysis and for the
interpretation of its future prospects.

45
 Propositions and Arguments Surround Uncertainty
 Uncertainty:
o Results in sub-optimum economic decisions at the micro economic level
of the unit of production (absence of profit maximization)
o Results in unwillingness or slowness to adopt innovations [peasant
conservatism]
o Results in using various farming systems, like mixed cropping, which
represent successful adaptations to uncertainty by lowering its effects.
o More severe impact for poor than for better-off farm households,
implying that it reinforces social differentiation.
o Reduced by increasing market integration due to improved information,
communication, markets outlets, etc,

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 6.2. Definitions of Risk and Uncertainty
 The terms Risk and Uncertainty are not strictly interchangeable in the
economic context: risk has a rather precise meaning which is distinct
from the descriptive sense of uncertainty.

 RISK is restricted to situations where probabilities can be attached to

the occurrence of events which influence the outcome of a decision-
making process.
 Example: If drought occurs on average in two years out of five, the probability of a drought
risk occurring is 2/5 = 0.4 = 40%. In this context probability means the expected frequency
of occurrence of an event or a set of events, and it always expressed out of one.

 UNCERTAINTY refers to a situation where it is not possible to attach

probabilities to the occurrence of events. The likelihood of their
occurrence is neither known by the decision maker nor by anyone else.

47
Definitions of Risk and Uncertainty…
 This distinction between risk and uncertainty has changed in
economic literature.

 Its underlying basis is a notion of risk as an objective matter, i.e., it

assumes that provided enough information were available it should
always be possible to attach objective probabilities to the incidence
of events.

 Thus, is might be argued that historical patterns of rainfall are

known from weather station records permitting the calculation of an
objective probability for the incidence of drought.

 Current practice in economic analysis of risk is not based on this

notion objective risk.

48
Definitions of Risk and Uncertainty…
 What is relevant is not the likelihood of uncertain events, but rather
the decision maker‘s personal degree of belief about the occurrence
of events.

 Thus in the example of patterns of rainfall what is important is not

the known past average occurrence of drought, but rather the
farmer‘s personal view about the likelihood of drought.

 It is thus personal view which determines the course of action taken

by the farmer to cope with the incidence of drought.

 This changes the analysis of risk and uncertainty from an objective

to subjective matter

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 Difference Between Risk and Uncertainty
RISK
 Risk still refers to probabilities, but these are now
the subjective probabilities attached by farm
decision makers to the likelihood of occurrence
of different events.
 Analysis of risk involves not just 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.
 Variability of income is measurable
 Risk is objective in nature
 Risk is based on decision makers’ personal
degree of belief about the occurrence of event
 Risk can be included as component of cost
Uncertainty
 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
households, an environment 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
 Probability distribution of outcome cannot be
quantitatively established.
 Uncertainty is subjective in nature.
 It cannot be included as a component of cost.
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 6.2. Sources of Risk and Uncertainty
1. Production and technical risk

 Factor such as weather, diseases, insects, weeds, feed conversion,

and soil fertility which affect yield or output. These factors can not
be predicted accurately

 Technology change: production risk due to new technology

(unexpected performance in terms of yield or cost).
2. Marketing risk or price risk
 Price variability: annual, monthly, daily. Some price movements follow
seasonal or cyclical trends, which can be predicted, but even these
movements exhibit a great deal of volatility.
 Costs (input price). The cost of production pre unit of output depends
on both costs and yield and therefore can be highly variable
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Sources of Risk and Uncertainty…
3. Financial risk:

Uncertainty about :-
 Future interest rates if borrowed money is used to finance business.
 A lender’s willingness to continue lending at the levels needed now and
in the future
 Changes in market values of loan collateral,
 The ability of the business to generate the cash flows necessary for
debt payments.

4. Institutional and Legal risk: factors such as contracts regarding

purchases, land leases, changes in government programmes and
procedures and supply of farm inputs
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 6.3. Type of uncertainty
• Uncertainty is a condition which in 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 and other natural
factors on output, and the length of the production cycle.

The different types of uncertainty are:

1. Yield or output uncertainty
2. Price uncertainty
3. Social uncertainty
4. State actions and war

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Type of uncertainty…
1.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 (from cultivation to harvest). Combating pests and
diseases may depend on the ability to purchase relevant
cash inputs such as pesticides and herbicides.

 Natural hazards may also be described as yield or output

uncertainty.
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Type of uncertainty…
2. Price uncertainty

 The lengthy lag between the decision to plant crop or rear livestock
and the achievements of output means that market prices at point if
sale are unknown at the time decision are made.

 This is common to agriculture everywhere and is a major reason for

state intervention in agricultural markets in many countries.

 The problem is more severe where information is lacking and markets

are imperfect, features which are prevalent in developing country
agriculture systems.

 Market fluctuations may also be described as price uncertainty.

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Type of uncertainty…
3. Social uncertainty

• This refers to insecurity caused by differences of control over

resources within the agricultural sector and the dependence for survival
of some farm households on others through such devices as crop sharing
and usury.

• This occurs where there is unequal ownership of land in peasant rural

communities; it typically expresses itself in a high level of uncertainty
concerning land access for some households but not for others.

• It is more prevalent in some parts of the world than others.

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Type of uncertainty…
4. State Actions and War

 Peasant economies as a whole are susceptible to unforeseen changes in

decisions 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.

 Above all, the insecurity of refugee peasant families who typically

have very few social or legal rights in their countries of adoption.

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 6.5. Analysis of Risk Behavior
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 reference is often made in the context of farm production to risk as

the “income variance” which results from uncertain events.

– Variance is of course a concept of statistics which measures the average

deviation of a set of figures from their mean.

– Thus, risk in this approach is the probability of events occurring which

result in incomes above or below the average expected income in a succession
of crop seasons.
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Analysis of Risk Behavior…

 The second approach is to treat risk as the probability of disaster

that is to mean the probability that the variable outcome of certain
events will take on a value less than some critical minimum or disaster
level.

– This is closer to the dictionary definition of risk than the former approach,
and also accords with the normal idea of risk from the perspective of
insurance against loss or damage.

– 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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 A. Analysis of Risk based on Income Variance approach to risk

 The implications of risk for the neoclassical model of farm production

can be examined with the aid of figure 6.1.

 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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 Figure 6.1 Production Function Involving Risk : Income Variance approach

 The graph explores a risk situation involving

uncertainty in weather condition. Suppose that
two weather situations can occur:
 The weather may be good (adequate rainfall and
best crop yield)

 The weather may be bad (significant lack of

rainfall and poor crop yield)

• The graph contains alternative output response

curve to describe the outcome of these two events
(i.e., good and bad weather situations)

• As well as the farmer‘s subjective assessment of the

balance between according to the following
definitions:

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 Production Function Involving Risk : Income Variance approach…

 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) traces out 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 bad
seasons.

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 Example: Income Variance approach

 Assume that 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 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)

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 Example: Income Variance approach…

 In risk analysis TVP1 and TVP2 are described as

the outcomes of events or states of nature.
 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
response depicted by TVP2.
 The subjective probabilities attached by the
farmer to the occurrence of good and bad years
are p1 and p2.
 These Ps must sum to 1 since it shows two states
of nature, and one or other of these must occur.
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 Example: Income Variance approach…

 (TVP) is a weighted or average of these two

outcomes, TVP1 and TVP2, where the
weights are probabilities p1 and p2.
 With the inclusion of TFC (total factor cost)
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.
 This Figure 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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 Example: Income Variance approach…

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.

 This is because he/she prefers to take a chance at the

largest possible profit, even though it only has a
probability in the farmer ‘s mind of 0.60 of happening
than taking a safer position with less possibility of
incurring a large loss [where aa1> a1a2]

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 Example: Income Variance approach…

B. Input use X2
 This position is consistent with allocative
efficiency on TVP2.

 It means that if TVP1 occurs, a profit equal to

the vertical distance 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 in the farmer ‘s mind this only has a
probability of 0.4.

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 Example: Income Variance approach…

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.

 A farmer choosing to operate here is described

as risk-neutral.

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 B. Treat risk as the probability of disaster
 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. 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.

 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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 Treat risk as the Probability of disaster …
 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,
unless the probability of it falling below that level is very low indeed.

 The consequence of risk aversion for optimum resource use, whether as

a matter of choice or of survival, is illustrated in figure 6.2

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 Treat risk as the Probability of disaster …
Figure 6.2. Marginal Value Product Under Risk
 Economic rationality in the pure 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 MVP1 = MFC.

 This ensures that household consumption needs

are covered in all seasons, even though profit is
not being maximized except in bad seasons.

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 Decision Tree analysis

 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 in figure 6.1.

 The components of the decision theory approach can be

interpreted to give somewhat broader understanding on the
basic terms as follows:

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Decision Tree analysis…
Figure 6.3. Decision Tree analysis
Act: 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.
 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 the decision tree.
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 Decision Tree analysis…
Figure 6.3. Decision Tree analysis
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 which can occur.

 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 (a circle symbol) of each act.

 They are the same as the states underlying

TVP1 and TVP2 of figure 6.1.

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 Decision Tree analysis…
Figure 6.3. Decision Tree analysis
 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 and
these of course are the same as in
figure 6.1.
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 Decision Tree analysis…
Figure 6.3. Decision Tree analysis
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.
 In figure 6.3 these payoffs are shown down the right-hand
side of the decision tree and, as an example, will have the
following values:
 These payoffs correspond, respectively, to the gaps (vertical
distances) aa1, a1a2, cc2, and c1c2 in figure 6.1.
Profit of birr 2000 – Good weather
Act a1 =
Loss of birr 375 – Bad weather
Profit of birr 1300 – Good weather
Act a2 =
Profit of birr 300 – Bad weather
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 Decision Tree analysis…
Figure 6.3. Decision Tree analysis
 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:

i. Calculating the EMV [expected money

value] of the outcome of each node. In this
example the EMVs are

 Chance node A: 0.6 (2000) + 0.4 (-375) =

1050 EMV

 Chance node B: 0.6 (1300) + 0.4 (300) =

900 EMV

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 Decision Tree analysis…
ii. Obtain the Certainty equivalent (CE) net income for each act.
 The certainty equivalent (CE) is a guaranteed income that someone would accept now than the higher, but
uncertain return in the future. Or we can say it is the certain or the guaranteed cash that investor would
prefer instead of taking a risk for a larger amount than he may get in the future.
 For our example suppose that the certainty equivalent (CE) income for Act 1 (a1) is 850 and for Act 2(a2)
is 900.

iii.Reject the alternative which has the lower certainty equivalent. In the above example Act a1 is
eliminated (since 850< 900) and the farmer would maximize utility by choosing act a2.

 In summary the outcome of risk-averse decision-making is different from profit

maximization. The profit-maximizing alternative is Act a1 i.e., EMV is 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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 6.6. Policy Implications of risk
Alternative policy implications of risk-aversion may be grouped broadly
in line with the categories of hazard they are designed to overcome as
follows

1. Natural hazards

a) Irrigation: Perhaps the most obvious policy response to natural

uncertainty is that of irrigation as an answer to rainfall variability.
Irrigation can serve both

•(1) to alleviate the risk of drought between one season and the next, and

•(2) to smooth out within season fluctuations of water supply to plants.

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Irrigation…
 In addition, it can permit higher productivity cultivation practices,
such as multiple cropping in the same year, with a direct impact on the
volume of output and farm incomes.

 In this way irrigation is not only just for risk avoidance strategy; it
also has a major impact on output via its complementarity with multiple
cropping, increased fertilizer use, and improved seed.

 Irrigation does not of necessity requires state intervention, indeed a

great proportion of tube well irrigation takes the form of private
investment by individual farm households.

 However, large-scale irrigation schemes involving dams, canals, flood

control, etc. are infrastructural investments of a size which are
unlikely to attract private investment

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Natural hazards mitigation Mechanism/Policy…

b) Crop insurance: The most theoretically consistent and

comprehensive proposal for alleviating the adverse impact of natural
hazards is crop insurance.

 People pay risk premiums, representing the average social degree of risk
aversion, and are then protected against the incidence of uncertain events.

 However, insurance for crop production faces very difficult practical

problems.

 A major difficulty is posed by the fact that crop disasters tend to be

catastrophic over a wide areas, implying that a workable insurance
scheme would require the capacity to meet enormous fluctuation in
claims from one year to the next.

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Natural hazards mitigation Mechanism/Policy…

C) Resistant Varieties: More practical and relevant, because of the much lower
cost in relation to potential benefits, 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.

 Research station breeding of disease resistant strains may not be that much
more successful than traditional varieties, or agronomic practices, which
achieved the same ends in the past.

 Moreover, there may be sacrifices in palatability, storability etc. which are not
foreseen when new varieties are released.

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 2. Market risks mitigation Mechanism/Policy

a) Price stabilization: This may 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, under the market, prices rise in low yield years
(lack of supply) and fall in high yield years (oversupply), resulting in
some smoothing out of annual incomes.

 With stable prices this does not occur and income variation follows
yield variation.

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Market risks mitigation Mechanism/Policy…

b) Marketing information: Where risk-aversion is attributed to

inadequate information (about prices, about new seeds, etc.), 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.

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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THANK YOU!

Agricultural Economics 85