A COMPREHENSIVE ASSESSMENT OF THE ROLE OF RISK IN

U.S. AGRICULTURE

NATURAL RESOURCE MANAGEMENT AND POLICY

Editors: Ariel Dinar Rural Development Department The World Bank 1818 H Street, NW Washington, DC 20433

EDITORIAL STATEMENT

David Zilberman Dept. of Agricultural and Resource Economics

Univ. of California, Berkeley Berkeley, CA 94720

There is a growing awareness to the role that natural resources such as water, land, forests and environmental amenities play in our lives. There are many competing uses for natural resources, and society is challenged to manage them for improving social well being. Furthermore, there may be dire consequences to natural resources mismanagement. Renewable resources such as water, land and the environment are linked, and decisions made with regard to one may affect the others. Policy and management of natural resources now require interdisciplinary approach including natural and social sciences to correctly address our society preferences.

This series provides a collection of works containing most recent findings on economics, management and policy of renewable biological resources such as water, land, crop protection, sustainable agriculture, technology, and environmental health. It incorporates modern thinking and techniques of economics and management. Books in this series will incorporate knowledge and models of natural phenomena with economics and managerial decision frameworks to assess alternative options for managing natural resources and environment.

Agricultural producers are exposed to risk, both in terms of crop prices and crop yields, as a result of changing global institutions and global environment. Although agricultural policies in the U.S. and elsewhere shift continuously from income-support to risk-related help, the treatment of agricultural risk is not satisfactory at all. This book defines and critically evaluates the current state of the literature on economic risk in agriculture. The book sets a research agenda that is expected to meet future needs and prospects on agricultural production risk.

The Series Editors

Recently Published Books in the Series Casey, Frank, Schmitz, Andrew, Swinton, Scott, and Zilberman, David: Flexible Incentives for the Adoption of Environmental Technologies in Agriculture Feitelson, Bran and Haddad, Marwan Management of Shared Groundwater Resources: the Israeli-Palestinian Case with an International Perspective Wolf, Steven and Zilberman, David Knowledge Generation and Technical Change: Institutional Innovation in Agriculture Moss, Charles B., Rausser, Gordon C., Schmitz, Andrew, Taylor, Timothy G., and Zilberman, David Agricultural Globalization, Trade, and the Environment Haddadin, Munther J. Diplomacy on the Jordan: International Conflict and Negotiated Resolution Renzetti, Steven The Economics of Water Demands

A COMPREHENSIVE ASSESSMENT OF THE ROLE OF RISK IN

U.S. AGRICULTURE

edited by

Richard E. Just University of Maryland, College Park

and

Rulon D. Pope Brigham Young University

.... '

SPRINGER SCIENCE+BUSINESS MEDIA, LLC

ISBN 978-1-4419-4924-0 ISBN 978-1-4757-3583-3 (eBook) DOI 10.1007/978-1-4757-3583-3

l..A ' Electronic Services <http: I lwww. wkap. nl >

Library of Congress Cataloging-in-Publication Data

A CLP. Catalogue record for this book is available from the Library of Congress

Copyright © 2002 by Springer Science+Business Media New York Originally published by Kluwer Academic Publishers in 2002 Softcover reprint of the hardcover 1st edition 2002

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photo-copying, recording, or otherwise, without the prior written permission of the publisher, Springer Science+ Business Media, LLC.

Printed on acid-free paper.

Contents

List of Figures .............................................................................................................. ix

List of Tables ............................................................................................................... xi

Preface ....................................................................................................................... xiii

PART I BEHAVIOR UNDER RISK: GENERAL CONCEPTS AND THEIR SIGNIFICANCE FOR AGRICULTURE

Expected Utility as a Paradigm for Decision Making in Agriculture .................... 3 Jack Meyer

2 Non-Expected Utility: What Do the Anomalies Mean for .................................... 21 Risk in Agriculture? David E. Buschena

3 Ordering Risky Choices ....................................................................................... 41 Lindon J. Robison and Robert J. Myers

4 Conceptual Foundations of Expectations and ..................................................... 53 Implications for Estimation of Risk Behavior Richard E. Just and Gordon C. Rausser

5 Information, Processing Capacity, and ............................................................... 81 Judgment Bias in Risk Assessment David R. Just

PART II CONCEPTUAL ADAPTATIONS OF RISK MODELS FOR AGRICULTURE

6 Dual Approaches to State-Contingent Supply Response .................................... 105 Systems Under Price and Production Uncertainty Robert G. Chambers and John Quiggin

7 Can Indirect Approaches Represent Risk Behavior Adequately? ...................... 121 Rulon D. Pope and Atanu Saba

8 The Significance of Risk Under Incomplete Markets ......................................... 143 Jean-Paul Chavas and Zohra Bouamra-Mechemache

9 Contracts and Risk in Agriculture: Conceptual and .......................................... 167 Empirical Foundations Brent Hueth and David A. Hennessy

vi THE ROLE OF RISK IN AGRICULTURE

PART III ADEQUACY OF GENERAL METHODOLOGICAL APPROACHES FOR RISK ANALYSIS

10 Programming Methods for Risk-Efficient Choice .............................................. 193 C. Robert Taylor and Thomas P. Zacharias

11 The Econometrics of Risk ................................................................................... 213 Matthew T. Holt and Jean-Paul Chavas

12 Agriculture as a Managed Ecosystem: Implications for .................................... 243 Econometric Analysis of Production Risk John M. Antle and Susan M. Capalbo

13 Survey and Experimental Techniques As an ...................................................... 265 Approach for Agricultural Risk Analysis Brian Roe and Alan Randall

PART IV SOURCES AND CONSEQUENCES OF AGRICULTURAL RISK: HOW FARMERS MANAGE RISK

14 Modeling Price and Yield Risk. .......................................................................... 289 Barry K. Goodwin and Alan P. Ker

15 Agricultural Technology and Risk ..................................................................... 325 Michele C. Marra and Gerald A. Carlson

16 Quality and Grading Risk .................................................................................. 353 Ethan Ligon

17 Finance and Risk Bearing in Agriculture .......................................................... 3 71 Peter J. Barry

18 Does Liquidity Matter to Agricultural Production? .......................................... 391 Michael J. Roberts and Nigel Key

19 Precision Farming Technology and Risk Management .................................... .417 James A. Larson, Burton C. English, and Roland K. Roberts

PARTV POLICY ISSUES RELATING TO RISK IN AGRICULTURE

20 Crop Insurance As a Tool for Price and Yield Risk Management ..................... 445 Keith H. Coble and Thomas 0. Knight

CONTENTS vii

21 Risk Management and the Role of the Federal Government .............................. 469 Joseph W. Glauber and Keith J. Collins

22 Risk Created by Policy in Agriculture ............................................................... 489 Bruce L. Gardner

23 Risk Management and the Environment ............................................................ 511 Mark Metcalfe, David Sunding, and David Zilberman

PART VI CONCLUSIONS REGARDING THE SIGNIFICANCE OF RISK RESEARCH FOR AGRICULTURE

24 How Much Does Risk Really Matter to Farmers? ............................................. 537 Wesley N. Musser and George F. Patrick

25 Past Progress and Future Opportunities for Agricultural Risk Research ......... 557 Richard E. Just and Rulon D. Pope

INDEX 579

List of Figures

Probability Weighting Function

Properties 1-4 Illustrated

Property 5 Illustrated

Property 6 Illustrated

Agroecosystems Represented as Loosely or Closely Coupled Ecosystem and Economic Models

Decision Times (t,) and Intervals (8,)

Observed vs. Simulated Mean Land Use in Montana Dryland Grain Production, Risk-Neutral and Risk-Averse Models

Structure of an Econometric-Process Simulation Model and Linkages to Biophysical Simulation Models in a Closely Coupled Model of an Agroecosystem

Volatility Smiles: July Com and May Wheat

Simulated Yields, Prices, and Revenues

Mean Yield and Yield Variability Changes from Wheat Cultivars of Various Vintages

Diversity- Yield Frontiers, Actual and Recommended Cultivars

Predicted Adoption of Modem Varieties as a Function of Own and Neighbors' Asset Levels

The Relationship Between Farm Size and Technology Adoption: Theoretical and Empirical Evidence

The Investment/Disinvestment Decision with Uncertainty and Sunk Costs

Land Use and Profits: Concave Production

Land Use and Profits: Convex Production

Land Use and Profits: Lumpy Capital Investment

Actual and Predicted Wheat Yield: Cowley County, Kansas

27

127

127

128

245

246

258

261

307

318

332

333

334

341

344

398

399

399

401

X THE ROLE OF RISK IN AGRJCUL TURE

Estimated Yield Shocks and Lagged Yield Shocks: Cowley County

Real Wheat Price: Kansas

Log of Real Wheat Price: Kansas

Estimated Wheat Yield Shocks in Close-Together Counties

Estimated Yield Shocks in Farther-Apart Counties

County Map of Kansas

Summary of U.S. Crop Insurance Liability, Subsidy, and Loss Ratio, 1981-2000

Illustration of the Incentives to Purchase Crop Insurance

Farm Prices Received (Real), Milk and Hogs

Com and Soybean Prices Received by Farmers, Monthly, September 1973 - September 1999

Investment and Capital Stock in U.S. Agriculture

The Risk-Generation Process

Optimal Input Under Risk Aversion

Expected Returns-Risk Trade-Off

402

404

404

405

405

406

448

453

494

503

506

515

523

547

List of Tables

Variance Function Elasticities for Montana Dryland Grain 257 Production Based on Primal and Sequential Models

Simulations from a Mixture of Two Normals 295

Sources of Risk, Utility Formulation, and Evidence on 337 Marginal Risk Effects of Pest Control Inputs

Information and Grading Risk 367

Wheat Yields Unit Root Test: Cowley County, Kansas 403

Log Wheat Yields Unit Root Test: Cowley County, Kansas 403

Wheat Prices Unit Root Test: Kansas 403

Fixed Effects of Lagged Shocks on Plantings 406

Fixed Effects of Lagged Shocks on Residual ofLoess-Esimated Plantings 407

Summary of First-Stage Regressions 411

Summary of Group Mean-<1>11 Estimates from Second-Stage Regressions 412

Estimated Com Yield Response Functions for Applied 430 Nitrogen for Collins, Memphis, and Loring Soils

Optimal Nitrogen Application Rates, Yields, Net Revenues, 431 Certainty Equivalents, and Risk Premiums for Alternative Risk A version Criteria

Uniform Nitrogen Application Rate, Variable Nitrogen 432 Application Rate, Nitrogen Application Rate Difference, and Nitrogen Loss Difference for Alternative Risk-A version Decision Criteria and Field Scenarios

Net Revenue Difference and Percentage Change in the 434 Standard Deviation of Net Revenue for Alternative Variable Rate and Uniform Rate Risk-Aversion Decision Criteria and Field Scenarios

Differences in Certainty Equivalent Income for Variable Rate and Uniform Rate Application of Nitrogen Fertilizer on Com for Risk-Averse Decision Criteria

436

xii THE ROLE OF RISK IN AGRICULTURE

Differences in Certainty Equivalent Income for Variable Rate and Uniform Rate Application ofNitrogen Fertilizer on Com for Risk-Neutral Decision Criteria

Recent Legislative History of U.S. Federal Crop Insurance

Selected Works Representing the Major Veins of Crop Insurance Literature

Federal Crop Insurance Program

Premium Subsidy Rate - Multiple Peril Crop Insurance

Federal Costs of the Crop Insurance Program, 1981-99

Change in Com Market Price Due to Subsidization

Averages and Standard Deviations of Ratings of Importance of Highly Rated Sources of Risk for Top Farmer Crop Workshop Participants

Averages and Standard Deviations of Ratings of Importance of Risk Management Responses by Top Farmer Crop Workshop Participants

Human Resources Characteristics of Farmers with Sales of $100,000 or More in Indiana and Maryland

Numbers of Farms with Different Crops for Farms with Sales of $100,000 or More in Indiana and Maryland, 1997

437

447

455

475

480

481

484

541

542

543

544

Preface

This book has grown out of a request to us to co-chair the annual meetings of the Regional Agricultural Experiment Station Project SERA-IEG-31, which is an exchange group of the leading economists working on agricultural risk in the United States. It was inspired by the two papers that were presented at the annual meetings of this group last year, one which assessed the past twenty-five years of research on agricultural risk since that group was first formed by Professor Arne Hallam oflowa State University, and the other which assessed possibilities for the next twenty-five years of research on agricultural risk presented by Professor Richard Just of the University of Maryland. Feeling that the extent of those two papers could hardly be comprehensive in their efforts, the program for the March 22-24, 2001, meetings of SERA-IEG-31 was organized with the intent of preparing a thorough assessment of the importance of risk in agriculture and preparing from the proceedings a comprehensive reference book on the economics of agricultural risk. A great need exists for this kind of book because risk received relatively little treatment in the new Handbook of Agricultural Economics currently in preparation due to the wide class of issues it covers, and because there has been no comprehensive book on agricultural risk since the well-known book edited by James A. Roumasset, Jean-Marc Boussard, and lnderjit Singh on Risk and Uncertainty in Agricultural Development published in 1979, which had a clear emphasis on agriculture in developing countries.

This book is intended to (i) define the current state of the literature on agricultural risk research, (ii) provide a critical evaluation of economic risk research on U.S. agriculture to date, and (iii) set a research agenda that will meet future needs and prospects. This type of research promises to become of increasing importance because agricultural policy in the United States and elsewhere has decidedly shifted from explicit income support objectives to risk-related motivations of helping farmers deal with risk. Beginning with the 1996 Farm Bill, the primary set of policy instruments for U.S. agriculture shifted from target prices and set aside acreages to agricultural crop insurance. The related risk motivation is likely to be at the center of the upcoming farm bill debate, which will consider continuation or alteration of this dramatic legislation, as well as subsequent agricultural policy required under free trade agreements. Because this book is intended to have specific implications for U.S. agricultural policy, it has a decidedly domestic scope, but clearly many of the issues will have application abroad. Our hope is that this volume will inspire further research on agricultural risk and serve as a guide to where that work may be most productive. Our final thoughts along this line are offered in the concluding chapter.

xiv THE ROLE OF RISK IN AGRICULTURE

We wish to thank all those authors who have contributed excellent papers to this work and have gathered to discuss their contributions at the annual meetings of Regional Agricultural Experiment Station Project SERA-IEG-31. We thank collectively the discussants who provided the excellent critical discussions at those meetings, which have inspired further refinements in the papers, including the following: Brian D. Wright, University of California, Berkeley; Loren W. Tauer, Cornell University; Matthew T. Holt, North Carolina State University; Shiva Makki, Economic Research Service; Paul D. Mitchell, Texas A&M University; Meredith Soule, Economic Research Service; Bruce L. Ahrendsen, University of Arkansas; and Agapi Somwaru, Economic Research Service. We especially want to thank Ms. Liesl Koch of the University of Maryland who provided the excellent technical editing of this volume. Without her work the quality would be far from what it is.

Richard E. Just, University of Maryland Rulon D. Pope, Brigham Young University

July, 2001