LECTURE VII

RISK AND UNCERTAINTY

Risk and Uncertainty When a farmer embarks on any productive

activity he/she is uncertain of what the actual outcome will be.

Uncertainty has three main causes including: Environmental variations causing a production and

yield uncertainty Price variation causing market uncertainty Lack of information.

All of these are significant in African agriculture, where unreliable rains and pest and disease outbreaks cause wide variation in resource availability and in crop and livestock yields.

Risk and Uncertainty Human diseases are frequent, unpredictable

and costly to treat. Ill health or injury of a family member at a

critical period may cause serious loss of production and income.

Generally there are wide seasonal and unpredictable fluctuations in market prices, while information on alternative technologies or the market situation outside the immediate locality is often lacking.

Types of Risks

Risk is a measure of the effect of uncertainty on the decision-maker.

Common source of risk include Production and Technical Risks Price or Marketing Risks Financial Risks

Production and Technical Risks

Some types of manufacturing firms know that the use of a certain collection of inputs will always result in a fixed and known quantity of output.

This is not the case with most agricultural processes.

Crop and livestock yields are not known with certainty before harvest or final sale.

Production and Technical Risks

Weather, diseases, insects, weeds and infertile breeding livestock are examples of factors that cannot be accurately predicted and cause yield variability.

Even if the same quantity and quality of inputs are used every year, the above and other factors will cause yield variations that cannot be predicted at the time most input decisions must be made.

Production and Technical Risks Inputs such as seed and fertilizer must be

applied before the weather is known and regardless of the input level selected weather will affect the output level.

This creates uncertainty about the output that will be received for any input level as well as uncertainty about what input level to use.

This uncertainty is often further compounded by less than perfect knowledge about the true technical relationships in the production function.

Production and Technical Risks Combined with uncertainty about output

levels may be uncertainty about production costs.

Input prices have tended to be less variable than output prices but still represent another source of production risk.

The cost of production per unit of output depends on both costs and yield and therefore can be highly variable as both of these factors vary.

Production and Technical Risks

Another source of production risk is new technology.

There is always some risk involved when changing from an old and proven production technology, to new technology e.g. will the new technology perform as expected? Will it actually reduce costs and/or increase yields?

Most new technology has proven to be advantageous and farmers who are slow to adopt it often find themselves at a cost or yield disadvantage compared to those who were among the first to use it.

Price or Marketing Risk A major source of risk in agriculture is the

variability of output prices. While farmers may feel they have some

influence on yields through their decisions, prices are often beyond their control except possibly through some type of co-operative effort or government action.

Commodity prices vary from year to year and many have substantial seasonal variation within a year.

Price or Marketing Risk Much of the price risk would be eliminated if

the production process was very short as there would be less time for price changes between when the production decision were made and when the output was sold.

However, agricultural production decisions are generally made six months or more before harvest, allowing time for substantial changes in commodity prices.

Commodity prices change for a number of reasons, which are beyond the control of an individual farmer.

Price or Marketing Risk

The supply of a commodity is affected by production decisions made by many farmers and the resulting weather.

Demand for a commodity is a result of many factors including consumer incomes, exports and export policies, and the general economy, all of which can be affected directly or indirectly by government policies of many types.

Financial Risk

Financial risk is incurred when money is borrowed to finance the operation of the business.

One aspect of financial risk is explained by the principle of increasing risk. This Principles states that there is an

increasing risk of loosing equity due to a decline in income as borrowing, and the debt/equity ratio increases.

Financial Risk

Any time money is borrowed there is some chance that future income will not be sufficient to repay the debt without using equity capita.

This risk increases as a business increases its leverage and debt/equity ratio.

Financial Risk

In addition to uncertainty about the ability to repay loans without using the equity capital, financial risks include a number of other factors including: Level of future interest rates Lender’s willingness to continue lending at

the levels needed now and in the future, Market values of loan collateral and The ability of the business to generate

cash flow necessary for debt payments.

Risks

Production, marketing and financial risks exist on most farms & ranches and are interrelated.

The ability to repay debt depends on production levels and market prices received for the production.

Financing the production and temporary storage for commodities depends on the ability to borrow the necessary capital.

Methods of Reducing Risk

The reasons for reducing (managing) risk and uncertainty include:

To reduce the variability of income over time. This allows more accurate planning for

items such as debt payment, family living expenses, and business growth.

To ensure some minimum income level to meet family living expenses and other fixed expenses.

Methods of Reducing RiskTo reduce or minimize risk and

uncertainty for business survival. Several consecutive years of low income

may threaten business survival or result in bankruptcy.

Many managers rate business survival as their most important goal and would be willing to accept a lower expected income if it reduces income variability and hence the risk of business failure.

Methods of Reducing Risk The methods employed in reducing

(managing) risks and uncertainty include: Diversification Stable Enterprises Insurance Spreading Sales Hedging: Contract sales Government farm programmes Self-liquidating Loans Credit Reserve Net worth:

Diversification Many business firms diversify or produce

more than one product to avoid having their income totally dependent on the production and price of one product.

If profit from one product is poor, profit from producing and selling other products may prevent total profit from falling below acceptable levels.

In agriculture, diversifying by producing two or more commodities may reduce income variability if all prices and yields are not low or high at the same time.

Stable Enterprises Some agricultural enterprises have a history

of more stable income than others Dairy enterprises for example tend to have

relatively stable incomes. At the other extreme, cattle feeding for beef and

raising vegetables tend to have highly variable incomes.

Irrigation will provide more stable crop yields than dry land farming in areas where rainfall is marginal or highly variable during the growing season.

Production risk can therefore be reduced by careful selection of the enterprises to be included in the whole farm plan.

Insurance

This helps reduce production risk and/or financial risk.

Formal insurance can be obtained through an insurance company or the business could provide its own insurance (Self-insured).

This is where a business has some readily available or liquid financial reserves must be available in case of a loss.

InsuranceThe types of insurance that could be put

in place include: Life insurance Property insurance Liability Insurance Crop Hail insurance All risk crop insurance

Life insurance In case of the loss from untimely death

of the farm owner/manager or a member of the farm family.

The insurance proceeds can be used to Meet family living expenses Pay off existing debts Pay inheritance taxes Meet other expenses related to transferring

management and ownership of the business.

Property and Liability insurance

Property insurance Protects against the loss of buildings, machinery,

livestock and stored grain from fire, lightening, windstorm, theft,

Liability Insurance Protects the insured against lawsuits by third

parties for personal injury or property damage for which the insured and/or employees may be liable.

Liability claims on a farm may occur when livestock wander onto a road and cause an accident or when a third party is injured on the farm property.

Crop Hail and All risk crop insurance

Crop Hail insurance: This insurance makes payments only for crop

losses caused by hailstorms.

All risk crop insurance: Several levels of protection are available and are

based on the “normal yield” for the insured farm. This insurance provides protection against

essentially everything including neglect, poor management practices and theft, floods, drought, hail, early freeze and insect damage.

Spreading Sales Instead of selling the entire crop at one time,

the farmer/manager could sell part of the crop at several times during the year.

Spreading sales avoids selling the entire crop at the lowest price of the year but also prevents selling the entire crop at the highest price.

The result of spreading sales is an average price that is near the average annual price for the commodity.

Hedging

A market price can be established within a fairly narrow range by hedging on the commodity futures market.

Hedging is even possible before the crop is planted as well as during the growing season.

Livestock can also be hedged at the time of purchase or any time during the feeding period.

Hedging is a technical procedure that involves trading in commodity futures contracts through a commodity broker.

Contract sales

Producers of some speciality crops such as seed corn and vegetables often sign a contract with a buyer or processor before planting the crop.

The contract will usually specify some management practices to be followed as well as the price to be received for the crop.

A contract of this type removes the price risk, as the price is known at planting time.

It is also possible to obtain a price contract for many field crops and some types of livestock.

Contract sales

Many grain and livestock buyers will contract to purchase a given amount of these commodities at a set price for delivery in a later month.

These contracts are often available during the growing season as well as after the crop has been harvested and stored.

Contract sales remove price uncertainty but also prevent selling at a high price if prices rise later in the year.

Government farm programmes These programmes are always subject to

change but in the past have provided a way to guarantee a minimum price for certain commodities.

Participation in the programme may require setting aside or idling a percentage of the crop acres in exchange for some type of price guarantee.

This guarantee or minimum price may be determined by a target price, support price, loan price, or some combination depending on the commodity and the current farm programme.

Self-liquidating Loans

There are loans that can be paid off out of the gross income from the loan collateral e.g. loans for the purchase of feeder livestock and crop production loans.

Credit Reserve

Many farmers do not borrow up to a limit imposed on them by the lender.

This unused credit or credit reserve means additional loan funds can be obtained in the event of some unfavourable outcome.

This technique does not directly reduce risk but provides a safety margin.

Net worth

In the final analysis, it is the net worth of the business that provides the solvency, some of the liquidity and much of the available credit.

Therefore net worth should be steadily increased particularly during the early years of the business.

Choice under Risk In practice the farmer’s choice is likely to be

influenced by probabilities of occurrence of the different states of nature.

But given the complexity of the real world, decision-makers may not be aware of the possible states of nature and/or possible strategies.

It is even less likely that they can estimate probabilities of all states of nature and rank alternatives so as to find an optimum.

Thus it might be concluded that most people are sub-optimizers or satisficers, guided by fairly crude “rules of thumb”.

Choice under RiskWhatever the case it can be concluded

that Risk aversion has a cost in terms of

income foregone on average. Some activities are more risky than others

and may therefore be avoided. Diversification reduces risk provided that

the component activities are not strongly positively correlated.

Choice under Risk

Risk aversion may explain Why farmers are reluctant to adopt new

crop varieties with high but variable yields Why they prefer to grow subsistence crops

even when food may be purchased more cheaply

Why they practice mixed-cropping and Why they pursue many on- and off-farm

activities