CHAPTER SEVEN

7. UNCERTAINTY AND FARM DECISION MAKING

Risk is a situation in which all possible outcomes (results) of an activity are not certain (not
known), but the probabilities of alternative outcomes (results) are known or can be estimated.
The probability may be estimation based on past experience or data. Example, if a farmer know
that his maize crop is likely to fail in one of the four years of consecutive production period by
25% then this is a risk because even if he doesn’t know the exact year he is expecting failure in
one the four years of production period.
Uncertainty is a situation where all possible outcomes and the probability of the outcomes are
unknown or neither the outcome nor the probability is known. Uncertainty is not insurable. It is a
situation where an action has got a set of possible outcomes the probability of which is
completely unknown. For example, no one can assign probability to how many times he will fall
sick within a year. Farmer normally calculates his labor requirements on the ground that his
workers will be healthy throughout the year and that each labor will supply at least eight working
hours per day. Similarly, no one can precisely predict when he is going to die. Farm manager
may project his activity for the whole year and he may not reach the end of that year before he
dies. Any situation where one cannot predict what can happen is normally regarded as uncertain
situation.
Profit maximization as a goal: Profit maximization is usually assumed to be the overriding goal
of management. However, this assumption has two shortcomings: it fails to account for the
timing of earnings, and risk and uncertainty. Although the terms "risk" and "uncertainty" are
frequently used interchangeably, there is a classical distinction between them. Both define a
situation in which a number of outcomes are possible. Risk describes a situation in which these
outcomes follow a known probability distribution, while uncertainty refers to cases where the
probabilities of different outcomes are unknown.
Types and source of risk agriculture
The more common sources of risk can be summarized into the general types as: production risk,
marketing risk, financial risk and technological risk.
Production or yield risk: refers to the unpredictable impact of climate, crop and livestock
diseases and pests, and other natural and manmade calamities on outcome (output).

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Price or marketing risk: are risk associated with the variability of output of price and its effect
on the farm income. Commodity prices vary from year to year and may have substantial seasonal
variation within a year.
Financial risk: a risk incurred when money is borrowed to finance the operation of the business.
That is, any time money is borrowed there is some chance that future income will not be
sufficient to repay the debt without using equity capital. Financial risk determines how much
capital should be acquired. Financial mangers really have only two basic capital sources: their
own equity capital and non-equity capital. However, the use of non-equity capital creates a fixed
financial commitment in the form of principal, interest, rent, or other obligations. This
commitment to the supplier of non-equity capital results in financial risk. As leverage, the
amount of non-equity capital relative to equity capital, increases, the financial commitment
increases, so that the risk increases also.
Technological risk: Another source of production risk is new technology. Will the new
technology perform as expected? Will it actually reduce costs and increase yields? These
questions must be answered before adopting new technology.
Business risk is the variation in net earnings arising from the nature of the kinds of enterprises in
which the firm is engaged, including weather, disease, and price changes. The profit
maximization rule, which compares mean or average returns, could be used to select superior
projects with more profit, while standard deviation is used to select projects with less risk. A
project with higher return and low risk can be considered as a profitable project. However, the
choice is largely subjective depending on personal preference for risk versus returns as well as
on financial ability to carry the greater degree of risk involved.

7.1 Type and Sources of Uncertainty

There are different types of uncertainties which arise when the producer commits his resources to
production in the present and then waits for the outcome till sometime in the future: These are:
A) Yield uncertainty: refers to uncertainty related to the output level of the products from
agriculture. Since agricultural activities are highly influenced by nature (weather
condition), it is not possible to guess the output for certain product. The degree of
uncertainty may differ from product to product, crop to crop, on season to season or place

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 to place. Therefore, it is not possible to exactly produce the output level as determined by
the principles of resource allocation.
B) Price uncertainty: refers to change in price due to either one or all of the following
factors:
 Actions of farmers’ cooperatives against price
 Change in the total supply of agricultural products in the market
 Discontinuous production cycles etc (Seasonality of the business/production)
C) Tenure Uncertainty: refers to the uncertain ownership of land by tenants. If they did not
own their agricultural land by themselves i.e. if they are provided the land by someone
else (for example, the government), they will not be encouraged to make some type of
long-term investment or improvement or development on the land to increase their
productivity.
D) Uncertainty related to the prices or qualities of inputs: again there is uncertainty with
regard to the prices of inputs in the factor market and the qualities of such inputs.
If this is so it is not possible to produce again the decided level of output for the selected
product at the estimated cost and then be in equilibrium.
E) Political Uncertainty: refers to the uncertain political condition in a country. Example,
political instability of the country to perform economic activities related to agriculture,
change in government policies related to land reforms.
F) Personal Uncertainty - refers to the uncertainty about the welfare of farmer’s family –
for example, the health or productivity of farmer’s family.
G) People’s Uncertainty- refers to the relationships of the farmer with persons he deals with
like laborers, bankers, landowners etc.
7.2 Measures to Deal with Uncertainty
A. Measures at Farm level
Price and yield uncertainty have an important bearing on the decisions taken by farmers in regard
to the conduct of the farm business. They take the following important measures to reduce the
uncertainty even though the measures may involve some cost.
a. Diversification: means that the farmer carries on several farm products simultaneously in
order to avoid the dangers of having all his eggs in one basket. This implies that even in a
situation where the marginal rate of product transformation and the expected price-ratios

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 suggest production of only a few products, the farmer, as a precaution against
uncertainty, doesn’t do so and instead, diversifies his production by producing several
products. Because if he loses the price or yield of some, he will get from the other
products. But this is true as long as the correlations between prices and yields of different
products are negative. i.e., if they move in opposite direction. If prices or yield
correlations are positive, the method cannot reduce uncertainty or income variability.
b. Flexibility: means that the farming system is so arranged that the farmer can move out of
one product in to another without much cost if economic conditions make this shift
desirable. It involves the avoidance of rigid production method or production pattern.
Flexibility may be in terms of:
 Product i.e. product flexibility -– to shift among two or more types of products.
 Time i.e. time flexibility -– to shift the amount of different activities in different times.
 Cost/factor i.e. cost or factor flexibility -– to shift among different types of factors of
productions by considering their cost.
Compared to diversification, flexibility is not intended to prevent the happening of the uncertain
event. It is a method only to reduce the impact of such an event. The former, on the other hand,
in some cases, also prevents the occurrence of the uncertain event itself, e.g. production or
drought or disease resistant crops. However, both methods work against specialization in
product.
c. Liquidity: refers to a condition where the farmer holds a reasonable proportion of his
assets in the form of near money or money. This enable the farmer to either produce more
by purchasing resources if the prices of his products go up or to abstain from selling his
products till their prices go up if they go down.
In general, the above three measures result in a pattern of resource use which is less efficient and
therefore less profitable when compared with the general condition given above. As such the
resultant input structure does not ensure a minimum cost of production and the resultant output
mix does not ensure the maximum revenue as given by the principles of resource allocation
(factor-factor relationship and product-product relationship, respectively).
d. Capital Rationing: is a general term which means a restricted flow of capital to an
enterprise even when the return to it is quite high. Capital rationing may be.

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  Internal capital rationing: the farmer invests a sufficient amount of his own resources to
ensure equality of marginal return to the amount invested with its marginal cost.
 External capital rationing: means that private money lenders and financial institutions
are reluctant to advance loans to the farmer on account of uncertainty.
In short, capital rationing is not a method of reducing uncertainty rather a method that avoids
uncertainty by running away from the uncertain thing/event.
e. Contract Farming: involves contractual agreements in money terms between the farmer,
manufacturing firms and input suppliers – this is to guarantee the farmer a certain price
for a given grade of product at a given time.
f. Choice of Reliable Products: the farmers should produce those products whose yield
variability or uncertainty is less, for example, cereal crops instead of root crops.
g. Stick to Traditional Crops: the farmers have to rely on those crops which they know
well instead of on new innovative crops in order to avoid yield uncertainty.
h. Discontinuing for risk: this implies that the farmers use insufficient inputs and produces
at less than the optimum level of output – this is, in order to reduce losses under
unfavorable circumstances. Smaller production will reduce the losses if the situation turns
out to be unfavorable.
i. Maintaining Reserves: refers to maintenance of extra multipurpose equipment and labor
forces larger than what is normally necessary to meet some types of uncertainty for
example floods.
B. Possible Measures by Government
 Guaranteed Agricultural Prices: involves enactment of legislation giving the farmer
more or less prices guarantee of the price level or the minimum price he may expect some
time ahead.
 Buffer Stock Scheme: refers to the purchase of stocks of agricultural commodities in
years of bumper crops and unloads them into the market in years of crop shortages with a
view to raising price in times of glut and lowering them in times of shortage. It brings
about greater regularity in the year-to-year availability of crops and at the same time
promotes rational economic decisions on the part of farmers by reducing price
uncertainty.

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  Crop Insurance: refers to the chance of reducing uncertainty (especially yield
uncertainty) by incurring insurance premium or cost. Crop insurance can be:
 Insurance for specific crops
 Insurance for all crops taken together
 Voluntary crop insurance, or
 Compulsion crop insurance
7.3 Decision Making under Uncertainty
The primary objective of a farm business may be profit maximization. However, profit
maximization is associated with a variety of risks involved in every business. While we are
planning to maximize our returns from a farm business activity, we are planning to face risk and
uncertainty. How can we measure risk and uncertainty in agriculture? What are the major
decision rules applicable to select an optimal portfolio of enterprises?
The major problem of agricultural investment is the high variability in returns associated with
various factors and constraints prevalent in the sector. It is also difficult to measure the risk
associated with the environment and individual enterprises.
Risk can be defined in terms of variability of returns. It is the potential for variability in returns.
Risk refers to the chance that some unfavorable event will occur. An investment whose returns
are stable is considered a low-risk investment, whereas an investment whose returns fluctuate
significantly is considered to be a high-risk investment. The measures of profitability and risk
can be used in two cases of analyses.
A. On a stand-alone basis, where the enterprise is considered in isolation to estimate the
expected return and risk involved in a single business; and
B. On portfolio basis, where the enterprise is held as one of a number of enterprises in a
portfolio to select among alternative enterprises or investments.
In financial management, the profit maximization goal can be modified to account for the fact
that decision makers actually consider both expected return and risk. The financial manager is
assumed to have a goal of maximizing the utility of the owner of the business, where utility is a
function of both risk and expected returns. In this case, utility is the capacity of the business to
satisfy the profit wants of the owner, i.e., maximum return and minimum risk. It is generally
assumed that the manager prefers a higher return to a lower value. It is also assumed that the
manager is risk-avert in which case lower amount of risk is preferred.

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In uncertain environment where there are a number of possible outcomes, each with a probability
of occurrence, the producer seeks to minimize risk. The objective would be to maximize
expected utility. The production decision rule depends on the farmer’s attitude towards risk.
Rationality in pure neoclassical sense demand that the producer should operate at the point where
E(MVP)=MFC. That is the expected marginal value product of the factor should equal the price
of the input. This is the profit maximizing position taking good years with bad ones over a long
period of season. The risk averse farmer operates at the position where MVP 1=MFC which
means MVPE>MFC. This implies that the household profit is not maximized though consumer
needs are covered except in bad season.
Output

1 E2 E MFC

E (MVP)

1 MVP

0 X1 XE Input X
Fig 7.1 utility maximization of risk averse peasant

But this does not mean that peasants are irrational in making decisions. Rather the objective
of peasants in such uncertain environment in agriculture would be to minimize risk. This
minimization of risk maximizes expected utility. The theory of expected utility states that in a
condition of uncertainty, individuals maximize their expected utility not expected income
and should not be blamed if income/profit is not maximized at equilibrium.

A risk-averse individual maximizes expected utility E (U), given the belief about events and
outcomes. At the core of decision theory is a concept called certainty equivalence. This is
what enables less and more risky alternatives to be compared and placed in a scale of
personal preferences by the decision maker. It refers to the amount that would make us just
as happy, or indifferent, to taking the chance on two widely differing outcomes.

7.4 Mechanisms of Mitigating risk and uncertainty

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1. Risk-Averse Peasant
Prefers a lower level of certain income to a higher level of risky income [IA < EMV] (where IA
is certain income and EMV is risky income) which yields the same utility or happiness. She or he
is prepared to forgo EMV [Yc] - IA [Yr] = r (known as risk/insurance premium) in order to
achieve certainty. Risk premium is the amount of income required to make the individual
indifferent between a risky outcome and a certain outcome. If the value for r is positive, it means
the individual is risk aversive. If it is negative, it means the individual is risk loving. If it is zero,
it means the individual is risk neutral. The income that results from the expected utility is known
as certainty equivalent.
The utility function shows diminishing marginal utility of income.
E.g. U (w) =w1/2 Utility

Utility I
−1/ 2
MU = 1/2W
EMV
r

0
Yc Yr
Income

Figure 7.2: Certain income (IA) and risky income (EMV) of a risk averse peasant
2. Drudgery-Averse Peasant (Peasants as consumers and producers)
The theories of peasant farm household behavior examined so far, profit-maximizing and risk
aversion, take no account of the consumption side of peasant decision making. The fact here is
the peasant is both a household and a business concern. The dual character of the peasant
household family and enterprise, consumer and producer are stated to be the most important
aspect of the definition of the peasant. Moreover, there exists the situation that the interaction of
consumption and production within the household causes a unique form of decision making
which sets peasants apart from any other kind of production unit under capitalism.
A central consideration in the construction of more complete theories of household behavior is to
achieve a more accurate representation of the multiple goals, and the impact these have on the
response of the household to changing circumstances. In the profit maximization theory, there is

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a single goal, and economic responses are predictable provided that the assumptions of the
theory are roughly made. In the risk-averse theory, this single goal is modified but not
abandoned and responses are predictable subject to the impact on them of subjective response to
uncertainty. In the full household theory, the pursuit of various different goals in consumption
may result in variable or unpredictable response to different kinds of economic and social
changes. Hence the major aim of this theory is to clarify as far as possible the links between
goals, actions and the outcomes of such actions.
The theory of drudgery-averse peasant is related to the Chayanov model which emphasizes the
influence of family size and structure on household economic behavior via the subjective
valuation of labor within the household. This theory has crucial implications for the concept of
peasant household production which go beyond the mere mechanics of its working as a
microeconomic model.
In the consumption side, equilibrium is determined as follows.

Leisure At point E, slope of IC = slope of BL

0 BL Income
Figure 7.3: Household’s utility
In the production side, the Chayanov farm household model is used. It refers to a theory of
household utility maximization which focuses especially on the subjective decision making by
the household with respect to the amount of family labor to commit to farm production in order
to satisfy its consumption needs. It involves a tradeoff between the drudgery or irksomeness of
farm work (disutility of work) and the income required to meet the consumption needs of the
household (utility of income). In this model, the household has two opposing objectives, namely:
 An income objective which requires work on the farm and
 A work avoidance objective – which conflicts with the income generation

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The main factor influencing the tradeoff between leisure and income (work) is the size of the
peasant household and its composition between working and non-working members i.e. the
demographic structure of the household. This factor is summarized by the ratio of consumers to
workers. For example, if a household consists of 2 adults with no children its c/w ratio is 1:1 but
two adults with an elderly peasant and four children say two of which each makes half an adult’s
work contribution would have a c/w ratio of 7/3.

output/income
output/income

A
TVP
Ye
d
I1
I dH
Ymi Ymi

0 L
L Lma

Leisure days

Labor days(H)

Figure 7.4: Chayanov model of peasant household behavior

The predictive power of the model almost entirely rests on its demographic structure. This
implies that the model is a demographic model of household decision making. The following
points are the key assumptions of the model as microeconomic theory of peasant household
model.
 There is no market for labor (neither hiring of labor by the household nor wage work by
family workers outside the household). In effect, this means that there is subjective rate
which depends on the demographic structure of the household, but there is no
objective/market determined wage rate.
 Farm output may be retained for home consumption or sold in the market and is valued at
market price.

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  All peasant households have flexible access to land for cultivation.
 Each peasant community has a social norm for the minimum acceptable consumption
level.

The central elements of the Chayanov model or theory of peasant household behavior is
depicted graphically fig 7.4. The gross output of the peasant farm which equals gross farm
income is measured on the vertical axis. The farm income is expressed in money terms due to
the presence of output market. The horizontal axis measures the total labor time available to
the household, which is determined by its number of workers. This total time can be
allocated either to farm work or other activities like leisure. The number of days committed
to farm work is measured from left to right, OL, and the number of days engaged in other
pursuits (activities) is measured from right to left, LO. The model comprises both the
production and consumption aspects of household decision making. The production aspect is
handled by a production function describing the response of output to varying levels of labor
input. This production function (TVP) curve displays the property of DMRL. In this model,
the TVP curve can be described as a family income curve i.e. Y= Pyf (L). This means the
total income of the family is a function of only market price of the output and the labor input.
The above farm production function does not capture the flexible access to land which is an
important part of Chayanov theory. The impact of flexible access to land makes a difference on
the onset of diminishing returns as labor use increases since extra labor is combined with
additional rather than fixed land. In other words, the production function may have a linear
(constant marginal returns) or non–linear portion before diminishing returns sets in.
In general, the equilibrium point is found at the point of tangency of the indifference curve to the
total value product curve where utility is maximized subject to a given output, a socially
desirable minimum level of income and the maximum available labor within the household.
i.e., Max U = f (H, Y)
St. Y = f (L, Y) Ymin and L Lmax

3. The Share Cropping Peasant Theory

Share cropping is a type of land tenancy in which the payment for the use of the land, the rent, is
a percentage of the total physical output obtained in the crop season. Since this proportion is

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fixed in advance, the absolute quantity of rent varies with the level of harvest. Share cropping
has tended to be as interesting theoretical puzzle by neoclassical economists and as an oppressive
form of exploitation by some Marxian economists. The link between these two angles on share
cropping – the economic riddle and the exploitation – is founding the concept of
interlocked/interlinked factor markets. This refers to the lack of independence (lack of arm’s
length prices) between different input markets when multiple transactions are tied together in a
single tenancy contract.
Models of Share Cropping Peasant
There are two opposing competitive models of share cropping peasant, one which views
production behavior from view point of the tenant, the other from the view point of the land lord.
a) The Tenant model
In this approach the share tenant is taken to be a profit maximizing in a competitive market
subject to the output shares being fixed in advance. Assume that the share going of the landlord
is “r” percent. The amount left to the tenant would be 1-r percent. The economic position of the
share tenant is shown in fig 7.5 in comparison to the land owner.
Total output in monetary terms is given by TVPo. The amount left to the tenant is given by (1-r)
TVPo. The tenant maximizes profit at point Et where she/he employees OLt units of labor and
get 0Yt level of income which results in lower profit AEt compared to EoD which would be
gained if the tenant has used TVPo. The use of the variable input, labor is at sub-optimal and
share cropping is said to be inefficient. At point Et, profit is maximum by the condition set as
(1r) MVP=W. While it is MVP=W for the equilibrium condition at point Eo.
Output

Yo
Eo

A TVPo

TFC
Yt
Et
D TVPt = (1-r)TVPo
C
12
 0 Lt Lo labor
input
Figure 7.5: Profit maximization of a tenant in a competitive market
This model is based on assumptions of:
 The tenant is free to choose the level of labor input supplied.
 The same results occur for all variable inputs.
 The economic waste of the share cropping tenant is given by the area AEB (see fig 7.6)
but incurred by the land lord.
 Land is assumed to be gained at zero cost. The rent on land is paid as part of the share
that goes to the land owner.
 The tenant gets higher income and the land lord gets lower income than would be the
case the land lord used wage labor or leased out the land for fixed cash rent. The gain for
the tenant or the loss for the land lord is equivalent to FGA.

Output MVP
E
G (1-r) MVP

F A B Wage line

0 Lt Lo Labor input

Figure 7.6: MVP and MC curves show gain and loss of a tenant
b) The land owner model
In this model, the land owner is a profit maximizing who can vary the amount of land at his/her
disposal, decide the number and size of land parcels distributed amongst share tenants, decide the
rent share, and stipulate in the share contract and the amount of tenant labor input which is
required. The only constraint on the land owner is the market wage. Since the land owner sets the

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labor input of the tenant, profit maximization ensures that this occurs where the MVP = W i.e.,
point B in the figure above. Farther, the landowner will adjust the number of tenancies, tenancy
size, and the share rate so that the implicit rent per unit land is equal to the marginal product of
land. With both these conditions satisfied share cropping becomes efficient. In effect, this model
turns the landlord in to a capitalist farmer. However, the model is criticized on the following
backgrounds:
 It places the landowner in the position of a monopolist who can offer all or nothing
choice of prospective tenants.
 It is thought unlikely that the individual land owner could use the share proportion as a
variable in seeking efficient land use.
 The notion that the land owner can stipulate the labor intensity of the tenant is open to
doubt. It assumes a zero enforcement cost to monitoring the labor process on the tenant
farm.

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