The presence of risks in agriculture influences farm production and investment choices in several ways, including:
i. The specific mix of commodities farmers produce and the inputs used to produce these commodities.
ii. Strategies to manage and cope with risk.
iii. Dynamic or investment impacts when the resolution of uncertainty results in a negative impact on farm incomes.
The nature of the first two impacts on farm businesses depends principally on the attitude of farmers toward risk. In general, farmers may be risk-averse (i.e., they dislike riskier outcomes), risk-loving (prefer riskier outcomes), or risk-neutral.
However, studies within the agricultural sector have found that farmers tend to be risk-averse (OECD 2008), preferring outcomes that are more certain, although larger farms are relatively less risk-averse.
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Effects of Risk on Production
Of all the risk categories discussed in previous articles, price and production risks tend to influence farm production decisions most directly. In the absence of instruments for managing risks, economic analysis of production under uncertainty often suggests that farmers will base their choices on some “expected outcome” (e.g., expected yield or price).
Risk-averse producers tend to prefer “low-risk and low-return” outcomes at the expense of higher payoffs that are more uncertain. In practice, this means that producers may choose low-risk production technologies and low-risk crops at the expense of innovation and riskier choices that potentially offer higher returns.
This generally leads to lower average income and lower levels of economic efficiency, as resources may not be directed toward the most profitable farm enterprises.
This may be reflected in a reluctance of farmers to adopt new production techniques and technologies that may improve farm efficiency and profitability but result in some (perceived) increase in the variability of returns.
Where support policies reduce income variability, either through direct payments or indirectly through, for example, market price support, farmers may be more willing to undertake riskier activities, effectively maintaining the riskiness of their portfolio.
It is important to highlight that it is not only the risk that output prices will be lower than expected (“downside” risk) that affects economic efficiency.
Higher-than-expected prices (“upside” risk) also have implications for economic efficiency, as a profit-maximizing farmer would choose to produce more of a particular commodity at a higher price (assuming input costs and prices of other commodities are unchanged), reallocating resources toward the more profitable enterprise.
On-Farm Risk Management Strategies and Efficiency
There are several mechanisms for reducing or managing risks. However, agricultural producers may implement on-farm strategies to manage risk. Diversification of farm business income is one of the on-farm strategies of risk management.
Diversification of this type redirects investment and labor time away from the farm toward off-farm activities, especially those generating income not strongly correlated with on-farm business income. To the extent that such diversification competes for resources (e.g., labor time and capital) with agricultural production, it may reduce agricultural production or capacity.
Diversification can also occur at the farm business level. In this case, rather than specializing in enterprises that give the highest rate of return, the farm business is diversified to include other enterprises where returns are not positively correlated or that are less risky.
However, this will result in lower average income and lower economic efficiency, as resources are not directed toward the most profitable farm enterprises.
In the face of increasing trade liberalization, farmers may experience conflicting pressures arising from the need to specialize activities to exploit production efficiencies and maintain competitiveness while ensuring that risk exposure is minimized through on- and off-farm diversification.
However, where risks can be managed efficiently and effectively through market-based risk management, businesses will be more able to specialize while mitigating the level of risk faced.
Impacts on Investment
While there are several risk management options available to farmers, these often only provide partial protection for potential losses.
Where the remaining risk exposure causes returns and farm income to vary, and this variation is uncertain, it can make it difficult for farm businesses to plan long-term investment.
For example, volatility in output prices can make it more difficult for farmers to identify trends in prices, which is often a basis for making long-term investment decisions.
In the presence of such volatility, the level of investment by risk-averse producers is likely to be lower than in a risk-free environment, which in turn has negative impacts on long-term productive capacity in agriculture.
In addition, where unexpected shocks result in significant income losses, this can constrain future farm investments. This is largely a product of inefficient credit markets; otherwise, farm businesses should be able to borrow to smooth their income for any fluctuations.
The impacts of risk on investment described above account for how levels of input use, output, and investment in agriculture may fall below optimal levels in a production environment characterized by risk or uncertainty.
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Effect of Risk on Welfare of Producers
Risk has a negative effect on welfare. Under the situation of isolated markets, there is a negative correlation between the individual’s own production and the market price. The expected profit will be lower under uncertainty than under certainty.
This is because a year of bumper harvest for an individual farmer corresponds with a year of bumper harvest for most other farmers, thus resulting in a fall in the local market price.
Since the producer receives a low price whenever output is high and a higher price when output is low, for average production, the farmer receives a price lower than the average price. This implies that risk affects even the welfare of risk-neutral farmers.
Farm households can raise their agricultural output, earnings, and productivity by:
i. Increasing land under cultivation.
ii. Applying more purchased inputs.
iii. Hiring more labor and equipment.
iv. Switching from subsistence to higher-value cash crops.
v. Selling a greater proportion of crop yield.
However, these methods expose them to more risks since output or market prices may fall below expected levels. The farm household decision in such a situation will depend on its assessment of the risks involved and its capacity to withstand the losses should the outcome turn out bad.
In this article, it has been established that risks impinge on the welfare of farmers by reducing productivity and efficiency, as well as net returns to farmers.
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