⚠️ Risk and Uncertainty

Decision under Risk and Uncertainty

• Farmers must make decisions on crops to be planted, seeding rates, fertilizer levels and other input levels early in the cropping season. The crop yield obtained as a result of these decisions will not be known with certainty for several months or even several years in the case of perennial crops. Changes in weather, prices and other factors between the time the decision is made and the final outcome is known can make previously good decision very bad.
• Because of time lag in agricultural production and our inability to predict the future accurately, there are varying amounts of risk and uncertainty in all farm management decisions. If everything was known with certainty, decision would be relatively easy. However, in the real world more successful manager are the ones with the ability to make the best possible decisions, and courage to make them when surrounded by risk and uncertainty.

Definition of risk and uncertainty

• Risk is a situation where all possible outcomes are known for a given management decision and the probability associated with each possible outcome is also known.
• Risk refers to variability or outcomes which are measurable in an empirical or quantitative manner.
• Risk is insurable.
• Uncertainty exists when one or both of two situations exist for a management decision. Either all possible outcomes are unknown, the probability of the outcomes is unknown or nether the outcomes nor the probabilities are known.
• Uncertainty refers to future events where the parameters of probability distribution (mean yield or price, the variance, range or dispersion and the skew and kurtosis) cannot be determined empirically.
• Uncertainty is not insurable.

Sources of risk and uncertainty

Production risk

• Crop and livestock yields are not with certainty before harvest or final sale weather, diseases, insects, weeds are examples of factors which cannot be accurately predicted and cause yield variability.
• Even if the same quantity and quality of inputs are used every year, these and other factors will cause yield variations which cannot be predicted at the time most input decision must be made.
• The yield variations are examples of production risk. 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. Therefore, cost of production is highly variable as both input prices and yield vary.

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.

Price or Marketing risk

• Variability of output prices is another source of risk. Commodity prices vary from year to year and may have substantial seasonal variation within a year.
• Commodity prices change for number of reasons which are beyond the control of individual farmer.

Financial risk

• Financial risk is incurred when money is borrowed to finance the operation of farm business. There is some chance that future income will not be sufficient to repay the debt. Changes may take place in the interest rates, scale of finance, and ability of the business to generate income.

Method of Reducing Risk and Uncertainty

• Diversification: Production of two or more commodities on the farm may reduce income variability if all prices and yields are not low or high at the same time.
• Stable enterprises: Irrigation will provide more stable crop yields than dry land farming. Production risk can be reduced by careful selection of the enterprises with low yield variability. This is particularly important in areas of low rainfall and unstable climate.
• Crop and livestock insurance: For phenomena, which can be insured, possible magnitude of loss is lessened through converting the chance of large loss into certain cost.
• Flexibility: Diversification is mainly a method of preventing large losses. Flexibility is a method of preventing the sacrifice of large gains. Flexibility allows for changing plans as time passes, additional information is obtained and ability to predict the future improves.
• Spreading sales: Instead of selling the entire crop output at one time, farmers prefer to sell part of the output at several times during the year. Spreading sales avoids selling all the crop output at the lowest price of the year but also prevents selling at the highest price.
• Hedging: It is a technical procedure that involves trading in a commodity futures contracts through a commodity broker.
• Contract sales: Producers of some specialty crops like gherkins, vegetables often sign a contract with a buyer or processor before planting season. A contract of this type removes the price risk at planting time.
• Minimum support price: The government purchases the farm commodity from the farmers if the market price falls below the support price.
• Net worth: It is the net worth of the business that provides the solvency, liquidity and much of the available credit.