How do Farmers Make Risky Choices?
A variety of paradigms have been proposed to explain how individuals make risky choices. The predominant theory used by economists is the expected utility hypothesis (EUH). Given a set of alternatives (e.g., which crop to plant or how much fertilizer to apply), EUH asserts that individuals will choose the alternative with the highest expected utility. The distinct components that make up expected utility are 1) the possible outcomes, 2) the value or utility of possible outcomes, and 3) the probability of possible outcomes. Specifically, expected utility is the sum over all possible outcomes of the value of an outcome weighted by its probability (see Dillon 1971 for a more complete, yet still accessible treatment).
While EUH has been the predominant theory used by economists to explain the risky choices, it is not without critics. These critics have proposed a variety of alternative paradigms of which only a few have been applied to evaluating the risk attitudes and risky choices of poor farmers in the developing world.
One set of alternatives to EUH that emphasize the importance of subsistence requirements are referred to as safety first models. For example, Roy’s safety first model hypothesizes that an individual chooses to minimize the likelihood of income falling below some threshold or subsistence level (Roy 1952). Alternatively, Kataoka’s safety first model hypothesizes that individuals maximize income subject to some low probability of income falling below subsistence (Kataoka 1963). While these models have been around for more than 50 years and are particularly compelling in the context of poor farmers, their application has been limited.
Another alternative to EUH that emerged in the late 1970’s is prospect theory (Kahneman and Tversky 1979). Prospect theory and the more recent cumulative prospect theory (Tversky and Kahneman 1992) emerged as alternatives to EUH due to several regularities that were observed in psychological and economic experiments on risky choice that could not be explained by EUH. These regularities include (i) risk averse behavior over likely gains, (ii) risk preferring behavior over unlikely gains, (iii) risk averse behavior over unlikely losses, and (iv) risk preferring behavior over likely losses (Tversky and Kahneman 1992). To accommodate such behavior, prospect theory and the subsequent cumulative prospect theory modify EUH in several important ways. First, individuals are assumed to have a reference outcome, which in the context of poor farmers in the developing world, might be subsistence income. Outcomes are assumed to be framed in relation to this reference point such that outcomes above it reflected gains, while outcomes below it reflected losses. Second, individuals are assumed to have risk averse attitudes toward gains, but risk preferring attitudes toward losses. Third, individuals are assumed to exhibit loss aversion meaning that they are more sensitive to losses than they are to gains. Finally, individuals are assumed to overweight the likelihood of low and underweight the likelihood of high probability outcomes when summing the weighted value of all possible outcomes. While it is clear that safety first models will not supplant EUH as the predominant theory for interpreting the risky choices of farmers in the developing world, recent and successful applications of prospect and cumulative prospect theory suggest that the predominance of EUH may be diminishing.
References
Dillon, J.L. 1971. An Expository Review of Bernoullian Decision Theory in Agriculture: Is Utility Futility? Review of Marketing and Agricultural Economics 39(1):3-80.
Kahneman, D. and A. Tversky. 1979. Prospect Theory: An Analysis of Decision under Risk. Econometrica 47:263-91. Kataoka, S. 1963. A Stochastic Programming Model. Econometrica 31:181-96.
Roy, A. D. 1952. Safety-first and the Holding of Assets. Econometrica 20(3):431–449.
Tversky, A. and D. Kahneman. 1992. Advances in Prospect-Theory - Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty 5(4):297-323.
