Chapter 7: Risk and Uncertainty

Difference Between Risk and Uncertainty

RISK
1. Variability of income is measurable

2. Risk is objective in nature

3. Risk can be included as component of cost

Uncertainty
I. Probability distribution of outcome cannot be
quantitatively established.

II. Uncertainty is subjective in nature.

III. It cannot be included as a component of cost.

 Classification of Risks
Pure vs Speculative risks
• Pure risks exists when there is uncertainty as to
whether loss will occur.

• It is the situation where there is no possibility of

gain, only potential loss.

• Speculative risk exists when the is uncertainty about

an event that could produce either profit or loss.
Subjective vs Objective Risks

• Subjective risks refers to the mental state of

individuals who experience doubt or worry as to the
outcome of the given event.

• Objective risks differs from subjective risk because it

is more observable and measurable.
 The World Bank Classification of Risk
• WB classify risks in six different types:
• Natural, health, social, economic, political and
environmental.
• All these risks affect farmers in some ways.
• Particularly natural (rainfall, landslides, floods,
droughts...).
• Most risks eventually take the form of economic risk
that affects the stream of income, consumption and
wealth.
 Source of Risk in Agriculture
• There are two types of risks in agriculture:
a). Major sources of risk
• Drought, flood, insects- pests, plant disease, frost,
cattle epidemic, and sudden fall in the price if farm
products.
b). Minor sources of risks
(i). Risk due to technical cause such as defective seed
breakdown of machinery, death of oxen, delay in
transport of perishable farm products.
(ii). Risk due to special hazards such as labor trick on
farm, theft, robbery, fire etc.
Types of Agricultural Risks
Production risks:
Natural calamities such as Drought and Flood
Pest and disease outbreak
Management failure
Post-harvest issues (storage/ transport/ processing/
marketing)
Technological change
Market ( Price) risks:
Volatility in output price
Variability in input price
Exchange rate volatility

7
Types of Agricultural Risks…
• Regulatory/ Institutional risk:

Agriculture policies
Regulatory risk
Crop substitution
Infrastructure risk
Political risk
Food safety and environmental regulation
• Ecological risks (climate change, management of
natural resources such as water).
 Characteristics of Risks

• Risks are often characterized by their frequency, in terms

of probability of occurring, intensity, and in terms of the
magnitude of the loss.
Idiosyncratic risk
• An individual risk that is independent or uncorrelated
with any other risk.

• But typically a risk has some degree of correlation with

other risks.
 Characteristics of Risks…
• Systematic risks. If there is a high degree of correlation
among individuals in the same region or country.

• Systematic risks are related to events that repeat over time

with a pattern of probabilities that can be analyzed in
order to have a good estimate.

• Non-systematic risks are characterized by very short or

imperfect records of their occurrence.

• There is difficulties in estimating an objective pattern of

probabilities or distribution of outcomes of non-systematic
risks.
b). Statistical Probability of Outcomes

• Statistical probability of outcome can be determined

on the basis of observation.

• Example: Mortality table of cattle insurance company

which can predict the statistical probability of death
of cattle with certain degree of certainty.

• To the owner of a cow, the probability of loss is

uncertain. This could happen as a regular percentage
and can be computed on the basis of law of averages
by insurance company.
Risk Management
 Risk Management
• Risk management is the process that attempts to manage the
uncertainty that influences the achievement of objectives.

• Risk management attempts to identify risks and take appropriate

action to diminish their impending effects on an organization/
individual.
• Managing risk is an important part of farming and its management
is a concern for those governments which include risk as one of
their agricultural policy objectives.

• Risk management should be analyzed as a system in which there

is interaction between many elements.
 Risk Management…
• These elements have been organized around three
axes: the sources of risk, farmers’ strategies and
government policies.

• A number of issues and concepts are crucial to the

understanding of these interactions and must be
discussed from all three axes.

• Because a linear analysis dealing with only a specific

source of risk, a specific farmer’s strategy, or a
specific policy measure is likely to lead to inefficient
policy choices.
 Risk management process
1. Set objective.

• The first step is to clearly state the objective to be achieved.

• The objective can involve a financial, customer, internal

process.

2. Identify risk.

• Identify internal and external risks that form a threat to the

object.
3. Asses impact
• To be able to assess the impact of each of the identified
events.
• This can be done in either or both a qualitative or
quantitative way. Example PSM impact analysis.
4. Prioritize risks
• Prioritization of risks is done by comparing individual
risks. This can be done in several ways.

• The expected value method, which ranks risks

according to the product of a risk’s probability and
impact, and plotting risks on a risk matrix, which offers
a visual aid to compare risks.
5.Respond to risks
• When risks have gone through the prioritizing step, an
appropriate risk response is applied to deal with the risk.
• Possible risk responses include treat ( reduce consequences
and dangers) transfer (e.g. Insurance), terminate and
tolerate (adaptation measures).

6. Monitor risks
• After selecting an appropriate risk response, the risk should
be monitored to ensure it will not become a threat again.

• This step in the risk management process serves as a

monitoring and feedback moment and closes the cycle of
risk management.
More Concrete Risk Management Strategies
• Prevention strategies to reduce the probability of
an adverse event occurring.

• Mitigation strategies to reduce the potential

impact of an adverse event.

• Coping strategies to relieve the impact of the

risky event once it has occurred.
 Stages of Risk Management
• Risk management is part of a broader risk governance
framework that typically includes at least four stages:
• Risk assessment: refers to a systematic processing of
available information to identify the frequency and
magnitude of specific events.
• Risk evaluation: consists of fixing priorities and defining
some risks.
• Risk management: is the system of measures taken by
individuals and organizations that contribute to reducing,
controlling and regulating risks.

• Risk communication. refers exchange and sharing of

information about risk between decision makers and other
stakeholders.
 Level of Risk Management
• Risk management strategies start with decisions on the farm and
the household: on the set of outputs to be produced, the allocation
of land, the use of other inputs and techniques, including irrigation
and the diversification of activities on and off-farm.

• Farmers can also manage risk through market instruments which

include insurance and futures markets.

• However, not all risks are insurable through markets. Why?

• The main reasons for non-insurability are being the systemic

nature, the lack of information on probabilities and information
asymmetry with respect to those probabilities.

• It is therefore useful to segment all risks into three different layers

according to the instruments most appropriate or available.
 Level of Risk Management…
1. Micro/Mild Risks: Risks that are frequent but do
not imply large losses are typically managed on the
farm.
2. Catastrophic risk: Risks that are infrequent but
generate a large amount of damage to farm income
are likely to fall under the catastrophic risk layer, for
which market failure is more likely.
3. Intermediate risks: Risks that fall between these
two layers there for which some insurance or
market solutions can be developed.
 It is important to allow solutions to each type of
layer.
 Level of Risk Management…

• Micro or idiosyncratic risk that affects the individual

• Meso-risk affecting a whole community

• Macro or systemic risk affecting a whole region or

country
 Level of Risk Management…
• In order to manage risk in an optimal manner, we need to
understand how farmers think about it, recognize and feelings
the risk.

• Their behavior are determined by psychological factors,

social, cultural and political influences.

• Enterprise diversification, vertical integration, contracting,

hedging, liquidity, crop yield insurance, and household
.
off-farm employment or investment are some options of
managing the risks the farmers face.
 Factors influencing Decision Making
Demographic and socioeconomic factors
• Demographic and socioeconomic factors such as
age, sex and income status influence on risk taking
behavior of agents.
• Research finding show a positive correlation
between being more risk seeking and
• Being male
• Being older
• Being married
• Being professionally employed
• Having more education
• Having more business knowledge
• Having higher economic expectations
 Decision Theory

• Decision theory is the part of probability theory that

is concerned with calculating the consequences of
uncertain decisions.
• This can be applied to state the objectivity of a choice
and to optimize decisions.

There are several aspects of decision theory

• Risk appetite
• Risk attitude
• Expected value
• Expected utility
 Risk appetite and risk attitude
• The risk appetite is the amount of risk, on a broad level, an
entity is willing to accept in pursuit of value.
• A rational person should take calculated risk.

• Another term that is associated with this is risk attitude,

which describes the tendency to risk averse, risk seeking or
risk neutral behavior.

• In other words, risk appetite relates to taking risks in a broad

sense and risk attitude relates to making a risky decision.

• Risk attitude can be expressed in a quantitative manner by

use of risk appetite, which reflects risk taking behavior.
 Risk appetite…
• A decision maker is indifferent when the expected
value of both options are identical.

• If EVc is the expected value of the certain option to

obtain amount x and EVr is the expected value of the
risky option that involves a gamble,

• Then for EVc>EVr, the agent is risk seeking

• EVc<EVr for the agent is risk averse

• For EVc=EVr the agent is risk neutral

 Risk Preference
• Individuals differ in comfort with uncertainty based
on circumstances and preferences.
• Risk averse individuals will pay “risk premiums” to
avoid uncertainty.

– Risk averse fear loss and seek sureness

– Risk neutral are indifferent to uncertainty
– Risk lovers/risk-taker or risk-seeker, hope to “win
big” and don’t mind losing as much.
Expected value
• The expected value can be used to assess the risk attitude of the
agent.
• When two options equally attractive to the agent, then he will be in
indifference.

• However, calculating the expected value of the two choices, using

the well known general definition of expected value, EV= 𝛴 ni=1 рiχi.

• where expected value EV is the sum of all products of an option

with n possible outcomes with possibility p and consequence x for
every possible outcome.

• It can be shown that the certain and uncertain choice should not be
equally attractive.
 The Utility Theory
• When individuals are faced with uncertainty they make
choices as is they are maximizing a given criterion: the
expected utility.

• Expected utility is a measure of the individual's

implicit preference, for each policy in the risk
environment.

• It is represented by a numerical value associated with

each monetary gain or loss in order to indicate the
utility of these monetary values to the decision-maker.
Expected utility
• In the world of economics, utility is used as a
measurement of satisfaction.

• This can also be used in decision theory.

• The expected utility of an outcome, with consequence

x and probability p, is calculated by multiplying the
probability and the utility of the consequence, so that
EU(р, χ)= р*U(χ)
• This definition of expected utility can be used to
evaluate differences between a certain and a risky
option.
The DOSPERT Concept

• This is the concept which states that if one is prone to

risky behavior in one area, such as gambling, one is
likely to show risky behavior in other areas as well,
such as sports and health.

• DOSPERT (Domain-Specific Risk-Taking) offers a

psychometric scale that assesses risk perception in
five content domains, including financial, health and
safety, recreational, ethical and social decisions.
Uncertainty
 Uncertainty
• A farmer or farm manager faces situation of uncertainty
in agriculture when the probability associated with the
outcome of a production process are unknown.

• All possible outcomes are unknowns and farmers or

farm managers remain completely in dark.

• Hence uncertainty requires that at least the probabilities

are not known.
 Uncertainty…
• The term uncertainty is used to include all
circumstances in which decision is required to be
made without perfect knowledge of future event.

• In uncertainty there is no way to predict the

probability distribution of outcome and only the
anticipation of future can be made.

• In order to make the analysis, it is often assumed that

the word ‘risk’ and ‘uncertainty’ are interchangeably
used without any clear cut distinction between the
two.
 Types of Uncertainty
• Knowledge on several types of uncertainty are
important for producers to formulate a plan and
devise course of action for production.
• There are four types of uncertainties in agriculture
1. Price Uncertainty
2. Yield Uncertainty
3. Technical/Technological Uncertainty
4. Institutional/ Policy Uncertainty
1. Price uncertainty
• Individual farmer has no control over prices to be
received.
• It depends on actions of other producers, degree of
probability, changes in consumer taste, etc.

• The price of the output is typically not known at the

time the production decisions are taken.

• Inelastic demand is often cited as a main explanation

for agricultural price variability.
 Sources of Price uncertainty
• Price variability and uncertainty arise in agriculture
particularly from:
1. Fluctuation in national income and prosperity.
2. Recurring commodity cycle/discontinuous production cycle.
3. Random disturbances caused by weather fluctuations.
4. External and internal policy shocks

• Example: suppose the of price of fuel increases by x

%:
 Would transport cost increase?
 Would supply of corn decrease/increase?
 Would GDP decrease/increase
 Government role
• The potential contribution of governments to risk management
could be summarized:
1) Ensuring a stable macroeconomic and business environment, with
competitive markets and clear regulations.
2) Facilitating access to market-based instruments such as insurance
systems.
3) Providing specific measures to help farmers reduce their risk
exposure or deal with the consequences of adverse events.
Example, EIA.

 The latter group of measures is considered here as risk-related as

they impact directly to reduce price, yield or income variability,
or to smooth consumption following an adverse event.
 2. Yield Uncertainty
• Yield/production uncertainty: The amount and quality of the
output that will result from a given bundle of production decisions
are not known with certainty.

• Uncontrolled elements such as weather conditions play a

fundamental role in agricultural production.

• It refers to variation in production coefficients for a given technique.

• This types of uncertainty is more pronounced in agriculture than
non-farm industry.

• The farm mangers faces complex task of formulating farm plans for
use of resources.

• He must estimate plans in terms of yield as well as uncertain prices.

 3. Technical/technological Uncertainty
• This is more common in non-farm industries.

• Technological change may cause variability which in

turn give rise uncertainty in both agricultural and on-
agricultural industries.

• A new discovery of a product by a rival firm may

decrease the demand for the product of the second firm.
• Research and development efforts are typically not
made at the farm level but at the input supplier firm
level.
 4. Institutional/Policy Uncertainty
• Uncertainty is also created by sociological and legal
framework in which farmers are run.

• Decline of employment give rise to uncertainty for

industrial firms but are important in agriculture.

• Economic policies that affect agriculture as any other

sector (taxes, interest rates, exchange rates…).

• Agriculture is typically characterized by an intricate

system of government interventions, changes which
may create risk for agricultural investment.
Steps/percussion to Minimize Risk and Uncertainty
 Percussion to Minimize Risk
• A farmer can adopt one or all of the following three
measures for survival.

a) Measures may be to reduce availability in income.

b) Measures may be adopted to prevent profit from

falling below some minimum level.

c) Measures may be adopted to increase the ability of

farm to face unfavorable economic situation.
1. Selection of products and production process
with low variability
• This is done on the bases of past experience.
• The products or enterprises which have shown small
variability in past, should be selected.
• Enterprises which have shown greatest fluctuations
in the past should be considered most risky and
uncertain.
• Production methods or resource combinations
should be selected which have effect of stabilizing
income or minimizing the probability of variable
returns.
 Suppose there are three enterprises
Income variability Dairy Piggeries Poultry

Variance 300 1150 415

Range 56 141 62

Coefficient of variation 14 24 19

Maximum loss 13 26 15

Minimum gains 57 110 62

The farmers which interested in stabilizing income would like to
select first dairy, then poultry enterprise over piggeries.

By doing so, he would forego the possibilities of getting big gains

in some years; he would also minimize the possibility of large
losses in other years.
2.Formal Insurance and risk management
• Individual level and System level

• Individual level insurance includes

• Diversification
• Sale of assets
• Raising debts
System level Insurance are:
– Crop insurance
– Income insurance
– Weather/ rainfall insurance

• Insurance is generally adopted to reduce income variability or

minimize the probability to fall income below some minimum level.

• This is adopted so that business may not collapse due to lack of

capital in the initial stage.
• Two types of errors are involved in insurance
a) If damage does not take place, the insurance premium is
sacrificed.
b) If farmer does not insure and damage to enterprises takes
place, the value of enterprise is sacrificed.

• Insurance is not available to cover loss due to

uncertainties that arise in agriculture.

• The uncertainties that arise due to price cannot be reduced

through formal insurance contracts.

• Similarly, large variations in yield due to drought, insects,

pests, forest and other natural hazards cannot be
eliminated through insurance.
 Management of Property and Casualty Risk

• Use Insurance
– Self-insurance: farm assets cover the loss
– Market insurance: insurance company covers the
loss in exchange for an annual pre-paid premium

• First Principle of Insurance:

– Premiums of the many pay the losses of the few.
 Crop Insurance
• A means of protecting the farmers against
uncertainties of crop yields arising out of natural
factors beyond their control.

• Compensation is paid to the farmers when the actual

average yield of an area of a particular crop is less
than the guaranteed yield.

• It is an important technique of protecting farmers

against risk in crop production and stabilizing farm
income.
Date: College of Agricultural Banking, RBI, PUNE 50
 Crop Insurance - concepts

• What is the basis of coverage ?

• Individual basis/ area basis
• Data availability

• Which crops are covered ?

• All crops or some crops
• Who is eligible for coverage ?
• Loanee/ non-loanee farmers
• What type of risk is covered ?
• Natural calamity and other risks

Date: College of Agricultural Banking, RBI, PUNE 51

 Crop Insurance – concepts…
• How is the threshold yield determined ?
• Based on past performance
• How is the premium determined?
• Actuarial method? Or arbitrary determination?
• Whether premium subsidy is available?
• For small and marginal farmers
• Who is the implementing agency

Date: College of Agricultural Banking, RBI, PUNE 52

 Commodity-specific insurance products
• Wheat insurance
• Mango insurance
• Potato insurance
• Grapes insurance
• Coconut insurance
• Rubber insurance
• Coffee insurance
 Crop insurance as Risk Management
1) It protects farmers against failure of crops and stabilizes
their income.
2) It improves the credit worthiness of farmers in obtaining
the loan from credit agency.
3) It provides confidence to farmers in adopting modern
agricultural technology involving higher expenditure on
modern inputs and greater risk due to weather
conditions and attack of insects, pests and diseases.
4) It reduces the responsibility of government to provide
relief in case of failure of crops.
3. Forward Contracts and Risk Management

• Through forward contacts, future prices of products and inputs

can be reduced to certainly.
• Forward contact can be made in terms of money or kind.
Contracts in money.
• Forward contacts in money can be made by farmers for e.g. in
case of vegetable crops, fruit crops etc. produces can contract
with forward market by selling in future.

• The forward contract and future contract differ in the sense that
in the case of forward contract an agreement for actual physical
delivery is made.

• But ordinarily in case of future contract, physical delivery is not

Contract in kind
• This is another means of reducing income uncertainty
in the situations where contacts in money have
opposite effect.
• Contacts in kind can be adopted to reduce the effect of
both price and production variability.

• Forward contracts are more effective in reducing

uncertainty and possible range of outcomes in cases of
products with stable yields.

• They increase the level of possible loss and decrease

the size of possible profit when yield and production
are highly unstable.
 4. Diversification of Production (Selection of Multiple Products)

The Principle of Diversification

• Diversification of production across space and crops.

– Don’t put all your crops into one area (if possible)
– Don’t plant only one crop
– Raise both crops and livestock
 Diversification…
• The purpose of diversification is that if returns from
one product is low, the return from other product will
compensate the loss and protect the farmer from great
economic loss.
Diversification can be made in two ways

i. The amount of resources can be increased.

ii. The amount of resources is held constant but part

of them can be shifted to other products.
 Diversification…
• A farmer under subsistence economy follows diversified farming as a
precaution against risk and uncertainty.

• Under specialized farming one lean year may be sufficient to damage

the farmer financially.

• Taking of more than one enterprise is needed in order to utilize

resources in a situation of higher uncertainty.

• Livestock enterprise is must without which it is difficult to carry on

farm operations and get dairy products.

• The crop and livestock enterprises allow fuller utilization of farm

resources.
• Both mixed farming and mixed cropping are more effective in reducing
variability of farm production.
 Diversification…
• Income variability through diversification can be
reduced only if prices or yield of products bear proper
correlation.

• If correlation coefficients between two enterprises is

+1, the two products need not reduce variability.

• If correlation coefficients between two enterprises is -1

the two products are helpful in reducing income
uncertainty.

• A zero correlation coefficients is preferable to greater

correlation coefficients.
 Diversification…
• Diversification may be helpful and employed as a
method of handling two aspects of income variability.

1. Variability of income over entire operating period of

the farmer/producer.

2. Minimizing income variability in single year.

 5. Flexibility as Risk Management
• Flexible farm plan allows a farmer to transfer his
resources from one enterprise to another enterprise and
to derive higher profit if there is possibility to rise in the
price of the product.

• The production of short duration crops like vegetables,

cereals and pulses represent flexible plan.

• For e.g. if market condition is unfavorable for wool

production, sheep can be sold for meat.

• Flexibility allows change in farm plan as time passes,

additional information are obtained and possibility to
predict future improves.
 Differences…
Flexibility
• Flexibility allows both to reduce income
variability from one year to next year and
increase total return.

• Diversification is mainly a method of

preventing large losses. It is a rigid plan.

• Flexibility also allows quick changes (large

gains) at a lower cost sacrifice than a rigid.
 Flexibility can be of three types
1. Time flexibility
• Time flexibility can be introduced in production plan either through
selection of products or selection of production process.

• Annual crops such as corn are more flexible than perennial crops
(such as fruits).

• In general, a resource of short duration nature provides greater time

flexibility.

• Durable nature resource(such as machinery and equipments) have low

time felexibiltiy.

• Time flexibility is important to many farmers for e.g. a new entrant

farmer would be interested in growing such crops which generate
income quickly.
Cost flexibility
• Cost flexibility is more important where possibility of time
flexibility is limited.

• Cost flexibility refers to change in output within the structure

of long duration nature of plant.

• Cost flexibility may be selected to make adjustment in the

level of physical output.

• It makes possible for increasing output at lower cost with a

given size of plant under the situation of favorable prices.

• Similarly, it also make possible for increasing output at lower

cost when product price goes down.
Cost flexibility …

• Incorporation of cost flexibility into plant allows

minimum cost for output which fluctuates between
years.

• The farm operator can select a production function

which involves high fixed cost but gives initially a
high marginal product (MP) for variable factors.

• He may also select a production function which

involves a low fixed cost and gives initially low MP
of variable factors .
 Cost flexibility …
•If output to be produced is 200 then inflexible production function
(TCI) gives lower cost.

For small output, the flexible production function (TC F) gives

lowest cost.

•For larger output, flexible production function (TC F) hives lower

cost than the inflexible plant (TCI).

•When output varies regularly between 100 and 300 units the
flexible production function allows minimum cost for output level
of 200.

• If output is to remain constant at 200 units, the inflexible plant

would be most desirable as it gives lower cost as compared to
flexible production function.
Product flexibility
• The purpose of product flexibility is adoption of a
production pattern which allows to change in
production according to changes occurring in prices.

• For example, dual purpose breed of cows are preferred

over single purpose cows.

• Raising of sheep breeds which produce more wool

when prices of wool go high as compared to sheep
meat.
Liquidity
• Liquidity represents a flexible resource. Farmers must
maintain some money to stand against emergencies
such as failure of crops, loss of bullock or milch
animals or other calamities occurring in farming.

• Under these situations, cash provides security to

farmers as it is a method to safe guard against
damages of economic shocks.

• It is characterized by cash, bank deposits and unused

borrowings.
 Futures Contract/Exchange
Are agreements for buying and selling of goods, in which is agreed
before a particular future time at which the good will be provided.
Platform for buying & selling of standardized futures contracts of
various commodities.
Advantages
No credit risk
No delivery risk
Governed and regulated by Own Rules, Regulations, Bye-laws
In Different countries forward Markets Commission serve as
Regulatory Body the of the future agreement.
 Futures contracts…
For the seller of commodities:

• Has acquired the obligation to sell the underlying commodity at the

current price.

• He will profit if the market price of the commodity declines before the
future date.

For the buyer of commodities:

• Has acquired the obligation to buy the underlying commodity at the

current price.

• He will profit if the market price of the commodity goes up.

 Settling Futures Contracts
• Futures contracts can be closed by taking/making
delivery of the goods described in the contract.

• All contracts carry a compulsory delivery clause in

case contract remains open till expiration.

• Less than 2% of futures contracts are settled with

actual physical delivery.
 Functions of Futures Market
Price discovery

• An expression of the consensus of today’s expectations about the price

at some point in the future.

• The market disseminates in a transparent manner the likely future price

of a commodity.
Mitigating price risk

• Purchase in the futures market by those hedging against upward price

risk

• Sell in the futures market by those hedging against downward price risk
Decision Making Under Risk and Uncertainty
 Decision making under Risk and Uncertainty

• Decision problem have four components under the

situation of risk and uncertainty:
1) Events that affect economic gain but decision maker
has no control over them.
2) Actions which decision maker can take
3) Consequences related to each combinations of events
and the actions which decision maker can evaluate
4) Choice criterion
 Decision Making Under Risk and Uncertainty…

• Under situation of uncertainty when there is no scientific

method to collect information about events i,e. when
probabilities of happening events cannot be assigned, then the
components mentioned above only are important decision
maker.

• The problem of decision making under uncertainty can be

cited for allocation of area under various crops in rained areas.

• Suppose in a rained area, a farmer has 2 ha of land on which

he can grow maize and rice.

• He can allocate this area under these two crops in several

ways.
Decision making under Risk and Uncertainty
• For simplicity let as consider only the following three
alternatives:
A 1: he may grow only rice on entire land
A 2: he may grow only maize on entire land
A3: he can grow both rice and maize on half-half land.

• The net income from each alternative will depend on

amount of rainfall, price of product and cost of
production.
• However, farmers do not have reliable information
about these variables at the time of decision making.
 Decision making under Risk and Uncertainty…

• Rainfall is generally uncertain.

• However good yield of rice is obtained if rainfall is good while

yield of maize is good even if rainfall is least.

• Similarly, no reliable information is available about the prices

of these products that would be available at the time of harvest.

• In this example price of product and amount of rainfall can be

considered as events.

• For simplicity we can assume that rainfall would be heavy or

light and price will be favorable for rice or maize.
Decision making under Risk and Uncertainty…

• All possible combinations of unknown events of

rainfall and prices can be expresses as:

= favorable price for rice and light rainfall

= favorable price for rice and heavy rainfall
= favorable price for maize and light rainfall
= favorable price for maize and heavy rainfall
Decision making under Risk and Uncertainty…

• The probable net income for each of the above combination can
be calculated on the basis probable yield, price of product and
cost of production.
• Suppose the probable net income for various combination of
event is as given by the following table

• This type of table is called as ‘pay off’ or ‘gain’ table. This is

based on component 1,2 and 3 only.

• In order to make decision about the crop or crop combination to

grow.

• Choice criterion i,e. component no.4 can be adopted.

Decision making under Risk and Uncertainty…

1) Wald decision criterion also called “Maxmini” or

Minimax criterion.
2) La-place decision criterion also called as Baye’s
decision criterion
3) Hurwicz pessimism-optimism criterion
4) Savage decision criterion also called “Minima regret”
criterion
5) Principle of maximum expected gain
Probable net income from rice, maize, rice + maize under various
combinations of amount of rainfall and level of prices:
Events (pay off table) Alternative actions, net income (Birr/ha) Probability of events
Rice Maize Rice + Maize

𝛩1 900 1500 1200 0.2

𝛩2 1900 700 1300 0.3
𝛩3 600 2000 1300 0.2
𝛩4 1400 1000 1200 0.3

MINIMUM 600 700 1200

INCOME
MAXIMIN 1900 2000 1300
INCOME
AVERAGE 1200 1300 1250
INCOME
PROBABLE 1290 1210 1250
INCOME
Probable income has been calculate as follows
a1 = 0.2 x (900) + 0.3 x (1900) + 0.2 x (600) + 0.3
(1400) =1290.

a2 = 0.2(1500) + 0.3(700) + 0.2(2000) +0.3(1000)

=1210.

a3 = 0.2(1200)+ 0.3(1300) +0.2(1300) + 0.3(1200)

=1250.

• A brief descriptions about each criterion is given

below.
 1. Wald’s Maximin or Minmax Criterion
• According to this criterion, from each action the lowest expected
income is considered and decision is made w.r.t. action for which
pay-off is maximum.

• This is pessimistic criterion as decision maker expects the worst

outcome.

• The alternative which offers maximum pay-off out of the worst

ones, is selected.

• This criterion is appropriate for making decision in dry farming

areas.

• From table, we select minimum value of gain (pay-off) from

each row and then select the highest pay-off out of minimum.
 Wald’s Criterion…
CROPS NATURE’S STRATEGY (EVENT) MINIMUM
PAY OFF

RICE (a1) 900 1900 600 1400 600

MAIZE (b2) 1500 700 2000 1000 700
RICE + MAIZE (a3) 1200 1300 1300 1200 1200

•The highest pay off out of minimum pay-off is for

Rice + Maize which is 1200.

•Therefore decision maker should select Rice +

Maize.
2.La-place Decision Criterion Bayes’s Decision Criterion
• Since decision maker does not have the knowledge of
future, he can assign equal probability of each event’s
pay-off and calculate the expected pay-off for each action
and select the action for which expected gain in
maximum.

• In the given example, decision maker assume that for all

few types of events, the probability of happening event is
the same ie 0.25.

• The probable pay-off for each event is calculated on the

basis of this probability as given below:
 La-place Decision Criterion…
a1 = 0.25(900) + 0.25(1900) + 0.25(600) + 0.25(1400) =1200.

a2 = 0.25(1500) + 0.25(700) + 0.25(2000) +0.25(1000) = 1300.

a3 = 0.25(1200) + 0.25(1300) + 0.25(1200) + 0.25(1300) = 1250.

• Highest pay off according to this criterion is 1300 for a2

action maize, hence decision maker should grow maize.

• Similar result would be obtained if simple average gain is

calculated for each action in this row of table.
 3. Hurwicz Pessimism-Optimism Criterion

• According to this criterion, weighted average of

minimum and maximum gain of each action is calculated
and the action for which weighted average of gain is
highest is selected.

• As a weight we can take 𝛼 and (1-𝛼) with the value of

each between 0 and 1.

• Assuming 𝛼 and (1-𝛼) = by taking maximum and

minimum gain for each action, weighted average gain is:
Weighted average gain = [(𝛼) (minimum gain) + (1-𝛼)
(maximum gain).

a1 =2/3 (600) + 1/3(1900) = 1033.33

a2 = 2/3(700) + 1/3(2000) = 1133.33

a3 = 2/3 (1200) + 1/3(1300) = 1233.37

• Thus, according to his criterion, decision maker should

decide to grow Rice + Maize as value of weighted average
gain is highest i,e. 1233.37
 4. Savage Minimax Regret Criterion
• According to this criterion ‘pay-off’ table is converted
into regret table and then minimax criterion is applied
in selecting the action.

• In the given example, if farmer decides to grow Rice

(a1) and event 𝛩2 happens, then gain would be 1900
Birr/ha which is highest than the gains of the other two
alternatives i,e a1 and a3.

• However, if farmer takes decision to grow maize (a 2)

under the event 𝛩2 the gain would be 700 birr/ha and
regret would be equal to (1900-700) = 1200
 Method of Preparing Regret Table
For converting ‘pay-off’ table in to regret table under each
event, the value of each action is subtracted from maximum
value of action under that event, the table thus obtained is
called regret table.
The regret table for pay-off table above would be,
Event Alternative action (pay-off in Birr /ha)
Rice (a1) Maize(a2) Rice + maize (a3)

600 0 300
0 1200 600
1400 0 700
0 400 200
Maximum 1400 1200 700
Regret
Minimax 700
The farmer should decide to grow Rice + Maize as it gives
minimum regret of 700 birr/Q

Event Alternative action (pay- off in /ha)

Rice (a1) Maize(a2) Rice + maize (a3)
600 0 300
0 1200 600
1400 0 700
0 400 200

Maximum 1400 1200 700

Regret
Minimax 700
The farmer should decide to grow Rice + Maize as it gives minimum regret
of 700 birr/Q
 5. Principle of Maximum Expected Gain
• This is the best principle for making decision under uncertainty.
• This principle can also be applied under the situation of risk
where decision maker has the knowledge of probability
distribution events.
• For given example , if we assume that decision maker has the
knowledge of probabilities of all few events, the probable gain
for each action can be calculated as:-
a1 = 0.2(900) + 0.3(1900) + 0.2(600) + 0.3(1400) = 1290
a2 = 0.2(1500) + 0.3(700) + 0.2(2000) + 0.3(1200) = 1210
a3 = 0.2(1200) + 0.3(1300) +0.2(1300) + 0.3(1200) = 1250

Thus according to this criterion, maximum gain could be as 1290

birr/Q by growing Rice (alternative a1).
Thank you!!