Risk Market Inefficiencies  

 

Farmer may be reluctant to adopt risky technology.

Coping with risk and uncertainty.

The classic economic view of poor farmers is that their lack of savings and other resources to fall back on causes them to prefer agricultural approaches with more reliable, but lower average returns. Farmers may see adoption of new technologies as risky, especially early in the adoption process when proper use and average yields are not well understood. Allowing farmers to experiment with the technology on a small scale before adopting it minimizes the amount of risk and uncertainty associated with adopting a new technology for the first time. Research on adoption and diffusion of technologies has termed this technology feature “trialability”.1 Some evidence suggests that this strategy for minimizing risk is not used as much as it should be. Few farmers, for example, put fertilizer on a portion of their crop when they cannot afford fertilizer for the whole field.

Coping with Risk

Risk and uncertainty can lead to low levels of technology adoption, particularly where resources to help farmers deal with risk, such as insurance, are not available. However, rural communities have developed many informal mechanisms to cope with risk. For example, households may buy or sell assets in response to fluctuations in income, and communities may temporarily assist households experiencing a negative shock to their income (e.g. unexpected medical expense), with the expectation that the household will do the same for others in the future. While these strategies are useful, in many cases they are insufficient. In particular they are poorly suited to offset the voluntary risks of adopting a new agricultural technology. Even within a household, research has shown that differences in the riskiness of crops grown by men and by women affect the consumption patterns of the household.2 This exposure to risk and uncertainty within the household can increase the effect of gender on an individual’s ability to take advantage of a new technology.

How do Farmers View Risk and Uncertainty

Farmers face many sources of uncertainty: Weather and other environmental factors, supply and demand (prices), and input and output networks. How these factors affect adoption decisions depends on attitudes toward risk and uncertainty—whether farmers are averse to risks and whether they respond consistently to probabilities. Behavioral economics research has made substantial progress in detailing the ways in which individual decisions are biased in situations characterized by risk and uncertainty. For example, if individuals care more about losses than they do about equivalent gains, then they may disproportionately prefer not to adopt a technology that offers the possibility of a loss. Some evidence suggests that these theories may be useful in explaining adoption patterns for new agricultural technologies.3

In addition to the risks inherent in agricultural production, new technologies often bear specific risks, such as uncertainty about how to use the technology correctly and how to market the output. In particular, crops that are bound for export markets may carry quality or production standards that create more risk for farmers, which may contribute to low levels of adoption of export-oriented crops. A randomized experiment with agricultural credit in Kenya demonstrated the underlying, systemic nature of risk in export markets, when the export market collapsed due to unmet quality controls by the importing countries.4 A lack of coordination and enforceable contracts further deters adoption in these circumstances. This problem cuts both ways, however, and greater risk and uncertainty impedes coordination and makes contracts more difficult to enforce.

1 Rogers, E. M. (2003). Diffusion of innovations, Free Press.
2 Duflo, E. and C. R. Udry (2004). "Intrahousehold Resource Allocation in Cote d'Ivoire: Social Norms, Separate Accounts and Consumption Choices." NBER Working Paper.
3 Liu, E. (2008). Time to Change What to Sow: Risk Preferences and Technology Adoption Decisions of Cotton Farmers in China, Princeton University working paper.
4 Ashraf, N., X. Giné, et al. (2008). Finding Missing Markets (and a disturbing epilogue): Evidence from an Export Crop Adoption and Marketing Intervention in Kenya, World Bank.

A number of different tools and strategies, such as insurance or safety nets, could reduce the amount of risk and uncertainty that a farmer takes on when adopting a new technology. However, a number of studies have examined whether insurance can mitigate the negative impacts of risk and uncertainty, and the evidence suggests that the adoption of risk coping strategies is not straightforward.

Adverse Selection

The lack of adequate insurance markets for developing country farmers can be traced to both low demand and inadequate supply. On the supply side, financial institutions may be hesitant to provide insurance because they fear that only the farmers who take on risky (and on average, bad) investments would ever buy insurance (i.e. adverse selection). To deal with adverse selection, insurance providers must charge high premiums to break even. (This is analogous to health insurance: Insurers fear that only the sickest individuals have reason to buy health insurance.) But doing so would again filter demand to the riskiest of the risk-takers. To avoid adverse selection, research has investigated bundling insurance with other products, such as microcredit, and making insurance mandatory.1 Nonetheless, recent rigorous research by Giné and Yang (2009) demonstrates that take-up of micro-loans among Malawian farmers decreases when weather insurance is mandatory.2

Moral Hazard

Alternatively, when otherwise risk-avoiding individuals purchase insurance, they are protected from the downside risk of their investment. Knowing they are protected, these clients have less incentive to avoid potential losses from the investment. Because the insurer now bears some of the risk, the client’s chances of failure are reduced. Thus, the client may stop taking measures to prevent failure—even those requiring little effort. The fact that clients are less keen to prevent losses can be costly to the insurer. This is referred to as “moral hazard,” and can be mitigated through close monitoring, charging a deductible, and other institutional structures. These systems, however, are often unavailable or costly to implement in rural areas. One promising approach to addressing the problem of moral hazard is through indexed insurance.

Indexed Insurance Schemes

Weather insurance and other forms of indexed insurance are tied to a source of risk that is easy for the insurance provider to observe and hard for the client to manipulate. This makes it both cheaper to monitor (using weather stations, for example) and less subject to cheating. In addition, rainfall is not related to other sources of risk borne by the insurer, such as stock market prices, and thus may be more appealing to private investors. Consequently, the number and type of index insurance schemes are growing. In Mexico, payouts for state-provided weather insurance are also calibrated by a proxy measure for poverty to better target the service. In Mongolia, livestock insurance is indexed to mortality rates for the local area and historical rates, with a guarantee offered to insurers by the government. A new effort to increase weather data collection in Africa may increase the potential for scale-up of weather insurance.

However, while farmers acknowledge the risk presented by rainfall, adoption of weather insurance has remained low, even when the product is offered at actuarially fair prices. A large pilot program in India found that demand for insurance was very sensitive to a small increase in price, and those who did purchase tended to purchase a very small amount.3 Low take-up was also found in Malawi.4 While the low take-up of weather insurance parallels low take-up of health insurance in other randomized evaluations,5 additional research is needed to understand how the design and marketing of insurance products can help farmers overcome the risks of adopting new technologies.

A recently supported ATAI pilot project led by Miguel and coauthors will explore alternative approaches to making weather insurance available to farmers in an effort to offset risk and uncertainty barriers to technology adoption.

1 Alderman, H. and T. Haque (2007). "Insurance against covariate shocks: the role of index-based insurance in social protection in low-income countries of Africa". World Bank Working Paper No. 95.
2 Giné, X. and D. Yang (2009). "Insurance, credit, and technology adoption: Field experimental evidence from Malawi." Journal of Development Economics 89(1): 1-11.
3 Cole, S., X. Gine, et al. (2009). Barriers to Household Risk Management: Evidence from India, Harvard Business School Working Paper.
4 Giné, X. and D. Yang (2009). "Insurance, credit, and technology
adoption: Field experimental evidence from Malawi." Journal of
Development Economics 89(1): 1-11.
5 Duflo, Esther, Abhijit Banerjee, Rachel Glennerster, and Richard Hornbeck. 2008. Health Insurance: Opportunities and Challenges. Presentation at the Centre for Microfinance/College of Agricultural Banking Conference on Microfinance. Pune, India. January 18.