Risk Management: Impacts on Productivity
To Risk or not to risk? Risk management and farm productivity. Vigani, M. & Kathage, J.
American Journal of Agricultural Economics, October 2019, Vol. 101, No. 5, Pages 1432–1454
David J. Williams, Graduate Research Assistant
Risk management is key for any business to successfully survive the various risks of their respective industry, whether they be market risks or natural phenomena. For agriculture, risk management is especially important due to the volatility of commodity prices and the systemic nature of risks such as drought or frost. While crop insurance may be the most popular risk management tool within the U.S., risk management practices go beyond financial instruments and extend to any allocation of resources to reduce the risk of some uncertain event. While the financial costs of purchasing insurance or a forward contract may be easy to see, the total impact of any given risk management tool on the bottom line may be obfuscated by the less obvious opportunity costs that affect total output.
This paper examines the impact of four common risk management practices on the total factor productivity of 700 wheat farms from France and Hungary. The results of the study can provide useful insight into the costs of various risk management portfolios. Total factor productivity is a measure of how efficiently a firm turns inputs into outputs.
The author’s study examines the impact of crop insurance, production contracts, production diversification and variety (genetic diversity of similar crops), and the 16 different combinations of those tools on the efficiency of the farm. By examining total factor production, the total effects of the risk management tool implementation can be analyzed.
The study finds that the adoption of risk management practices is most always associated with a negative impact on total factor productivity. This is not too surprising as most risk management tools trade profit for a reduction in risk as managers are willing to take a lower expected return for less variability. However, the study does find two risk management strategies that contradict this line of thinking: contracting and variety in low-risk farms. The positive effect of production contracts is believed to be due to the financial and technical support sometimes provided by the buyers, or rolling contracts which provide stability. The positive impact of variety in low-risk farms is estimated at a positive 19%, which the authors argue is evidence that variety is a useful “natural insurance” and is a viable and efficient risk management tool in low-risk conditions.
Other than the two exceptions, all other risk management tools were associated with reductions in productivity, and as the portfolio of risk management tools becomes more complex, the impact on productivity becomes increasingly large. Crop insurance alone was associated with a 15-18% reduction in productivity. Combining crop insurance with diversification is associated with a reduction of 31% in productivity. Combining insurance, diversity and variety is associated with a reduction of 46%.
Combining all four risk management tools — insurance, diversity, variety and contracts — is associated with a 50% reduction in productivity. The increasingly negative effects of creating more complex portfolios of risk management tools is not surprising as implementing these tools requires more and more financial or managerial resources to be reallocated away from production.
What this means for Food and Agricultural Business
While the results of the study are focused on only wheat farms in France and Hungary that are operating in an environment very different from U.S. farms, this study is still useful for food and agricultural businesses within the U.S. This study illustrates that the costs of risk management strategies are broader than they appear, and agribusinesses must be aware of how implementing those tools will affect their productivity. It also implies that there is diminishing returns to having multiple levels of risk management strategies in place at a given time.
The increased productivity associated with production contracts and increased variety or genetic diversity provides some evidence that these methods of risk management may be useful to U.S. farms. This would mean that obtaining a production contract where the buyer supplies financial or technical support or growing a broader, more resistant set of crops would be a desirable way of reducing risk without hampering productivity as much as some other alternatives.
To implement risk management tools requires the diversion of resources — financial and real — away from other productive uses. Whether the reduction in risk is worth it requires a close examination of exactly how that risk management tool will impact business operations, as well as the explicit costs of the tool. The risk appetite of each business will ultimately determine how much risk protection it puts into place.
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