Exploring Higher Order Risk Preferences of Drought Affected Farmers In
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Exploring higher order risk preferences of drought affected farmers in West Bengal, India Kanchan Joshi, Macquarie University, [email protected] Thiagu Ranganathan, Institute of Economic Growth of India, [email protected] Ram Ranjan, Macquarie University, [email protected] !"# ! " ! # #$ ! 1 Introduction: The lack of institutions facilitating risk mitigation and management, and resultant inability to cope with downside risks is a primary cause of poverty in the rural populations in developing countries (Dercon and Krishnan 2003, Dercon 2004). Specifically, agriculture in these regions is vulnerable to a variety of risks including fluctuating prices, frequent policy changes, and climatic risks involving prolonged droughts and floods (Fafchamps and Hill 2005, Kahan 2008, Hill and Viceisza 2012, Herberich and List 2012). The centrality of risks to livelihoods means that various financial decisions of rural households are influenced by their attitudes towards risk (Holt and Laury 2002, Menapace et al. 2013). Some of the decisions in this regard are crop choices and crop rotation systems (El-Nazer and McCarl 1986), technology adoption (Purvis et al. 1995), entrepreneurial take-up decisions, and investment behaviors. Given its significance, analyzing rural households’ attitudes towards risks has been of prime concern to academicians. Various studies have measured and analyzed risk attitudes of farm and rural households in developing countries. These studies have focused mainly on risk aversion and loss aversion of rural households. While risk aversion and loss aversion are crucial, there has been further research that suggests that individuals’ decisions under risk are influenced by higher order risk preferences, especially when background risks are present (Ebert and Weisen 2009, Deck and Schlesinger 2010, Heinrich and Mayrhofer 2014, Noussair et al. 2014). For instance, Kimball (1990) points to precautionary saving as resulting from the effect of future income uncertainty, and could be measured by third derivative of the utility function, termed as prudence. Likewise, Kimball (1993) observes the presence of negative fourth derivative utility function or temperance. The presence of background risks, in particular, hinders the investment in risky portfolios. Ranjan and Shorgen (2009) find a decline in the level of self-protection and self-insurance measures in the presence of multiple risks, making the affected individuals more risk averse. Rural households in developing countries face a variety of background risks. For instance, the decision to cultivate a cash crop involves considerations that are not just related to variations in incomes from that crop but also risks present in the labor market as well as risks associated with non-farm earnings. Similarly, the decision to invest in an enterprise is taken in the background of farm income risks. Furthermore, given the diverse livelihoods and the variety of risks involved in various income generating activities, the decisions of farm households could well be influenced by their higher order risk preferences such as prudence and temperance. It is thus important to measure these risk preferences of the farm households. Risk preferences are typically measured using three methods - the stated preferences approach, the revealed preference approach based on their economic decisions, and experiments involving real or hypothetical payoffs (Menapace and Colson 2012). In this paper, we use lottery choice field experiments to investigate the higher order risk preferences of drought stressed West Bengal farmers. We also examine the potential determinants of such risk preferences through regression analysis using household characteristics and decisions as explanatory variables. Finally, we comment on the observed correlations between real life decisions of farmers and their decisions during the experiments. 2 Literature review and research relevance Experimental methods have been used to assess the risk aversion of farmers since the mid- 1970s (Binswanger 1980, Binswanger and Sillers 1983, Sulewski and Kłoczko-Gajewska 2014, Gong et al. 2016). Some recent experimental studies have expanded on the risk preference assessments by examining loss aversion and ambiguity aversion. Liu (2013) conducted field experiments to measure loss and risk aversion among various groups of Bt cotton adopters in China. Likewise, Ward et al. (2014), and Ward and Singh (2015) conducted discrete choice experiments among Indian farmers (in the State of Bihar) to measure their attitudes towards risk, loss, and ambiguity and analyzed how these preferences affected adoption of drought tolerant rice varieties. Besides risk aversion, loss aversion, and ambiguity aversion, higher order risk attitudes such as prudence and temperance could also influence decision making, particularly when there are background risks. There has been very little research that has measured individual’s prudence and temperance related choices in experiments. Almost all of the existing studies have used students as experimental subjects. Noussair et al. (2014) is an exception, which measures higher order risk attitudes in a demographically representative sample. However, no empirical studies have been conducted among farmers thus far to measure their higher order risk preferences. This paper addresses this research gap by measuring higher order risk preferences of farmers in a drought stressed district in West Bengal, India. The study also analyses the correlations among these risk preferences and their associations with the households’ various traits. 3 Methodology We conducted a series of experiments involving 232 farmers in the Nalhati-II block of Birbhum district in West Bengal, India. Nalhati-II block was chosen as the study region as it is an agrarian economy with more than 70% of its population choosing agriculture as its primary occupation (Rajathat Prasari 2011). Households in this block are also dependent on various other forms of livelihoods. One of the villages has a significant proportion involved in sericulture. 3.1 Experimental design We used compound lotteries for our experimental design, similar to Ebert and Wiesen (2009, 2011), Deck and Schlesinger (2010), and Noussair et al. (2014) for measuring prudence and temperance. Farmers were presented with a series of choices involving risky outcomes. Each of the experimental series had five lotteries with binary options. To elicit risk aversion, respondents were asked to select between two options, a lottery choice option that could provide either a high payoff or low payoff with equal probabilities, or fixed payoff option. In the series measuring loss aversion, they had to choose either a lottery with a fixed payoff or a lottery with equi-probable chances of winning a high amount or losing a small amount. For eliciting prudence and temperance, individuals had to choose between two compound lotteries - prudent or imprudent, and either temperate or intemperate. The lottery choice experiment was designed in a way to make comprehension easier for the participating farmers with diverse educational backgrounds. Prior to participation in the experiments, farmers were asked comprehension related questions, as a part of cognitive reflection test, to gauge their understanding of the various decision tasks involved. Table 1: List of binary choice tasks modified from Noussair et al. (2014) Series of Lottery - Option A Lottery - Option B Expected value Risk aversion (EV) of (A-B) 1 10 [60_10] -25 2 20 [60_10] -15 3 30 [60_10] -5 4 40 [60_10] 5 5 50 [60_10] 15 Loss aversion EV(A-B) 1 10 [60_-10] -15 2 20 [60_-10] -5 3 30 [60_-10] 5 4 40 [60_-10] 15 5 50 [60_-10] 25 Prudence Prudent choice Imprudent choice 1 [(90+[20_-20])_60] [90_(60+[20_-20])] 2 [(90+[10_-10])_60] [90_(60+[10_-10])] 3 [(90+[40_-40])_60] [90_(60+[40_-40])] 4 [(120+[30_-30])_90] [120_(90+[30_-30])] 5 [(60+[20_-20])_30] [60_(30+[20_-20])] Temperance Temperate choice Intemperate choice 1 [(90+[30_-30])_(90+[30_-30])} [90_(90+[30_-30]+[30_-30])] 2 [(90+[30_-30])_(90+[10_-10])} [90_(90+[30_-30]+[10_-10])] 3 [(90+[30_-30])_(90+[50_-50])} [90_(90+[30_-30]+[50_-50])] 4 [(30+[10_-10])_(30+[10_-10])} [30_(30+[10_-10]+[10_-10])] 5 [(70+[30_-30])_(70+[30_-30])} [70_(70+[30_-30]+[30_-30])] The final analyses used only 191 data points after dropping the respondents who had incorrectly answered comprehension questions or displayed switching inconsistency in experiments (thus indicating a lack of understanding). Dropping the respondents exhibiting a switching problem is a common practice in such experiments (Gong et al. 2010). The list of lottery choices on risk aversion, loss aversion, prudence, and temperance is shown in Table 1. In Table 1, a lottery choice with different outcomes of equal probabilities is represented as [x_y]. The individuals could either get x amount of payoff or y amount of payoff. In risk aversion and loss aversion series, choosing Option A from the beginning indicates risk averse or loss averse nature, whereas switching after decision 2 from option B to option A shows risk and loss neutrality. Choice of option B from the beginning indicates risk-seeking or loss- seeking behavior. In prudence and temperance series from Table 1, Option A indicates prudent and temperate decisions respectively. To avoid giving any clues, while conducting the experiments, some groups were given prudent and temperate decision as option A whereas other groups were given prudent and temperate decisions as option B. 3.2 Experimental protocols and payoffs in lottery choice task Before each experimental session, farmers were given background information on risk in daily lives including agriculture, the purpose of the experiment and how payoffs would be decided. Each participant farmers were guaranteed Indian Rupees (INR) 120 as a payoff, which is roughly $ 2 (USD) and equals 2/3rd of the local daily wages. Each of 25 decisions from 5 series of risk, loss, prudence, temperance and a group game (in this paper, we do not analyze the group game), except for five decisions representing ambiguity and disaster, were assigned a number and kept in a bingo cage.