Livelihoods in low-income developing countries are generally undiversified and focus on crop production and animal raising. These activities are inherently risky and investment and production decisions by farm households are therefore made within environments that are affected by risk.
Despite risk’s potentially central role in farm investment decisions, there have been few attempts to estimate the magnitude and nature of risk aversion of farm households in low income developing countries. To partially close this gap, this paper uses a real payoff experimental approach applied to 262 households in the Ethiopian highlands. By incorporating both small and large stakes and gains and losses into the experiment, we test for the presence of low stake risk and loss aversion.
We find that more than 50 percent of the households are severely or extremely risk averse. This contrasts with findings from Asia where most decision makers exhibit moderate to intermediate risk aversion. We find that households that stand to lose as well as gain something from participation in games are significantly more risk averse than households playing gains-only games. This strongly suggests that agricultural extension efforts involving potential losses may face systematic resistance at the farm level in poor countries. Promotion of technologies with downside risks, even if the upside potential is enormous, should therefore be combined with cost effective insurance. We also find that even without the possibility of losses households are much more averse to risk when stakes are high than when they are low. Results suggest that insurance does not need to be provided forever. After initial successes have convinced farmers that technologies are viable, risk aversion declines. There are also significant differences in risk averting behavior between relatively poor and wealthy farm households. This suggests that as wealth is built up households are willing to take on more risk in exchange for higher returns.
These findings suggest strong path dependence. Efforts to develop poor rural areas through promotion of risky technologies must therefore take this path dependence into account. Early successes are important, but households should also be allowed to build up wealth in places like rural Ethiopia before they are challenged or tempted to take on more risky ventures. Furthermore, the finding that even without the possibility of losses households are much more risk averse when stakes are higher, suggests that agricultural extension should start modestly before asking households to take larger gambles
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