Intertemporal Risk Management Decisions of Farmers under Preference, Market, and Policy Dynamics

INTERTEMPORAL RISK MANAGEMENT DECISIONS OF FARMERS UNDER

PREFERENCE, MARKET, AND POLICY DYNAMICS

I. Introduction

Agricultural production is a dynamic stochastic process greatly affected by
unpredictable weather, technology advancement, individual farming practices, and price
fluctuations in commodity markets. The risk management situation confronted by farmers is
complicated with intra- and inter-temporal uncertainties in continuous multi-period production.
Modeling farmers’ risk management has been commonly based on a static approach, although a
stochastic dynamic approach is more consistent with reality.

Expected utility maximization, commonly used as a standard framework in many
studies including agricultural risk analysis, has been shown feasible in dynamic modeling. The
standard specification allows a risk averse farmer to maximize a summarized discounted von
Neumann-Morgenstern expected utility function of his or her stochastic income subject to a set
of policy and resource constraints. Such a specification, however, assumes utility is additively
separable and therefore implies the decision maker is intertemporally risk-neutral. A generalized
expected utility (GEU) maximization model, developed by Epstein and Zin (1989, 1991),
provides an alternative to study intertemporal decisions with further specification of the decision
maker’s preferences. The model utilizes a recursive constant elasticity of substitution (CES)
expected utility function, which allows risk aversion to be disentangled from intertemporal
substitutability of consumption.

Currently, U. S. farmers are able to use several risk management tools to manage risks,
and make long term strategic plans accordingly. Hedging in the futures markets has a long

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