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Investment and the dynamic cost of income uncertainty: The case of diminishing expectations in agriculture

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  • Heikkinen, T.
  • Pietola, K.

Abstract

This paper studies optimal investment and the dynamic cost of income uncertainty, applying a stochastic programming approach. The motivation is given by a case study in Finnish agriculture. The investment decision of a representative farm is modelled as a Markov decision process, extended to account for risk. A numerical framework for studying the dynamic uncertainty cost is presented, modifying the classical expected value of perfect information to a dynamic setting. The uncertainty cost depends on the volatility of income: e.g. with stationary income, the dynamic uncertainty cost corresponds to a dynamic option value of postponing investment. The model can be applied to agricultural policy planning. In the case study, the investment decision is sensitive to risk.

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Bibliographic Info

Article provided by Elsevier in its journal European Journal of Operational Research.

Volume (Year): 192 (2009)
Issue (Month): 2 (January)
Pages: 634-646

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Handle: RePEc:eee:ejores:v:192:y:2009:i:2:p:634-646

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Web page: http://www.elsevier.com/locate/eor

Related research

Keywords: Investment analysis Real options Stochastic programming OR in agriculture;

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References

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  1. Amegbeto, Koffi N. & Featherstone, Allen M., 1992. "Risk Costs And The Choice Of Market Return Index," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 17(01), July.
  2. Vercammen, James, 2003. "A Stochastic Dynamic Programming Model Of Direct Subsidy Payments And Agricultural Investment," Working Papers 15847, University of British Columbia, Food and Resource Economics.
  3. Heikkinen, Tiina & Pietola, Kyosti, 2006. "Investment and the Dynamic Cost of Income Uncertainty: the Case of Diminishing Expectations in Agriculture," Discussion Papers 11868, MTT Agrifood Research Finland.
  4. Keswani, Aneel & Shackleton, Mark B., 2006. "How real option disinvestment flexibility augments project NPV," European Journal of Operational Research, Elsevier, vol. 168(1), pages 240-252, January.
  5. Tauer, Loren W., 2006. "When to Get In and Out of Dairy Farming: A Real Option Analysis," 2006 Annual meeting, July 23-26, Long Beach, CA 21251, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
  6. Huisman, K.J.M. & Kort, P.M. & Pawlina, G. & Thijssen, J.J.J., 2004. "Strategic investment under uncertainty: Merging real options with game theory," Open Access publications from Tilburg University urn:nbn:nl:ui:12-142400, Tilburg University.
  7. Karl Claxton, 1999. "Bayesian approaches to the value of information: implications for the regulation of new pharmaceuticals," Health Economics, John Wiley & Sons, Ltd., vol. 8(3), pages 269-274.
  8. Keith C. Knapp & Lars J. Olson, 1996. "Dynamic Resource Management: Intertemporal Substitution and Risk Aversion," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 78(4), pages 1004-1014.
  9. Hong Bo & Robert Lensin, 2005. "Is the Investment-Uncertainty Relationship Nonlinear? An Empirical Analysis for the Netherlands," Economica, London School of Economics and Political Science, vol. 72(286), pages 307-331, 05.
  10. Luis Alvarez & Rune Stenbacka, 2003. "Optimal risk adoption: a real options approach," Economic Theory, Springer, vol. 23(1), pages 123-147, December.
  11. Joshua Aizenman, 1996. "New Activities, the Welfare Cost of Uncertainty and Investment Policies," NBER Working Papers 5825, National Bureau of Economic Research, Inc.
  12. Carl Johan Lagerkvist, 2005. "Agricultural policy uncertainty and farm level adjustments--the case of direct payments and incentives for farmland investment," European Review of Agricultural Economics, Foundation for the European Review of Agricultural Economics, vol. 32(1), pages 1-23, March.
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Cited by:
  1. Heikkinen, Tiina & Pietola, Kyosti, 2006. "Investment and the Dynamic Cost of Income Uncertainty: the Case of Diminishing Expectations in Agriculture," Discussion Papers 11868, MTT Agrifood Research Finland.
  2. Mittenzwei, Klaus & Bullock, David S. & Salhofer, Klaus & Kola, Jukka, 2011. "Towards a Theory of Policy Making," 2011 International Congress, August 30-September 2, 2011, Zurich, Switzerland 114639, European Association of Agricultural Economists.

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