Wealth, weather risk, and the composition and profitability of agricultural investments

Despite the growing evidence that farmers in low-income environments are risk-averse, there has been little empirical evidence on the importance of risk in shaping the actual allocation of production resources among farmers differentiated by wealth. The authors use panel data on investments in rural India to examine how the composition of productive and nonproductive asset holdings varies across farmers with different levels of total wealth and across farmers facing different degrees of weather risk. Income variability is a prominent feature of the experience of rural agents in low-income countries. The authors report evidence, based on measures of rainfall variability, that the agricultural investment portfolio behavior of farmers in such settings reflects risk aversion, due evidently to limitations on consumption-soothing mechanisms such as crop insurance or credit markets. The authors'results suggest that uninsured weather risk is a significant cause of lower efficiency and lower average incomes: a one-standard-deviation decrease in weather risk (measured by the standard deviation of the timing of the rainy season) would raise average profits by up to 35 percent among farmers in the lowest wealth quartile. Moreover, rainfall variability induces a more unequal distribution of average incomes for a given distribution of wealth. Wealthier farmers are willing to absorb significant risk without giving up profits to reduce production risk. Smaller farmers have to invest their limited wealth in ways that reduce their exposure to risk at the cost of lower profit rates. The authors found that at high levels of rainfall variability, differences in rates of profit per unit of agricultural assets were similar across classes of wealth. But over the sample range of rainfall variability, these rates of profit were always higher for the poorer farmers than for the wealthier ones, suggesting that the disadvantages of small farmers in risk diffusion are more than offset by their labor cost advantage.