PROSPECT THEORY

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Context: The researchers from the Indian Institute of Technology Madras (IIT Madras) have devised a mathematical model for contract farming to predict farmers' delivery of commodities using a decision-theoretic framework based on the 'Prospect Theory.'

Details

Background

• Contract farming is a form of agricultural production where farmers agree with a firm to supply a specified quantity and quality of a commodity at a predetermined price and time.
• Contract farming faces some challenges, such as asymmetric information, moral hazard, adverse selection, and opportunistic behaviour. For instance, farmers may not deliver the contracted quantity or quality of the commodity due to various factors, such as weather shocks, market fluctuations, or personal preferences. This can affect the firm's production planning and profitability.
• To address this issue, researchers from the Indian Institute of Technology Madras (IIT Madras) have devised a mathematical model for contract farming to predict farmers' delivery of commodities using a decision-theoretic framework based on the 'Prospect Theory.'

Prospect Theory

• Prospect Theory is a behavioural model that describes how people make choices under uncertainty.
• It assumes that people are more sensitive to losses than gains and that they evaluate outcomes relative to a reference point rather than in absolute terms.
• It accounts for the fact that people tend to overweight low-probability events and underweight high-probability events.

Prospect Theory to model the farmers' decision-making process

• The IIT Madras researchers used Prospect Theory to model the farmers' decision-making process when they face uncertainty about the spot price of the contracted commodity at the time of delivery.
• They assumed that the farmers have a reference-dependent utility function that depends on their initial wealth, the contracted price, the spot price, and the advance payment received from the firm.
• The researchers then derived the optimal contract design for the firm that maximizes its expected profit subject to satisfying the farmers' participation and incentive compatibility constraints. They also proposed two different strategies for determining the optimal timing of paying the advances to the farmers:
  • The first strategy favours the firm's profit maximization objective by paying the advances as late as possible.
  • The second strategy favours a socially inclusive payment policy by paying the advances as early as possible.

Significance

• The researchers found that the second strategy significantly improves the welfare of the farmers, especially those with smaller landholdings and limited access to credit while keeping the firm's profitability largely unaffected.
• The model can help calculate the upper and lower bounds of the contracted quantity that should be delivered and define the firm's production quantity. This can enable the firm to set its profitability limits with more precision than existing methods.
• The researchers claimed that their model can aid policymakers in designing mechanisms that would encourage more firms to offer advance-payment contracts. It can help identify the eligible farmers who would benefit most from these contracts based on their need for advance payments.
• They suggested that their model can be extended to other sectors where larger firms source from poor suppliers, such as handicrafts, textiles, or electronics.

Contract farming

About

• Contract farming is a form of agricultural production in which farmers agree to sell their crops or livestock to a buyer at a predetermined price and quality. The buyer usually provides inputs, technical assistance, and marketing services to the farmers.

Contract farming can have various features depending on the type and degree of the contractual arrangement, such as:

• The duration of the contract can range from one season to several years.
• The degree of exclusivity can vary from partial to total commitment of the farmers to the buyer.
• The scope of the contract can cover only one aspect of production (such as seed supply) or the entire production process (from input provision to post-harvest handling).
• The mode of payment can be based on fixed prices, market prices, or a combination of both.
• The degree of risk sharing can depend on the allocation of responsibilities and liabilities between the parties.

Contract farming can have significant benefits for both farmers and buyers, such as:

For Farmers

• Contract farming can provide access to inputs, credit, technology, and markets that they may otherwise lack.
• It can reduce price and production risks, increase income stability, and enhance quality standards and productivity.

For Buyers

• Contract farming can ensure a stable and reliable supply of raw materials that meet their specifications and requirements.
• It can reduce transaction costs, improve traceability and quality control, and foster long-term relationships with farmers.

Contract farming also faces several challenges and limitations, such as:

• The imbalance of power and information between farmers and buyers can lead to unfair contracts, exploitation, or opportunism by either party.
• The lack of legal and institutional frameworks to regulate and enforce contracts protects farmers' rights and resolves disputes.
• The high transaction costs and coordination problems involved in managing large numbers of small-scale farmers with diverse production conditions and capacities.
• The environmental and social impacts of contract farming, such as land degradation, water pollution, biodiversity loss, labour exploitation, and social exclusion.

To overcome these challenges and maximize the potential of contract farming, some possible ways forward are:

• Strengthening the capacity and bargaining power of farmers through collective action, education, training, and extension services.
• Promoting fair and transparent contracts that balance the interests and obligations of both parties, and that include mechanisms for monitoring, evaluation, and dispute resolution.
• Developing supportive policies and institutions that facilitate contract farming, such as legal frameworks, standards and certification systems, infrastructure development, and market information systems.
• Encouraging sustainable and inclusive contract farming practices that respect environmental and social norms, such as organic farming, agroforestry, gender equality, and local participation.

Conclusion

• The IIT Madras researchers' mathematical model on contract farming is a novel contribution to the literature on agricultural economics and behavioural decision theory. It demonstrates how Prospect Theory can be applied to understand and improve real-world problems in contract farming. It also shows how mathematical modelling can be used to create equitable and efficient solutions for both farmers and firms.

PRACTICE QUESTION Q. The weighting function in Prospect Theory reflects the fact that people tend to: A) overestimate low probabilities and underestimate high probabilities B) underestimate low probabilities and overestimate high probabilities C) overestimate both low and high probabilities D) underestimate both low and high probabilities Answer: A Explanation: The weighting function in Prospect Theory captures the idea that people do not judge probabilities objectively, but rather distort them according to their preferences. People tend to overweight low probabilities and underweight high probabilities, which leads to the possible effect and the certainty effect

https://www.indiatoday.in/education-today/news/story/iit-madras-researchers-devise-a-mathematical-model-that-promises-equal-benefits-to-both-farmers-agri-firms-2393963-2023-06-17