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

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. Investment decision 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 numerical investment model also yields the optimal investment behavior of a representative farm. The model can be applied e.g. in planning investment subsidies for maintaining target investments. In the case study, the investment decision is sensitive to risk.

Decoupling and agricultural investment with disinvestment flexibility: a case study

“…A novelty in this paper is to study the exit and reentry decision assuming a discrete time mean-reverting income process. In numerical examples, the case of a 100% recovery rate is observed to imply disinvestment, motivating the extension of the investment model in Heikkinen and Pietola (2007) to disinvestment.…”

“…For example in dairy production, the new 141-program implies that 141-support decreases from 2007 level by 11% during 2008-2011 and by 16% by year 2013. Agricultural income being determined by policy processes is constantly subject to policy uncertainty. Previous work in OECD (2000) and Heikkinen and Pietola (2007) address the role of expectations about future EU support to investment decisions in a dynamic setting. This paper is based on Heikkinen (2007) and extends Heikkinen and Pietola (2007) in two ways.…”

“…Previous work in OECD (2000) and Heikkinen and Pietola (2007) address the role of expectations about future EU support to investment decisions in a dynamic setting. This paper is based on Heikkinen (2007) and extends Heikkinen and Pietola (2007) in two ways. First, this paper studies the effect of the reduction and decoupling of the Finnish national 141-support on agricultural investment, focusing on a case study in dairy farming.…”

“…During 1995During -2004 of Finnish dairy farms have closed down and the estimated disinvestment rate in terms of the number of dairy farms 2004-2013 remains at 46% (Pyykkönen and Lehtonen, 2006). The empirical significance of disinvestment motivates the extension of the optimisation model in Heikkinen and Pietola (2007) to study of disinvestment. The high disinvestment rate indicates profitability problems and the need to increase the size of the production units to achieve economics of scale.…”

“…In Heikkinen and Pietola (2007), the investment analysis is based on assuming like in classical investment analysis, that when exiting the business, the farmer loses the original investment. No disinvestment activity assuming 100% exit and reentry costs was observed.…”