Risk, Tenancy, and Sharecropping
PRESENTED BY
NISHKRITY NIDHI
ROLL NUMBER- 22510041
Risk Aversion
❖ Define risk aversion: An individual prefers a certain (i.e., known or deterministic)
sum of money A to a lottery with the same expected value A.
❖ The very fact that a given amount is the expected value of some uncertain lottery
is intrinsically displeasing to a risk-averse person.
❖ Risk-averse individuals can be compensated for taking on risk.
❖ The greater the degree of risk aversion, the greater the compensation (above and
beyond the expected value of the lottery) required by the individual.
Comparing Risky Gambles
❖ Two risky gRisk attitudes imply more than the ability to compare a risky gamble with a
given amount of safe money.
❖ ambles can also be compared.
❖ Example: Nazim, the Turkish seller of hats (Chapter 10).
❖ Original project: Pays $10,000 or $2,000, each with probability 1/2.
❖ Alternative project: Pays $8,000 in the event of success, but pays more ($4,000) in the event
of failure.
❖ Both projects cost the same to set up.
❖ Both projects have the same expected value ($6,000).
❖ The alternative project involves a lower "spread" in the returns.
❖ Risk-averse Nazim prefers the second project.
: Utility Function and Project Preference
❖ The utility function captures this intuition.
❖ Project 1: Combination of points A and B.
❖ Project 2: Combination of points A' and B'.
•The expected utility of the second project lies above that of the first (the expected
monetary values are the same).
figure
Land Contracts and Uncertainty
his analysis applies to land contracts.
Assume a fixed amount of labor and other inputs on the tenanted land.
For now, we are ignoring the incentive effect.
Landlord and Tenant
❖ Landlord: Wealthy, less risk-averse (or risk-neutral). Income from this land is
a small part of overall wealth, can be diversified.
❖ Tenant: Poor, risk-averse. This land is a major source of income.
❖ Agricultural production is subject to uncertainty.
❖ Even with controlled inputs, harvest size varies due to factors like weather.
❖ For simplicity, assume two possible output levels: G (good) and B (bad).
❖ The probability of a good output is p.
Fixed-Rent Contract
❖ Consider a fixed-rent contract in which the tenant is required to pay a rent
of R to the landlord, irrespective of the fortunes of the plot.
❖ Tenant's payoff: G - R if things go well and B - R otherwise.
❖ Landlord receives a sure payment of R.
❖ Tenant bears all the risk.
Sharecropping Contract
❖ Imagine replacing this contract with a sharecropping contract,
where the share is purposely chosen to provide exactly the
same expected return to the landlord as before.
❖ s = the share of the crop accruing to the landlord.
❖ The expected return to the landlord is: p s G + (1-p) s B
❖ Equate this to the landlord's return from fixed-rent tenancy, R.
❖ s = R / [p G + (1-p) B] (Equation 12.2)
Comparing Tenant Returns
❖ The expected return to the tenant is also the same under the two contractual modes.
❖ Compare tenant returns in the good state under the two contracts.
❖ Fixed rent: G - R
❖ Sharecropping: (1-s)G
❖ (1-s)G - (G - R) = R - sG = R - [GR / (pG + (1-p)B)] < 0, because G > B.
❖ The sharecropping contract lowers the return to the tenant in the good state.
❖ Because the share has been chosen so that expected monetary values are the
same to either party under the two contracts, the sharecropping contract increases
the return to the tenant under the bad state (relative to fixed rent).
❖ Sharecropping and fixed-rent tenancy are like two projects with the same expected
value, but the "spread" of returns to the tenant is narrower under sharecropping.
Risk Sharing and Incentives
❖ If the tenant is risk-averse, he prefers the sharecropping contract over the fixed-rent contract.
❖ The landlord can play on this preference by cutting the tenant's share a bit more, but not too much,
so that the tenant still prefers the sharecropping contract.
❖ The landlord, who is risk-neutral, enjoys a larger expected payoff, so he switches from fixed rent to
sharecropping.
❖ Sharecropping emerges as a way to share, not just the output of productive activity, but the risk
that is associated with it as well.
❖ A tenant who pays fixed rent is forced to bear the entire uncertainty of production.
❖ He may be more than happy to yield some of this uncertainty to his landlord.
❖ Sharecropping accomplishes this by essentially varying the rent payable with the size of the
harvest.
