Decision-Making under Risk: Evidence from Northern Ethiopia

There is a long standing discussion of whether expected utility theory (EU) or prospect theory (PT) best explains the behavior with respect to risky choices. Often these two approaches are compared by putting questions to students in laboratory situations. Here we try to investigate stated preferences of farmers who are functioning under high levels of risk in real life. As part of a larger survey, four binary choices were offered during two successive years. The experimental test was performed 199 farmers in two districts in Tigray, Northern Ethiopia. Three items were central in comparing the risk attitude according to EU and PT: the asymmetry of risk perceptions, the independence axiom and the shape of the utility function. The farmers in the two different districts (Enderta and Hintalo-Wajerat) differed significantly in their risk attitude. Enderta farmers were significantly risk-averse for gains and risk-seeking for losses; their preferences conformed to the hypothesis of prospect theory. However, expected utility maximization was found to be an appropriate descriptor for Hintalo-Wajerat farmers. In order to identify the factors that affect farmer’s preferences, a binary choice model was used. Household income was found to be positive and significant while value of livestock had the expected negative sign and was directly related to a decrease in risk aversion. Knowledge of farmers’ attitude toward risk has important implications for policy makers to devise policies that can overcome the critical constraints they face in meeting their basic needs.