Decision‐Making Under Risk: Evidence from Northern Ethiopia

Abstract

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.