A Dynamic Agricultural Household Model with Uncertain Income and Irreversible and Indivisible Investments under Credit Constraints

A dynamic model of agricultural household behaviour in less developed countries in the presence of credit constraints and income uncertainty is developed. The production side of the model takes into account the irreversible and indivisible nature of non-stationary agricultural investment options, thereby combining the standard intertem- poral consumption model with features from the real option pricing literature. The model framework represents an interesting dynamic alternative to the static household models in the literature. It is shown that the model can be solved by use of dynamic programming routines, and numerical results are obtained for a variety of parameter values. Several interesting results emerge: First, the consumption policy functions of the agricultural household can become highly non-linear, violating the standard result that increased wealth implies increased consumption. This has implications for empirical estimation. Secondly, increasing uncertainty does not in general reduce the average propensity to consume, or increase the propensity to save. Thirdly, increased variation of income only to a limited extent carries through to variation in consumption. Fourthly, the effects of shocks to income depend crucially on the timing of shocks. And finally, reducing uncertainty does not reduce poverty significantly, whereas agricultural extension services and cash transfers are more likely to do so.