Uncertain Futures

Farmers are always concerned about the future and the uncertainty surrounding selling prices and growing conditions. They are also often uncertain about future demand and supply. They can try a number of different ways to reduce uncertainty and risk.

The farmer can reduce the uncertainty and risk about the future and future prices and market conditions by trading in the futures and forwards markets. The forward market enables farmers to sell specified quantities of farm produce at a specified price on a specified future date. A futures market enables farmers and agricultural traders to exchange contracts for future delivery of farm produce. Diversification is another option in risk management.

Diversification is simply the application of the principle of not putting all of your eggs in one basket. It reduces risk by spreading the uncertainty about risky asset prices over more asset holdings and increasing expected utility. It is more attractive to risk averse people which most of us are on average.

The forward and futures traders use economic information in running their markets. Huge amounts of information exists on prices, qualities and quantities of assets, goods and services. The reliability of much of it is questionable. There may be significant costs involved in searching for and buying reliable information which is scarce. A lot of information is created by advertising as producers tell the market about their products and prices in the hope of attracting customers. Asymmetric information, a situation in which one trader has more information than another, can give a competitive advantage to the person who has it but can also lead to moral hazard and adverse selection in the use of private information. Signals about growing conditions and future market conditions, incentives and warranties can reduce uncertainty and provide first mover advantages in forward and futures markets.

In this way asset markets can be efficient. Prices should be a rational expectation of future prices based on all the available, relevant information. Some people are more risk averse than others. For some there is always an opportunity cost. It is a problem of probability. Of course, there is always insurance.