AKU, CBE

Department of Economics

M.Sc. In Economics (DE)

EconD-571, Agriculture & Rural

Development
Course Contents
 Farm Household Economic Models

 Rural Financial Market

 Agrarian Input and Output Markets

 Rural Eco-Cultural Transformation

 Technological and Institutional Reform in Agriculture

 Farm Size and Productivity

 Food Security Prospects and Problems

 Environmental Aspect of Agricultural Practice

 Role of Infrastructure in Economic Development

 Agriculture Sector and Rural Development Policy Measures

Undertaken in Ethiopia
Farm-Household Economic Models
Chapter Content
 Introduction to the course
 Definition of Some Terms/Concepts

 Why Is Interest in Rural Development?

 Farm-Household Model Under,

 Perfect Market Scenario

 Mixed/Missed Markets Scenario

 No Market Scenario

 Farm Size, Intensity & Productivity Under Missed Markets

 Missing Markets and Production
 Pure Consumer Model Vs Farm-HH Model
 Conclusion
Concepts: Agriculture, Rural, Development?
 Every one of you is well familiar with these words.
 Agriculture is the study of farming, where it includes group of
interrelated activities that encompasses the planting, raising,
subsequent care and final disposition of a wide range of crops
and livestock.
 Alternatively, we can define agriculture as the production,
processing, marketing, and distribution of crops and livestock.
 Rural area relates primarily to areas
 That have a relatively low population density compared to cities,
 Where agriculture and related activities usually dominate the
landscape and economy, and
 Where transport and communications need to cover relatively large
distances making travel and service provision relatively difficult and
costly.
 Simply, rural areas are large and isolated areas of an open
country with low population density.
Development
 Development can be viewed as the process of economic and social
transformation that is based on complex cultural and
environmental factors and their interactions.
 Development as universal history: Karl Marx, Economic structure
(Agri-urban-Industry)
 Development as economic growth: The 1950s Model of growth in
national output, consumption and material living standards; capital
accumulation.
 Development as modernisation: The 1960s believe that
traditional societies could be transformed structurally (its social as
well as economic dimensions) into modern societies through the
active diffusion of the modern values, institutions and technologies
found in the developed countries.
 Development as world structural change: The 1970s Dependency
Theory.
 Development as growth led by the free market: The 1980s & 90s
Neo-liberalism ideology leading to economic reforms, known as
structural adjustment programmes- “Washington Consensus”,GLP
The “WASHINGTON CONSENSUS”
 By the end of the 1980s, the “Washington Consensus” was endorsed by the
U.S. Treasury and the Washington-based international institutions (the
IMF, WB, and Inter-American Development Bank).
 The main issues of this consensus was that policies of liberalization,
stabilization, and privatization were to be the principal means of
promoting sustainable growth in developing economics and making their
economies more efficient and competitive.
 The Washington Consensus made up Ten particular reform policies as a
requisite for LDCs (John Williamson, 1990):
 (1) Fiscal discipline,
 (2) Public expenditure priorities,
 (3) Tax reform,
 (4) Liberalization of financial markets,
 (5) Competitive exchange rate,
 (6) Liberalization of trade policy,
 (7) Foreign direct investment,
 (8) Privatization,
 (9) Deregulation, and
 (10) Property rights.
Rural Development
 Economic development usually refers to the adoption of new
technologies, transition from agriculture-based to industry-based
economy, and general improvement in living standards.
 The term “Rural Development” refers to the processes of change
in rural societies, through a distinct interventions taken by the
state (or other stakeholders) to improve the standard of living in
non-urban neighborhoods, countryside, and remote villages in
the economies of LDCs, where there is low ratio of inhabitants to
open space and the primary sector (production of foodstuffs and
raw materials) is prominent economic activities.
 Rural development is not just about agricultural growth and,
whilst agricultural growth is a very important dimension of rural
development.
 In comparison to ‘agricultural development’, it is
 broader— for it is about the development of the economy as a whole- &
 more specific—it focuses (in its rhetoric, and in principle) particularly
on poverty and inequality—.
Rural Development
 Rural development is an area-based approach in the sense
that its policy targets particular geographical areas (rural
areas) rather than an economic sector (eg. agriculture,
manufacturing, education) or a particular group of people (eg.
small farmers, female- headed households, ethnic minorities)
– even though individual sectors or groups of people may be
targeted as part of a broader rural development strategy.
 Rural development is a multi-sectoral in its dimensions as it
embraces a variety of different economic and social sectors,
such as:
 Agriculture and natural resources – crops, livestock, fishing, forestry
 The non-farm sector – services to agriculture (including input
supply, marketing, transport, finance, agricultural processing), rural
manufacturing, mining, and other rural services
 Rural infrastructure – roads, transport, energy, water
 Education and Health sectors in the rural area.
Rural Development
 Despite a multi-sectoral approach, current opinion is divided
concerning the relative importance of different sectors of
agriculture in particular.
 That is, there is a primacy debate on development based on:
 Small farm sector,
 Access to cheap food from imports or from large-scale
agriculture rather than small-scale agriculture, and
 Increasing diversity of livelihoods and income-generating
activities outside agriculture.
Why an interest in Rural Development?
 The failure of trickle-down
 In the 1950s and much of the 1960s, the key to economic development
was considered to be industrial growth and modernisation.
 The agricultural sector was hence relatively neglected by national
policy, in favour of investment in industry.
 It was assumed that the benefits of growth would trickle down to the
poor as they shifted into the modern sector of the economy, and that
the agricultural sector could act as a reservoir of surplus resources and
labour for industrial growth without requiring investment in its own
right.
 However, the poor, who lived primarily in rural areas, and were to
varying extents dependent upon subsistence agriculture, failed to
benefit from modernisation and industrial growth.
 The industrial sector in most cases did not expand rapidly enough
to provide the necessary jobs, and the agricultural sector itself remained
stagnant and unproductive.

 Often poverty persists because of the absence of growth.

Why an interest in Rural Development?
 Inefficiency and inequity of urban bias
 The urban bias comes about as a result of the economic and
political dominance of a relatively small urban elite.
 This elite— comprising of businessmen, politicians, bureaucrats,
trade-union leaders and a supporting staff of professionals,
academics and intellectuals— effectively control the institutions
of power— government, political parties, law, civil service, trade
unions, education, business organizations etc— and are far better
organised than the rural majority.
 The elites use their power to allocate resources— investments in
doctors, teachers, infrastructure, clean water etc— in ways that
are heavily biased towards urban needs.
 This bias is both inequitable and inefficient, since resources
allocated to rural areas often generate greater benefits in terms of
poverty reduction and economic returns.
Why an interest in Rural Development?
 About 75 % of the world’s poorest people reside in rural areas,
where in most LDCs they engage in subsistence agriculture
suffering higher levels of poverty (1/4 in extreme poverty) than
urban areas.
 Moreover, in the LDCs, about three quarters of the labour force is
involved in agriculture.

 Therefore, there is need for more direct focus on pro-poor

strategies through reallocation of resources to rural areas–
again, for reasons of both efficiency and equity that can lead to
poverty reduction and growth . These strategies focus on
 Human capital, Participation, Livelihood approach, pro-poor
markets and environment.
Agricultural Household Models
 Most people in rural areas of developing countries
 Earn at least part of their livelihood using their labour input into
the production process of their own enterprises (the farm)-
Economics of the firm, and
 Consume at least a portion of the output of their productive
activities- Economics of the household.
 Consequently, individuals make simultaneous decisions that
may be interdependent upon one another about
 Production (allocation/DD of factor inputs and the choice of
technology to output production) and
 Consumption (allocation of income from farm profit & labour
supply/sales and for commodity & services DDs/consumption).
 A model of a household that is jointly engaged in production
and consumption, is commonly known as ‘agricultural
household model’, which provides the starting point for our
analysis of rural development.
The Model
 In its dual role as producer and consumer, the HH’s objective is
to maximize its utility from a list of consumption goods
(output and leisure) by each member of the HH, subject to
budget constraint, which incorporates production on assets
owned by the HH.
 Constraints typically include cash income, family time and
endowments of fixed productive assets, and production
technologies (all of which may be combined into a single “full-
income” constraint), and prices of inputs and outputs.
 The budget constraint, however, assumes different forms,
according to the market environment in which the HH finds
itself, ranging from
 Perfect market,
 Mixed market, and
 No markets.
Agricultural Household Models: Assumptions
 Assumptions of the Separable Farm-Household model
 There is no market failure or markets are perfect
 The household can obtain perfect substitutes for family labor in local
labor markets—and conversely, that it can sell its own labor at a given
market wage.
 The HH is indifferent between consuming market-purchased goods and
own-produced goods (that could be sold at a given market price,
implicitly it purchases output or time for work/leisure from itself).
 No transaction costs

 Production decisions depend only on input prices (w, r) and the

characteristics of the plot, not on the HH's endowments and composition
or preferences (these influence only objective function), implying that
utility-maximizing farmers maximize profits. This is the ‘separation
property’ of the model, because the production decisions are separable
from consumption choices; but the converse is not true, as the HH budget
is endogenous in the farm-HH model.
 Two consumption goods (output & leisure) and two members in the HH
 Preferences & incomes are shared by all the homogeneous HH members.
 Households are risk neutral (changing “expected utility” to simply “utility”).
The Model: Perfect Neoclassical Markets
 The model could be specified as:
 (1) Max.U(c1, c2, l1, l2), Two member HH utility from consumption & leisure
(2) Sub.to. p(c1+ c2) + wLh+rAh ≤ F(L, A) + w(Lm1+Lm2) + rAm
cash expenditures on consumption(ci), hired labour (Lh), and rented land
(Ah) cannot exceed cash revenues from farming F(L, A), market labour
w(Lm1+Lm2), and land rented out (rAm)- budget constraint.
 r, w & p= price of a unit of land (rent), labour (wage), & output
 F(L, A) = HH produces on its farm based on Concave production function using Land & Labor
 The following Equations (3)–(6) define resource constraints
(3) L = Lf1+ Lf2 + Lh , Labour use on the farm is HH labour used on the farm (f)
plus hired labour (h)
(4) A = Af + Ah , Area of cultivated land is owned land used on the farm (f) + hired land (h)
(5) EA = Af + Am , the HH's land endowment is used on its own farm (f) or rented out (m).
(6) ELi = Efi + Emi + li ;i ε {1, 2} , each individual's time endowment equals their
labour use on the farm (f), + market labour time(m), + leisure time(l).
 (7) ci, li, Lfi, Lmi, Af, Am ≥ 0 ; i ε {1, 2}, non-negativity constraint
Cont’ . . .
 Substituting equations (3-6) in to (2) and rearranging, one can
get the ‘full-income’ constraint as:
(8) p(c1+ c2) + w (l1 + l2) ≤ π + w(EL1+EL2) + rEA
the value of consumption cannot exceed the value of the household's
endowment plus farm profits.
(9) π = F(L, A) - wL - rA
(10) ci, li, L, A ≥ 0 ; i ε {1, 2},
 The household's problem is now to maximize (1) (with respect
to L, A, ci, and li) subject to (8)–(10).

 The important fact to note is that the problem (1),(8)–(10) is

recursive or separable.
 As long as U() is characterized by local non-satiation, then (7)
is binding at the solution and the maximized value of U() is
increasing in Π.
Cont’ . . .
 L & A do not appear in (1), hence (1) & (8) can be replaced with :
(1’) Max. U(c1, c2, l1, l2)
{ci, li}
(8’) p(c1+ c2) + w (l1 + l2) ≤ π * wr + w(EL1+EL2) + rEA
(9’) where π * wr = Max. F(L, A) - wL- rA
{L, A}

 Equations (1)–(7) appear to be a joint problem in which production

and consumption choices are intertwined, where the HH's
preferences over consumption and leisure might influence its
choices regarding production.
 However, the transformation of the problem reveals the fact that the
HH's production decisions are characterized by a simple profit
maximization condition—equation (9′).
 A fundamental trait of the perfect-markets model is that it is
“separable” or “recursive”, because production decisions of the HH
are independent of consumption choices (although consumption
clearly depends upon production, via the budget constraint, (8’)).
Mixed Market Scenarios
 In real life, HHs may face missing markets for some goods but not
others, resulting in a mixture of tradables and non-tradables at the
household level.
 In general, a market is missing if the cost of participating in it
(transaction costs) are so high that self-sufficiency is the HH’s
optimal strategy.
 The separation property is robust to the non-existence of some
markets.
 For example, if there is no land market, then replace A by EA in (8′)
and set r = 0.
 The problem remains recursive, and the household chooses labour
inputs to maximize profits given the HH's endowment of land.
 This choice is independent of the household's preferences or
endowment of labour.

 An analogous result is true if there is no labour market but land can

be traded freely.
Graphical Analysis: Separability
•If c1=c2= c & l1=l2=l, no
market for land (c,l,L are
chosen), and F(L,EA) is the
production function,
graphical analysis is given.
• Given the real wage rate
w/p, farm Π are maximized
at Π(w/p, EA) using L* units
of labour on the farm
(where L*=argmax F(L,EA)-
(w/p) L).
• Then, given the budget
constraint
pc = wEL + Π(w/pL,EA)-wl,
HH utility is maximized by
choosing consumption c*
Thus, the HH's decision-making process & leisure l*
proceeds in two stages:
First, farm profit is maximized, and then utility is maximized given
the full income budget constraint.
Does Separation hold in LDSc?
 It is difficult to argue on the basis of descriptions of economic
conditions in the rural areas of developing countries that it is
generally the case that markets are (nearly) complete.
 Indeed, in most developing countries where the hypothesis
has been examined, it is clear that the separation property
does not hold.
 Everywhere in Africa, Latin America, and most of Asia where
the hypothesis has been examined, it has decisively been
rejected (Kevane 1994; Udry 1998; Barrett 1996; Collier 1983; Jacoby 1993;
Carter 1984; Bardhan 1973).
 Therefore, it would seem appropriate to begin with the
assumption that farmers do not maximize profits (with the
hypothesis of non-separability); that in fact their production
decisions are related to their preferences and endowments.
Possible reasons for failure of separation.
 “Shallow" reasons for failure of separation:
 Mis-specified utility function.
 Utility depends directly on production arrangements (e.g., prefer
to work on own land).
 Production depends directly on consumption side (e.g., marginal
product of labor depends on how well-fed workers are).
 “Transaction" costs.
 “Deep" reasons for possible failure of separation involve so-
called missing input and output markets.
Missing Multiple Market Scenarios
 In terms of model specification, when multiple markets are
missing/ incomplete, production and consumption decisions
are simultaneous, rather than recursive, and the separation
property no longer holds- called non-separability.
 A household model is said to be non-separable when the
household’s decisions regarding production (use of inputs,
choice of activities, desired production levels) are affected by
its consumer characteristics (consumption preferences,
demographic composition, and endowments of the household
etc), so that the household no longer maximizes profit.
 A classic example is the problem of a household that faces
imperfections in both the land and labour markets.
Cont’ . . .
 Many mixed-market scenarios are possible. For example,
markets for food (and other consumption goods) may exist,
with market-determined prices, but the labor market may not,
as high labor-transaction costs (e.g., costs of monitoring
workers’ effort) discourage hired labor use.
 Missing labor market would force the HH back to the subsistence
level
 Alternatively, a labor market might exist, but the cost (time,
information-gathering, transportation) of selling food output
or buying food for consumption at the nearest market center
may discourage HHs from participating in food markets.
 If goods market is lacking, it would have no rationale for
producing in excess of its consumption demands.

 The result in both cases would be precisely the same.

The Model: Missing Markets
 Let land market is missed (& some constraints in the labour
market), the HH problem (given just one person in the HH) is:
(11) Max U (c, l)
c,l, Lh, Lf ≥0
(12) Sub.to. pc = F(Lf+ Lh , EA ) – wLh + wLm
(13) EL = Lf + Lm + l
(14) Lm ≤ M, restriction in the labour market
where Lh is labour hired by the HH to work on its farm,
Lf is the HH's own labour on its farm,
Lm is the time spent by the HH working for a wage, and
M is the maximum amount of time the HH can spend
working for a wage as a result of some (here unmodelled)
labour market rationing.
 If (14) is not binding, then (12) becomes
pc+ wl = F(L, EA) – wL + wEL,
where L is the amount of labour used on the farm.
Cont’ . . .
 In this case, the household maximizes profits and the separation property
holds.
 If separation holds, and the production function has CRTS, then all farms
look quite similar.
 With CRTS, we can write F(L,EA) = EAf (L/EA), and the F.O.C. for labour use
is w = f ′(L/EA).
 All unconstrained farmers facing the same wage will use the same amount
of labour per hectare, and achieve the same yield (output per unit of area)
and output per unit of labour.

 However, suppose (14) is binding, as it will be for small M, and when HHs
desire to supply large amounts of labour to the market (perhaps because EL
is large relative to EA). In this case, Lm = M, Lh = 0.
 Setting the numeraire p = 1, the HH's problem becomes
(15) Max U (c, l)
c,l, ≥0
(16) Sub.to. c = F(EL – M – l, EA) + wM
 The F.O.C. becomes U1/Uc = FL, the separation property do not hold, as
shown in the figure below.
Graphical Analysis: Nonseparability
•The outer axes
measure the HH's
consumption (goods
consumption on y-axis,
the time endowment
less leisure on x-axis).
•The inner axes is farm
production, with
output on y-axis and
labour input on x-axis.
•M hours are spent
working in the market,
earning wM.
•The HH's remaining
labour time (Lf ) is
spent on the farm,
•So the HH works M+Lf hours and consumes producing q*- not max.
c* = wM+ F(Lf, EA) units of the good.
•The HH achieves a maximized utility of U(c*,l*) at pt A.
•The HH's production choice clearly depends on its preferences and its
endowment, and the separation property does not hold.
Farm size, Intensity & Productivity
 Many observers found that small farms in the rural areas of
less developed countries are often cultivated more intensively
than large farms.
 More labour per unit area is used on small farms, and yields are
larger on these smaller farms.
 The opportunity cost of family labor working on the farm is less
than the prevailing wage, or the presence of price risk.
 Consider a household with more land than the household
consuming at point A in the above figure, but facing the same wage
and labour market constraint.
 If this household were to cultivate with the same intensity as
household A, it would have to choose to produce and consume
at point C in the figure.
 If leisure is a normal good, C will not be chosen; Instead, the
household will choose to produce and consume at a point such as B,
cultivating its larger farm less intensively than the smaller farm of
household A.
Missing markets and Production
 More generally, when there are three or more goods (say,
staples, a cash crop, other market goods, and leisure), a
missing labor market may either dampen or stimulate
production of specific goods.
 In a labor-abundant HH, a missing labor market effectively traps
family labor on the farm by preventing it from engaging in wage
work. This stimulates production (and/or leisure demand), where
the HH can transform a non-tradable (labor) into a tradable (e.g.,
cash crop).
 However, in a HH with relatively shortage of labor, it will tend to
dampen production through low labour supply (and provoke a
shift towards less labor-intensive activities and technologies).
 Multiple other missing market scenarios are possible, most
with similarly ambiguous impacts on HH production and
consumption, and failure of reparability.
Consumer model Vs Farm-HH Model
 In both of the pure consumer and farm-HH models, the
objective function is to maximize utility subject to its budget
constraint.
 The fundamental difference between agricultural household
model and a pure consumer model is that, in the latter, the
household budget is generally assumed to be fixed, whereas in
household-farm models it is endogenous and depends on
production decisions that contribute to income through farm
profits.
 In a consumer model, when the price of a normal good (say,
food) increases, its demand unambiguously decreases: a
positive “real income” effect reinforces a negative
“substitution” effect, as illustrated in the Slutsky effects of
consumer model.
Cont’ . . .
 However, the HH as producer, it can allocates more labor (of
its own or from market, while consuming more leisure) to on-
farm production and less to wage work (as the opportunity
cost of labor on the farm has gone up) and increase production
(and profit), adding a positive “farm profit” effect to the
negative Slutsky effects on food demand, pushing the budget
constraint outward.
 If this profit effect outweighs the Slutsky effects, the HH’s
demand for food increases with the food price.
 Thus, to the standard Slutsky effects of the consumer model,
agricultural household models add an additional “farm profit”
effect, which may be
 positive (e.g., if the price of the home-produced staple increases)
or
 negative (as when the market wage increases, squeezing profits).
No Market Scenario
 In the extreme case of no access to labor or food markets to provide
it with prices or the opportunity to exchange food for leisure, the HH
faces a direct tradeoff (no substitutability) between producing food
& consuming leisure.
 Lacking access to a labor market indicates hired substitutes are not
available and the HH must supply its own labor to production,
implying that food output cannot be increased without sacrificing
leisure.
 In the missing markets model, production and consumption of
staples are equated by a subsistence constraint, and any increase in
production implies sacrificing leisure.
 If the HH produces no food, it can allocate all of its time to leisure.
 When all markets are missing, production and consumption
decisions are simultaneous, rather than recursive, and the model is
non-separable.
Conclusion
 In the perfect-markets neoclassical model, there is no longer a
tradeoff between work and leisure, since substitutability is possible
now, and no longer constrained to be self-sufficient but the HH
decouples production from consumption decisions.
 That is, households, like countries, are better off with access to
markets than without.
 Because, in complete market, if staple production exceeds
household consumption demand, the surplus is sold for profit,
which in effect, provide cash to hire labor, so that the household can
“consume” more leisure while producing more staples.
 Intuitively, missing markets impose constraints on HHs, and
removing constraints logically cannot make households worse off
than before.
 The separability property also holds if all markets are complete, or if
no multiple markets are incomplete.
 Unfortunately, in most developing countries where multiple markets
are incomplete, the separation hypothesis has been examined and it
has proven that it doesn’t hold.
THANK YOU !!!