A behavioral economic analysis of bounded rationality in farm financing decisions

Abstract

PurposeOften farmers do not switch to a new bank even if it offers better interest rates than the house bank. This can be attributed partly to transaction costs, and partly to bounded rationality. The purpose of this paper is to better understand farm borrowers by analyzing the role of incomplete information and limited cognitive abilities in their finance decisions.Design/methodology/approachThe data for the analysis were retrieved from a written survey conducted among German farmers who were “experimentally” confronted with a funding problem and who had to make a choice between two loan offers: one from the housebank, and one from a competing bank. Using contingent valuation, each farmer's willingness to pay (WTP) for continuing business with his house bank was assessed.FindingsApproximately 90 per cent of the farmers misjudged the absolute losses caused by higher interest rates. In the frame “accepted interest rate surcharge” the WTP for staying with the house bank was, on average, ten times higher than in the frame “accepted surcharge in Euro”. The misjudgment was found to differ depending on education, the duration of the business relationship, etc. The findings indicate that bounded rationality is a relevant determinant of the “reluctance to switch”.Originality/valueComplementing research on the decision making of lenders, this paper studies the demand side of the agricultural credit market. Two research questions are examined which, to the authors' knowledge, have not previously been investigated through empirical surveys: first, to what extent do farmers make bounded‐rational financing decisions? Second, which factors explain bounded rationality?