Economic efficiency and downside risk

Abstract

This article investigates the impact of downside risk on cost and revenue efficiency (RE) for a sample of farms. Downside risk or loss below a certain level of return is a concern regardless of producer risk preferences and thus a suitable measure of risk to use. Downside risk was measured as the weighted summation of net farm income below the amount needed for unpaid labour during the previous 10 years. Cost and RE were estimated using traditional input and output measures, and then re-estimated including each farm’s downside risk. Comparisons were made between the efficient farms with and without downside risk and the average for all farms. As expected, downside risk plays an important role in explaining farm inefficiency. Failure to account for downside risk overstates inefficiency and can lead to unrealistic expectations in potential efficiency improvements.