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Flat-earth economics Far-reaching consequences of flat payoff functions David Pannell University of Western Australia

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Starting point 1983

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Payoffs profit expected value of profit expected utility any other objective function that has an internal optimal solution

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Example: whole farm plan 51% 92%

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Example: herbicide dose 0.44 0.15

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Monopolist’s pricing decision

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Jardine (1975): “On presenting information to agronomists about flat profit curves for fertlizers, I observed such reactions as complete disbelief, blank incomprehension, incipient terror, and others less readily categorized.”

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Flat payoff functions are: A consistent empirical finding (almost universal) Very important Rarely acknowledged Debated in 1975, but apparently not since

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What is behind it?

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Diversified portfolios e.g. because of risk aversion variable resource quality resource constraints complementarity between enterprises

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Implications

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Implication 1: Margin for error Decisions without careful analysis Can consider extra factors Risk Personal preference DSSs focus on plateau, not optimum

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Implication 2: The value of monitoring Sustainability indicators/EMS The value of information decision theory framework What difference to the decision? information decision What difference then to payoff? decision payoff Weighted by probabilities Value often low

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Implication 2: The value of monitoring If payoff function is flat: Info may change decision But not change payoff by much

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Implication 2: The value of monitoring If payoff function steep Optimal solution obvious More info doesn’t change it Either way, low info value

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Implication 3: Precision farming Jock Anderson (1975): "In pursuing optimal levels of decision variables, precision is pretence and great accuracy is absurdity."

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Implication 3: Precision farming Example: lime application for acidity Very low precision: same low rate for all Low precision: rate set for each soil type for each region Moderate precision: paddock by paddock (High: adjust within paddock)

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Example: liming acidic soils Typical payoff function

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Implication 3: Precision farming Value of information $/ha from greater precision of info Change from moderate to high 0 0 0

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Implication 4: Value of research Consider two types of research increases the yield of a crop by 20% (increases yield directly) provides info that yield will be 20% higher than previously believed (increases yield indirectly through adjustments to input levels) Which is more valuable?

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Implication 4: Value of research Value of improving technology = P2,2 - P1,1 Value of improving information = P2,2 - P1,2

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Implication 5: Risk

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Accounting for risk aversion makes a small difference to payoffs (CE or U) Example: herbicides again

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Example: herbicide dose R=0 R=3.2

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A non-implication: Externalities “Surely, if you consider externalities, the point breaks down!” payoff function stops being flat input level starts to really matter

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Externality doesn’t change story 90% range

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Externality doesn’t change story

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Conclusion Flatness far more important than optimum Should emphasise flatness and its implications to our students to our clients to ourselves

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Conclusion Implications include Margin for error/Flexibility Low value of monitoring Diminishing marginal value of precision Research: value of new technology greater than value of new information Risk aversion not very important in normative studies

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www.davidpannell.net Pannell, D.J. (2006). Flat-earth economics: The far-reaching consequences of flat payoff functions in economic decision making, Review of Agricultural Economics 28(4): 553-566.

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