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

2. Starting point  1983

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

4. Example: whole farm plan 51% 92%

5. Example: herbicide dose 0.44 0.15

6. Monopolist’s pricing decision

7. 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.”

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

9. What is behind it?

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

11. Implications

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

13. 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

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

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

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

17. 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)

18. Example: liming acidic soils Typical payoff function

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

20. 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?

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

22. Implication 5: Risk

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

24. Example: herbicide dose R=0 R=3.2

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

26. Externality doesn’t change story 90% range

27. Externality doesn’t change story

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

30. 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

31. 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.