UW-Madison UW-Madison

Staff Paper No. 381 - Abstract

Low Capital Dairy Strategies in Wisconsin: Lessons from a New Approach to Measuring Profitability

Bradford L. Barham [barham@mailplus.wisc.edu]
Jean-Paul Chavas [jpchavas@wisc.edu]
Richard M. Klemme [rmklemme@wisc.edu]

Staff Paper No. 381, October 1994, 29p.


This paper proposes a new way to evaluate the role of profitability and risk in the dairy industry, one that incorporates the effects of uncertainty about future returns when investments are irreversible, or sunk. The usefulness of this new approach is demonstrated by the light it sheds on recent attempts by Wisconsin dairy farmers to develop low capital investment strategies and why these initiatives might be crucial to the vitality of the state's industry as a whole. The value of this paper, however, reaches beyond the contribution it offers to comparisons of the viability of alternative investment strategies in dairy, because it is applicable to evaluating profitability and risk in any economic activity, inside or outside of agriculture, where much of the investment is irreversible and uncertainty about future returns is important.

The central argument is that the irreversibility of some types of investments becomes fundamental in evaluating profitability when the risk of down-side losses are significant. Irreversibility and uncertainty, together, create two valuable investment options for investors that are omitted from standard, long-term profitability analyses. One is the degree to which during bad times investors can adjust their strategy to avoid losses by selling off investments for a favorable salvage value. The other is the option to delay investment in order to wait and see how industry prospects evolve. Thus, farm analyses of cost structures and returns generated by alternative investment packages that omit these valuable options will be misspecified, if irreversibility and uncertainty are basic features of the investments being compared.
Last updated on Thu, Jun 2, 2005 1:21pm