Estimating the Optimal Farm Size under Uncertainty: an Application of Real Options Methodology

Abstract

Farm structure and optimal farm size have always attracted the interest of research as they constitute some of the intense problems of farm efficiency and farm income. Although several approached have been employed to handle with this problem a real options approach can significantly contribute on this matter. This article provides an empirical example of applying real options approach in investigating a typical Greek farm in the town of Velvendo. Several scenarios are used to estimate the optimal farm size employing both discounted cash flow (DCF) methods and real options. Although DCF methods cannot be directly compared with real options theory, we use a direct comparison in order to highlight the constraints and the limitations of these methods since they are still widely used in the investment analysis. Despite the disadvantages of the DCF methods they are still useful in calculating the starting values used in the real options approach. Results clearly demonstrate the contribution of the real options approach as decision making is drastically alters when real options outcome is considered. Moreover results facilitate a better understanding in terms of public policy and agricultural policy dynamics.