Households in developing countries face fluctuations and shocks of many sorts. Agriculture introduces seasonal fluctuations into the lives of many households. Farming households reap most of their income in harvest seasons and might generate very little income the rest of the year. During nonharvest seasons, as farmers demand less labor and supply less food, wages fall and food prices rise, spreading seasonal difficulties to nonfarm households as well. In countries like Gambia, seasonalfluctuations are so profound that the last months before the new harvest are called the“hungry season” (Lawrence et al., 1989).
Another fairly predictable source of variation in income and needs has to do with households’ life cycles. As young families start out, they anticipate that income will soon rise, as the parents’ time is freed up and children start contributing to family income, but then diminish in later years, as children leave home and parents become elderly. As parents look to the future they also foresee that needs for expenditure can rise rapidly first with childbirth and care for young children, later with the need to provide dowries for daughters or bride prices for sons, and yet later with increased needs for health care as the effects of age set in. Unfortunately, these life-cycle variations in income and needs tend not to match up. Income doesn’t spike just when dowry payments are required, and incomes are often lowest just when health-related needs are highest in old age.
Recent research, including the Rutherford study for Bangladesh, highlights significant variation in income and needs over much shorter time scales that also create difficulties for households in developing countries. These variations arise out of the lumpiness of income receipts and consumption purchases. Even small-business owners with steady sales from month to month might experience only a few days of significant cash inflow during any given month. Similarly, workers with steady employment might receive their pay only once a month. The timing of these cash inflows might not match up well with the ideal timing of consumption purchases. Some foods must be purchased every day to prevent spoilage. Other basic goods are
more cheaply obtained through bulk purchases, which can require payments larger than the income available on a typical payday.
Unpredictable shocks to agricultural productivity result fromfluctuations in many factors beyond farmers’ control: temperature, rainfall, size of insect populations, exposure to crop dis- eases, and more. Dercon (2002) reports that in a sample of rural Ethiopian households, 78 percent reported having been severely affected by a harvest failure in the last 20 years. Crop loss not only deprives farmers of most income, it also reduces wages for rural workers. During a drought in 1974 in Bangladesh, for example, real agricultural wages fell 50 percent (Jayachandran, 2006). Another source offluctuation in well-being is variation in market prices. Rising food prices help farmers who sell food and hurt the landless poor who buy food. An index of world food prices rose 83 percent over the three years prior to 2008, and the World Bank (2008) estimates that the net effect of this“global food price crisis” (which we examine more closely in Chapter 7) was to increase poverty significantly in many regions of the world.
Households facefluctuating returns in nonagricultural businesses as well. Small businesses selling handicrafts or carpentry services might suddenlyfind that their clients have run short of cash. Production and sales can suddenly stop because input supplies run short or workers become ill. Households working for wages face the risk of job loss.
Households in developing countries face many other potentially devastating shocks. High rates of illness and injury place households at risk of shocks that simultaneously reduce their income-generating capacity and increase their need for expenditures on medicine and health care (see Chapter 22). Where judicial systems offer only weak enforcement of contracts, households face the risk of losing assets through fraud or theft. Where governments are not committed to respecting private ownership, people also face the risk of losing assets to the government through expropriation. On top of this, many of the world’s poor live in places where they cannot count on police to keep their neighborhoods safe and where they fear violence at the hands of warring militias.
The ebbs andflows of income, consumption needs, and prices matter because people would rather avoid great variation in their ability to meet needs. Many would prefer to eat two good meals every day rather than have several three-meal days followed by several one-meal days. When facing spikes in needs for expenditure when their daughters marry, they would rather be able to meet those needs without having to go hungry, even if it means consuming less at other times. In fact, people are generally willing to accept lower average consumption if this allows them to achieve fewer or smaller fluctuations, and thus fewer experiences of very low con- sumption. Economists often refer to this desire for steady consumption as an interest in consumption smoothing.
Households engage in many costly activities to smooth consumption in the face offluc- tuations in income and needs. Considerfirst the activities households undertake after they have been hit by shocks to income or needs, which are referred to as ex post responses tofluctuations. To maintain their consumption in the face of a shock, households might take out a loan, promising to repay it with interest out of future income (when income and needs have returned to normal levels). They might attempt to borrow from many sources, including friends and neighbors, local moneylenders, pawn brokers, banks, or microfinance institutions. They might instead draw down past savings. If the shock reduces only the profitability of their farm or small business, they might also compensate by working more in wage labor markets (Kochar, 1999).
Knowing that they will be exposed tofluctuations in the future, households also take steps now that will help them avoid futurefluctuations or cope with them better. These are referred to as ex ante responses tofluctuations. Households might save up, by spending less than their income on current consumption, so that they will have savings to draw down when needs rise relative to income. This saving can take many forms: placing currency in a mud bank, depositing savings in a bank account, buying durable goods like jewelry or household appliances, or lending to others against a promise of later repayment. In rare circumstances, households purchase formal
insurance. They might also insure themselves informally through their participation in informal mutual assistance arrangements (as discussed in Chapter 12).
A final set of ex ante approaches to consumption smoothing falls under the label of income smoothing. Households engage in income smoothing when they choose income- generating strategies that are purposely designed either to reduce the magnitude of seasonal fluctuations in income or to reduce the probability of being hit by shocks (Morduch, 1995). For example, farmers might allocate some of their land to each of several crops that produce harvests in different seasons in order to spread out their cash inflows over the year. They might work several plots of land at different altitudes or with different soil qualities, rather than working with a comparable quantity of land in a single location, hoping to avoid the destruction of their entire crop byflood, drought, or disease. By working in off-farm employment as well as cultivating their land, they can shield themselves against the most devastating effects of either agricultural or nonagricultural downturns. They might also simply choose not to cultivate certain crops whose yields are particularly sensitive to weather conditions. Income smoothing is a constructive response to the fear of fluctuations, but it nonetheless raises concern among development analysts, because these efforts to avoid fluctuations can come at the cost of reducing households’ average incomes, thereby increasing the average severity of their poverty (as we discuss in Chapter 10).