Economics of Agriculture
(Econ-4111)
Ermias Ashagrie (PhD)
Department of Economics
College of Business and Economics
Bahir Dar University
Bahir Dar, Ethiopia
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CHAPTER THREE
PRODUCER DECISION MAKING
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Introduction
This chapter presents the main elements of the theory of
agricultural production economics, which is concerned,
with the allocation of scarce resources to alternative
uses.
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Outline
3.1 Production with single variable input
The production functions
Physical input-output relationship
Value input-output relationship
3.2 Production with two variable inputs
The production functions
Input-input relationship
Least cost combination of inputs
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3.1 Production with single variable input
Production, in agriculture, is the process of combining resources in to
create agricultural products.
» using labor, fertilizer, mechanical implements….
for example, more production of wheat requires
some amount of arable land, seed, fertilizer, equipment and human
labor in addition to suitable climatic conditions
Production varies in a systematic way with the level of input usage,
»economists call this relationship as production function.
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Production Function
Production function can be expressed mathematically as:
Q=f(x1,x2,……..xn )
» where Q= quantity of specific product
» x1,x2,……..xn quantities of n inputs
The function purely states that output is related to the levels of input
usage
The production function is purely physical concept: it depicts the
maximum output for each combination of specified input
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Physical Input-Output Relationship
If we assume all inputs except one (fertilizer denoted as x1) are held
fixed, the relationship between output and single variable factor can
be denoted as:
Q=f(x1/x2,…,xn)
Where x2, …, xn are the fixed factors
x1 is the variable factor
This relationship is represented by Total Physical Product (TPP) or
total Product (TP) curve
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Physical Input-Output Relationship
For inputs like fertilizer, irrigation water, weedicides, etc, some level of
output is expected even if there is zero application of input
»the graph starts at some level above the horizontal axis
For other inputs like seed, labor or land, a zero input would cause
zero output
»the production function begin at the origin of the graph
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Physical Input-Output Relationship
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Physical Input-Output Relationship
The relationship states that as more of fertilizer (x1) is applied,
output (Q) increases until maximum, associated with input usage
(X”1) is reached.
Further application of fertilizer reduce the total output (why?)
Three aspects of factor-product relationship will be of interest:
I. Marginal physical product (MPP)
II. Average physical product (APP)
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Physical Input-Output Relationship
I. Marginal Physical Product (MPP) of the variable input
Output grows with successive increases in the variable input (fertilizer
application)
» the amount by which it grows changes because of the existence
of fixed quantities of resources
Marginal Physical Product (MPP):the quantity of additional output
obtained for each successive additional input
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Physical Input-Output Relationship
For a discrete change:
For an infinitesimal change:
The slope of the TPP curve,
MPP, first increases and is maximum (the slope of TPP is at
greatest) at the point of inflection of the curve (X’1),
It is zero at the point of maximum TPP(X”1) and becomes
negative at input levels beyond X”1
MPP curve slopes continuously downward reflecting lower and
lower additional output for each successive unit of input
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Physical Input-Output Relationship
II. Average Physical Product (APP) of the variable input
The average productivity concept is a very important measure of
productivity of factors of production
It is defined as total product divided by the total amount of the
variable input (fertilizer) used in production
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Physical Input-Output Relationship
The APP at a particular input level is the slope of the line from the
origin to the relevant point on the TPP curve
The law of diminishing marginal returns states
As more and more of a variable input is used, with other inputs held
constant, eventually the total product will become smaller and
smaller
»i.e. after some point the marginal product of the variable input will decline
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Physical Input-Output Relationship
The total product is a purely physical relationship; economic
considerations involving prices of inputs and outputs are not part
of the analysis.
Yet it is possible to determine, on technical grounds alone, a
range of input usage in which the rational producer will operate
The TP, MP and AP curves can be used to divide production into
three stages of production
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Physical Input-Output Relationship
Stage 1 : from the origin to the point AP=MPP or the average
product of X1, APX1, is rising;
Stage 2: from the point APP=MPP to MPP=0 or both marginal (MPX)
and average product are falling but both are positive;
Stage 3: from the point MP=0 onward or marginal product, MPX, is
actually negative
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Physical Input-Output Relationship
In Stage 3, additional units of fertilizer reduce total product
»the marginal product of fertilizer is negative
The fixed inputs (land) are overloaded and producers can increase
output would increase by using less fertilizer
It is irrational to choose a level of fertilizer in Stage 3
In Stage 3 the producer uses too much fertilizer
By contrast in Stage 1 not enough of the input is being applied, given
the level of the fixed factors
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Physical Input-Output Relationship
The optimum position in terms of variable input usage will lie
somewhere in Stage 2.
The precise position can only be determined by incorporating the
prices of inputs and of the final product into the analysis
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Value Input-Output relationship: Economic
Optimum
To decide the economic optimal usage of a single variable input
is the producer requires three pieces of information
I. The marginal product of the input (MPX), which indicates the
contribution to total output
II. The price per unit of the final product (P)
III. The price per unit of the variable input (px)
• The value of an additional unit of input to the producer is the extra
revenue that will be obtained as a result of additional input usage
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Value Input-Output relationship: Economic
Optimum
The economic optimum, yielding maximum profits, will be
attained where
The value of the marginal product of the variable input is equated
to its price :
At the particular level of input usage associated with the optimal
condition, the producer is said to be in equilibrium
In equilibrium there is no incentive to alter the production plan
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Production with two variable inputs: Input-Input
relationship
Typically in a given production period there would be more than
one variable factor of production
For example in the production of wheat,
» fertilizer, seed, and labor may be variable,
» land and mechanical implements may remain fixed
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Production with two variable inputs: Input-Input relationship
Assume two variable inputs, the production function is
defined as:
This relationship will be illustrated by an isoquant or iso-
product curve
An isoquant is a contour line or locus of different
combination of the two inputs that yield the same level of
output
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Production with two variable inputs: Input-Input relationship
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Production with two variable inputs: Input-Input relationship
Input combination at point A and B can produce ten units of output
In moving from A to B, the amount of x1 increased from x0 to x’1
and that of x2 decreased from x02 to x’2, i.e., x1 substitutes for x2
The rate at which one input substitutes for another at any point on
the isoquant is called Marginal Rate of Substitution (MRS)
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Production with two variable inputs: Input-Input relationship
MRS is negative since more usage of one input is associated with less
of another
i.e., the isoquant is downward sloping.
The negative sign is often omitted
Isoquants are convex to the origin
» MRS tends to diminish as more of one factor is used
The Diminishing Marginal Rate of Substitution (DMRS) results from
the principle of Diminishing Marginal Returns (DMR)
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Production with two variable inputs: Input-Input relationship
Examples of different rates of substitution between inputs, for a
given output level (Q) are depicted below
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Production with two variable inputs: Input-Input relationship
In panel a, the input X1 being increased for successively smaller amounts of the input
x2 being replaced
»i.e. MRS of X1 for X2 (in absolute terms) at A is greater than at B
In panel b, the amount of X1 required to replace a unit of X2 remains the same,
»As X1 increases, the marginal rate of substitution is constant
In panel c, there are no substitution possibilities, since the inputs must be used in
fixed proportions
MRS as a measure of the degree of substitutability of inputs has a serious defect
»it depends on the units of measurement of the inputs
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Production with two variable inputs: Input-Input relationship
This is a pure number (it has no units of measurement)
The numerator is the percentage change in the input ratio
In the decreasing rate of substitution, the factor intensity at A is given by the
slope of the ray (OA) from the origin to the isoquant
When we move from A to B, the ratio of x2/x1 falls and as x2-intensive
production is replaced by an x1-intensive production.
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Production with two variable inputs: Input-Input relationship
Similarly, the denominator is the percentage change in MRS as we
move along the Isoquant
When inputs are perfect substitutes, =∞
since, as the MRS is constant
the denominator in the equation is zero
In the case of fixed proportions =0
since the numerator is zero
The larger the value of , the greater the ease of substitution will be
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Production with two variable inputs: Input-Input relationship
The short run i.e. a period when the set of inputs available to the
producer is not wholly adjustable
In the long run changes in output can be achieved by varying all
factors
In the long run, the farmer may vary all available resources including
the size of the farm, the number of farm buildings and the type of
machinery
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Production with two variable inputs: Input-Input relationship
In the long run output may be increased by changing all
factors by the same proportion
i.e. by altering the scale of the operation
The response of output to scale changes in inputs will
depend on the production function
If all inputs are increased by the same proportion (say, by
50%), and output increases by the same proportion (i.e. 50%),
» there is constant returns to scale
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Production with two variable inputs: Input-Input relationship
If output increases less than in proportion (say, by 25%) with the same
(50 %) increase in all factors
Decreasing returns to scale
If output increases more than in proportion (say, by 75 %) when we
increase all factors by 50%,
Increasing returns to scale
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Least cost combination of inputs
To determine the appropriate level of input use when there are
two variable factors of production
a producer must know the rates at which input are exchanged
in the market [their relative prices]
the rates at which they can be exchanged in production [their
MRS]
To illustrate the former, we introduce isocost line
It is the locus of all combinations of two variable inputs that can
be purchased with a given cost outlay
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Least cost combination of inputs
Note that px1 the price of input x1 while X1 is the quantity of input
x1 and analogous notation apply for input x2.
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Least cost combination of inputs
The optimum for any given output level is found at the point of
tangency between the lowest isocost line and the appropriate isoquant.
At this point the slope of the isoquant is equal to the slope of the
isocost line
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Least cost combination of inputs
The least cost combination of the two inputs occurs at a point of
tangency between Isocost line (C0) and an isoquant line
At this point the slope of the Isocost line is equal to the slope of
isoquant
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Least cost combination of inputs
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