FARM MANAGEMENT.

 Apply economic principles and theories for optimum resource allocation and utilization

Identify various production relations in pursuit of optimal

resources combination that suites specific farm situation,

 Apply farm planning and budgeting techniques in farm management

decision-making

 Prepare farm plan and recommend on the feasible alternative activities.

 Apply management science and economics tools to solve farm related

problems,

 Analyze farm business investment opportunities for effective farm planning,

Identify various production relations in pursuit

of optimal resources combination that suites

specific farm situation,
 OBJECTIVE OUTLINE
2.1. Production Function
 Concept of Production
 Concept of production function
 Short-run and long-run production
2.2. Production Relationships
2.2.1. Factor-Product (F-P)
 TPP, AVP, MPP, the law of diminishing MPP
 Stages of production
 Determination of optimum input level and output level
2.2.2. Factor-Factor (F-F)
 Isoquant, Isocost , (price ratio, MRTS)
 Determination of least cost input combination
2.2.3. Product-Product (P-P)
 PPF, MRPT, price ratio,
 type of product r/ship (joint, antagonistic, complimentary,
supplementary, competitive enterprises)
 Production is synonymous with creating something.

 Economist does not restrict production to the

manufacture of commodities; but also takes the
expression to include the provision of services such as
those of lawyer, accountant, actor, musician, or market women.

 The central aim of all production is to satisfy people’s

wants and increase the economic welfare of a people, to
raise their standard of living by enabling to satisfy more
fully a greater number of their wants.
 Production is the process by which inputs are transformed into output in
output producing units.

 The output producing units include farms and factories.

 Production therefore means changing either the form of something or its
situation in space or time, or the provision of a service of some kind.

 Agricultural production involves many controllable and uncontrollable inputs.

 The controllable inputs include land, labor, capital, irrigated water and
management and their various disaggregated forms to give as more specific set of
factors.

 The uncontrollable inputs include rainfall, other weather variables and many
variables such as animal and plant nutrition or photosynthesis which are not
completely understood.

 Because of the uncontrollable inputs in agricultural production, last years

production response may be estimate of this year’s production response.
 The major resources used in agriculture are free and economic
resources.

A) Free resources are termed free because they are relatively

abundant in supply and hence have no cost elements attached
to them but they are highly essential in agricultural production.
Eg. air, heat, water (rain) and so on.

B) Economic resources are scarce in supply and limiting in

production. They possess high economic value (land, labor, capital and
management)

 The economic resources come into agricultural production in

different disaggregated forms for example, land of different types,
different categories of capital expenditure and labor of different
categories (hired labor, family labor, skilled or unskilled labor).
 Land: Land is the most important resource in
agricultural production.

 Its supply is relatively fixed except it can be

expanded slightly by drainage of swamps,
reclamation from sea bodies and water, and
chemical or biological improvement of non-
cultivable lands.

 Land (farm size) is measured in hectares but local

farmers measure their farm differently.
 Labor: Labor is the effort of human being that is used in making things happen in
the production process.

 It is the second most important resource next to land in agricultural production.

 Labor availability is a function of the economically active proportion of the population
released for agricultural activities.

 labor on peasant farms could be from both family or hired sources depending on
the size of the farm and type of operation to be performed, but in large
commercial farms, farm labor is purely hired and categorized as casual, unskilled,
semiskilled and skilled labor.

 The quality of labor in use is a function of the level of education and training in
relevant agricultural production, that is, the higher the level of training in the
cultivation and management of any crop the higher the productivity and
efficiency.

 Labor is measured in terms of the adult male equivalents, where (one man day is
the work done by one adult male in eight hours), and one woman is equivalence
of 2/3 of a man-day while a juvenile is 1/2 of a man-day.
 Capital: Capital resources come into farm production in three
forms, namely,
 Farm machinery, such as, tractors and various farm tools
 Biological capital such as fertilizers, pesticides, herbicides, improved
seeds and breeding stock
 Feed for Livestock.
 Also, capital can be categorized on the basis of their cost
structure, that is,
 Depreciation cost on building which are for farm
improvement.
 Maintenance and running costs on machinery and
equipment, livestock & feed expenses, feed and fertilizer
purchases.
 Depreciation cost on machinery.
 Management/entrepreneur/co-ordination is the most important factor of
production.
 In this, input resides the decision making power in farm business.

 It is concerned with efficient mixing of resources in the production process.

 An efficient resources planning and utilization ensures attainment of the
objective of the production function.

 Management is therefore concerned with

 planning,
 implementation and
 control of the farm business.
 Production is creation of output from resources fed into the production
process.
 Economic agricultural resources are land, labour, capital, water and
entrepreneur.
 Production Functions
A production function specifies:

 The relationship between quantities of

inputs used and the maximum quantity of
output that can be produced

 Given current knowledge about technology

and organization.

 For example, q = f(L, K)

 CONT…
 It’s a physical or technical relationship between inputs and output
in any given production processes.

 It describes the rate at which inputs are transformed into outputs.

It defines the production possibilities open to the farmers.

In an implicit form, the production function is defined as:
Y = f(x).
 It states that output Y is a function of input X.

 Where Y = output of product, X = input used, f() = functional form.

The production function can be expressed in three ways:

1) Tabular form
2) Graphical form
3) Algebraic (Mathematical) form

1. Tabular form: Production function can be expressed in the form

of a table, where one column represents input, while another
indicates the corresponding total output of the
product.

 The two columns constitute production function.

1) TABULAR AND

2) GRAPHICAL FORM
 3) ALGEBRAIC FORM:

 Algebraically production function can be expressed as Y= f(X)

Where , Y = dependent variable, output (yield of crop, livestock enterprise) and X =
independent variable, input (seeds, fertilizers, manure etc),

 When more number of inputs are involved in the production of a product, the equation is
represented as
Y=f(X1, X2, X3, X4………..Xn)
 When a single variable input is involved in production, keeping others constant, the PF is:
Y=f(X1 | X2, X3………….. Xn)
 The vertical bar is used for separating the variable input from the fixed input.

 The equation denotes that the output Y depends upon the variable input X1, citrus per bus.

 If more than one variable input is varied and few others are held constant, the relationship
can be expressed as
Y=f(X1, X2 | X3, X4……… Xn)
Classification of production runs
Very short run (VSR)

 all factors are fixed (remains unchanged).

Short run (SR)

 some factors are varied but some are fixed.

Long run (LR)

 all factors are variable and
 all required variations have been made.
 VSR SR LR

Any change in
All factors are
factor employment? Some factors are
variable and all
No varied but some
required changes
are fixed
are made

Any change in No Yes Yes

output level?
No adjustment — Temporary adjust. Final adjustment –
Time is needed —Time is needed
Time is long enough
to recognize the to identify if the
Reasons for the final adjust. to
change, make change is permanent
& to make gradual be determined &
decision &
implement adjustment to implemented.
adjustment minimize cost
 Short Run versus Long Run
 Short run: A period of time so brief that at least one factor of
production is fixed.

 Fixed input: A factor that cannot be varied practically

in the short run (capital).

 Variable input: a factor whose quantity can be changed

readily during the relevant time period (labor).

 Long run: A time period long enough so that all inputs

can be varied.
 AGRICULTURAL PRODUCTION FUNCTION
 There are two forms of agricultural production functions: biological and farm
functions.
 Biological functions: They are derived from experiments in crops and livestock.
o The experiments may be conducted in plants, group of animals, or using
area of land as basis for experimentation.
o Biological functions guide farmers in their decisions, such as, optimal plant
size, quantity of fertilizers to use per hectare.
o The data used in biological functions are of importance for purposes of
policy and as an instrument for planning economic development.

 Farm functions: They are used on farm survey of existing farms.

o Data are collected from secondary and primary sources.
o Because we do not keep good records, the better option is to draw up
questionnaires on information on average input and output quantities,
inputs and output prices, all within a given season or time period.
o From this information, we fix the production function and estimate using
appropriate procedures and methods of analysis.
 USES OF AGRICULTURAL PRODUCTION
FUNCTION

 They serve diagnostics purposes to diagnose input and

output relationship within sampled farms.

 They tell us the level of optimum use of inputs.

 Determination of the scale of production.

 They are useful in determination of enterprise combination.

 They guide farmers in decision making.

 BASIC PRODUCTION RELATIONSHIPS
 Production of farm commodities involves numerous relationships between
resources and products.
 Some of these relationships are simple, others are complex.
 Thus, the knowledge of these relationships guides the farmer/farm manager in
solving the 3 basic economic problems in agricultural industry .

 Major production relationships are:

1) Factor-Product relationship

2) Factor-Factor relationship

3) Product-Product relationship
 FACTOR-PRODUCT RELATIONSHIP
 It deals with the production efficiency of resources.

 The rate at which the factors are transformed in to products is the study of this
relationship.

 Optimization of production is the goal of this relationship.

 Known as input-output relationship by farm management specialists and fertilizer

responsive curve by agronomists.

 Guides the producer in making the decision ‘how much to produce?’.

 Helps the producer in the determination of optimum input to use and optimum
output to produce.

 Price ratio is the choice indicator.

 This relationship is explained by the law of diminishing returns.

 Algebraically, this relationship can be expressed as

Y = f (X1 / X 2,X3 Xn)

 It describes the transformation of a given input into a product.
 There is only one product such as cassava.
 We are interested in the effect of variation of only one input such as labor or
fertilizer while other inputs are fixed.
 Many farm decisions are mostly analyzed using this production relationship,
especially when the problem is to determine the intensity with which the given
variable input shall be combined with fixed quantities of other essential inputs
to achieve the stated objectives.

 Is not true to life because production always involves more than one variable input .

 It is only used for discussion/diagnostic purpose where one basic input is the
limiting input.
 PRODUCTION FUNCTION PARAMETERS OF INTEREST
FOR FACTOR-PRODUCT R/SHIP
 The following productivity measurements are derived from the analysis of the
production function.
They include:
1) TOTAL PHYSICAL PRODUCT (TPP)

2) AVERAGE PHYSICAL PRODUCT (APP)

3) MARGINAL PHYSICAL PRODUCT (MPP)

TOTAL PHYSICAL PRODUCT (TPP)

 illustrates the technological or physical

relationship that exists between output and one
variable input, ceteris paribus

 Total physical product (TPP) is the amount of

production expected from using each input level.

 Output or yield is often called total physical

product.
25
 TOTAL PHYSICAL PRODUCT (TPP)

– Starts increasing at an increasing rate.

– Continues to increase but at a decreasing rate

– Reaches the maximum, then decreases

 The functional form of a production function is:

Y = f (X),

 where Y is the quantity of output and X is the quantity of input

 X TPP=Y
0.00 0.00
1.00 10.00 Y

2.00 25.00
3.00 50.00
4.00 70.00 TPP
5.00 85.00
6.00 95.00
7.00 100.00
8.00 101.00 X1

9.00 95.00
10.00 85.00
TPP
 The point where TPP changes
from increasing at an increasing Y
Maximum Point
rate to increasing at a decreasing
rate is called the Inflection Y3
Points. C TPP
Y2 B

 Points A, B, and C Indicate

total amount of output Inflection Point
produced at each level of Y1
input use A

X1 X2 X3 X
 AVERAGE PHYSICAL PRODUCT

Average physical product (APP) is the average amount

of output produced per unit of input used.

TPP
APP =
Input level

29
 AVERAGE PHYSICAL PRODUCT (APP)

 Shows how much production, on average, can be obtained per unit of the
variable input with a fixed amount of other inputs

Indicates average productivity of the inputs being used - how

productive is each input level on average

APP = Y / X

Drawing a line from the origin which is tangent to

the TPP curve gives APP max
AVERAGE PHYSICAL PRODUCT (APP)

X TPP=Y APP
0.00 0.00 Y
1.00 10.00 10.00 TPP
2.00 25.00 12.50
3.00 50.00 16.67
4.00 70.00 17.50
Y X
5.00 85.00 17.00
6.00 95.00 15.83
7.00 100.00 14.29
8.00 101.00 12.63 APP
9.00 95.00 10.56
X
10.00 85.00 8.50
 MARGINAL PHYSICAL PRODUCT
 Measures the amount that total output increases as input
increases.

 It is the change in output resulting from a unit change in the

variable input.

• It reaches zero at the maximum point of TPP

 The MP is the slope of the production function curve.

 Mathematically it is derived thus: If Y = f(X)

MP = dY / dX = f(X).
 MARGINAL PHYSICAL PRODUCT
Since MPP is the slope of TPP, it reaches a maximum at
inflection point
Marginal physical product (MPP) is the additional TPP
produced by using an additional unit of input.

MPP = TPP
 input level
33
 LAW OF DIMINISHING MARGINAL RETURNS

“As successive units of a variable input are

added to a production process with the other
inputs held constant, the marginal physical
product (MPP) eventually declines”
MARGINAL PHYSICAL PRODUCT (MPP)

X TPP=Y MPP
0.00 0.00 Y
1.00 10.00 10.00 TPP
2.00 25.00 15.00
3.00 50.00 25.00
4.00 70.00 20.00
5.00 85.00 15.00 Y X

6.00 95.00 10.00

7.00 100.00 5.00
8.00 101.00 1.00
9.00 95.00 -6.00 APP

X
10.00 85.00 -10.00 MPP
 TPP, APP AND MPP

X TPP=Y APP MPP

Y
0.00 0.00
TPP
1.00 10.00 10.00 10.00
2.00 25.00 12.50 15.00
3.00 50.00 16.67 25.00
4.00 70.00 17.50 20.00 Y X
5.00 85.00 17.00 15.00
6.00 95.00 15.83 10.00
7.00 100.00 14.29 5.00
8.00 101.00 12.63 1.00 APP
9.00 95.00 10.56 -6.00 X
10.00 85.00 8.50 -10.00 MPP
MPP is negative
 RELATIONSHIPS BETWEEN TPP, APP AND MPP

 MPP reaches a maximum at inflection

point
 MPP = 0 occurs when TPP is maximum Y
 MPP is negative beyond TPP max
TPP

 Drawing a line from the origin which is tangent

to the TPP curve gives APP max
 At point where APP is max, MPP crosses
APP (MPP=APP) X
Y

 When MPP > APP, APP is increasing

 When MPP = APP, APP is at a max
 When MPP < APP, APP is decreasing
APP
The relationship between TPP, APP, & MPP is
very specific. X
MPP is negative
MPP
STAGES OF PRODUCTION FUNCTION

A. State I

B. Stage II

C. Stage III
 STAGES OF PRODUCTION – TP, AP AND MP
Stage 2
Stage 1 Stage 3
 Stage 1: average TP Q

product rising.
Pt of
Marginal
Returns
TP

 Stage 2: average Increasing Returns

product declining (but Negative Returns

marginal product Decreasing Returns

positive). AP,MP
L1 L2 L3 L

 Stage 3: marginal
product is negative, or
total product is declining.
AP

L1 L2 L3 MP L
 STAGES OF THE PRODUCTION
 There are three stages of the production function.
(a) Stage I
 MPP> APP
 MP is increasing, reaches its max, starts to decline and AP are increasing.
 MP is maximum at point of inflexion where the first derivative of the
production function, dY/dX1, is zero and the second level derivation, d2Y/dX21 is
also zero.

 MP equals AP at the boundary of stages I and II

 It is a stage of increasing marginal returns. b/c it doesn’t make sense to stop

increasing input if its efficiency is increasing (Y/x)

 It is an irrational zone of production

 The input use and output to produce should be continued until stage II is reached.
APP increasing,
MPP>APP,
TPP increasing
 It is a stage where the MP is less than AP.
 AP is still decreasing.
 MP is decreasing but positive.
 MP is zero at the boundary of stages 2 or 3.
 It is a stage of economic relevance in production where
total product increasing at a decreasing rate.
 it is a stage of decreasing positive marginal returns and
decreasing returns to scale.
 it is a stage of rational production where output and profit
are maximized and input use is optimized.
In this stage;
 AP is greater than MP.

 AP is positive and greater than zero.

 MP is less than zero and negative.

 Both MP and AP are falling.

 Production is not advisable in this stage because

increase in input use leads to reduction in total
product.
 LAW OF DIMINISHING RETURNS
 Factor - Product relationship or the amount of a resource that
should be used and consequently the amount of output that should be
produced is directly related to the operation of law of diminishing returns.
 Increases in one factor of production, Holding one or other factors
fixed, AFTER SOME POINT, Marginal Product Diminishes.

MP
point of diminishing returns

A Short-Run Law Variable input

The law of diminishing marginal productivity

 Law of diminishing marginal productivity [or the law of

diminishing returns or the law of variable proportions or the
principle of added costs and added returns.]

variable factor is added continuously to a

 States that if a _________
fixed factors, the marginal product
given amount of _________
variable factor must
(and the average product) of the _________
finally decrease, ceteris paribus.
Implications of the law (if the law is violated)

By adding a units of fertilizer or worker continuously to a given plot of

land, no matter how small its size is,
TP can be increased continuously.
Enough food can be produced to feed all the people in the world.

A small piece of land is adequate to supply the amount of food

required by the growing world population.
Hence the supply of land is no longer scarce.  Land price would drop to zero.
Graphical illustration:

Variable factors Fixed factor

MP
MP
AP

AP 
The slope of TP curve is
MP.

The slope of the line

joining the origin and a
point on TP is AP.
 STAGES OF PRODUCTION: RATIONAL &
IRRATIONAL
 The stage I of the production function is
between 0 and X1 units of X. Y
 In stage I: I

 TPP is increasing
TPP

 APP is increasing
 MPP increases, reaches a maximum &
decreases to APP
Y X
 Stage I is an irrational stage because
APP is still increasing

APP

0 X1 X
MPP
 STAGES OF PRODUCTION: RATIONAL &
IRRATIONAL

 The stage II of the production function is Y

between X1 and X2 units of X. I

 In Stage II: TPP

 TPP is increasing
 APP is decreasing
II
 MPP is decreasing and less than APP, but
still positive X
Y

 RATIONAL STAGE BECAUSE TPP IS

STILL INCREASING

APP

0 X1 X2 X
MPP
 STAGES OF PRODUCTION: RATIONAL &
IRRATIONAL

 Stage III of the production function is

beyond X2 level X Y
I
 In Stage III: TPP
II
 TPP is decreasing
 APP is decreasing
III

 MPP is decreasing and negative

Y X
 IRRATIONAL STAGE BECAUSE
TPP IS DECREASING

APP

0 X1 X2 X
MPP
Output = f(labor | capital, land,
and management)
Start with
one variable
input
Output = f(labor | capital, land,
and management)
Start with assume all other inputs
one variable fixed at their current
input levels…
Coordinates of input and
output on the TPP curve
 Total Physical Product (TPP) Curve

Variable input
Change in output as
you increase inputs
 Total Physical Product (TPP) Curve

Marginal physical product is

output .45 as labor is increased from
16 to 20

input
Output per unit
input use
 Total Physical Product (TPP) Curve

output Average physical

product is .31 if
labor use is 26

input
Plotting the MPP curve
Change in output
associated with a
change in inputs
Plotting the APP Curve
Level of output
divided by the level
of input use
 Average Physical Product

Output divided
by labor use is
equal to 0.19
Three Stages of Production

Average physical
product (yield) is
increasing in Stage I
 Three Stages of Production

Marginal physical
product falls below the
average physical
product in Stage II
Three Stages of Production

MPP goes negative

Beyond max of TPP
Three Stages of Production

Why are Stage I and

Stage III irrational?
Three Stages of Production

Productivity rising Output

so why stop??? falling
Three Stages of Production

The question therefore is

Page 114
where should I operate in Stage II?
 The question facing the farmer or decision maker
is:
 How much of the variable input should be used to the
set of fixed inputs in order to maximize profit?

 This question cannot be answered by

considering the physical quantities of input and
output.
 We need to introduce prices of input and
output to convert the physical quantities into
value terms.
 HOW MUCH INPUT TO USE
 Do not produce in Stage III, because more output can be
produced with less input.

 Do not normally produce in Stage I because the

average productivity of the inputs continues to rise in this
stage.

 Stage II is the “rational stage” of production.

70
MARGINAL VALUE PRODUCT
 total value product
MVP =
 input level
TVP = TPP × product selling price

If output price is constant:

MVP = MPP × product selling price

71
 MARGINAL INPUT COST
 total input cost
MIC =
 input level
TIC = amount of input × input price

If input price is constant: MIC = input selling

price

72
MARGINAL VALUE PRODUCT, MARGINAL INPUT COST AND THE
OPTIMUM INPUT LEVEL

Total Marginal Total Marginal Marginal

physical physical value value input
Input product product product product cost
level (TPP) (MPP) (TVP) Birr (MVP) Birr (MIC) Birr
0 0 0
1 12 12.0 24 24 12
2 30 18.0 60 36 12
3 44 14.0 88 28 12
4 54 10.0 108 20 12
5 62 8.0 124 16 12
6 68 6.0 136 12 12
7 72 4.0 144 8 12
8 74 2.0 148 4 12
9 72 -2.0 144 -4 12
10 68 -4.0 136 -8 12

input price = Birr 12; output price = Birr 2 73

 THE DECISION RULE
Optimum input level is achieved when;

MVP = MIC

1) If MVP > MIC, additional profit can be made

by using more input.

2) If MIC > MVP, less input should be used.

74
 HOW MUCH OUTPUT TO PRODUCE

 An alternative way to find the profit-maximizing point is

to find directly the amount of output that
maximizes profit.

75
  total revenue
MR =
 total physical product
Total revenue = Total value product

If output price is constant: MR = output selling price

76
  total input cost
MC =
 total physical product

77
 THE DECISION RULE
The optimum level of output is achieved when

MR=MC

 The decision rule, MR=MC, leads to the same

point as the decision rule
MVP=MIC.

78
MARGINAL REVENUE, MARGINAL COST AND THE OPTIMUM
OUTPUT LEVEL
Total Marginal Total
physical physical Total input Marginal Marginal
Input product product revenue cost revenue cost
level (TPP) (MPP) (TR) Birr (TIC) Birr (MR) Birr (MC) Birr
0 0 0 0
1 12 12.0 24 12 2.00 1
2 30 18.0 60 24 2.00 0.67
3 44 14.0 88 36 2.00 0.86
4 54 10.0 108 48 2.00 1.20
5 62 8.0 124 60 2.00 1.50
6 68 6.0 136 72 2.00 2.00
7 72 4.0 144 84 2.00 3.00
8 74 2.0 148 96 2.00 6.00
9 72 -2.0 144 108 2.00
10 68 -4.0 136 120 2.00

input price = Birr 12; output price = 79

Birr 2
 At each point we can multiply the MPP by the
price of the output to derive the;
A) Marginal value product (MVP).
B) MVP = MPP x PY
 where PY is the price of the output.
 Similarly,
B) Average value product (AVP)

AVP= APP x PY
C) Total value product (TVP)
TVP= TPP x PY
 THUS,
 In Stage II, the rational state of production, the quantity
of variable input to use is determined at the point where
the value of marginal product equals the marginal cost of
the input, that is
MVP = MIC.
 The marginal cost of the variable input X is actually its
unit price Px.

 Profit is therefore maximized where MVP = Px

i.e. when input price is constant.

 Consider a Production Function
TP = X2 – 1/30X3, Y
where TP (Y) is quantity of output I
TPP
and X is the quantity of input. II

III

 AP = TP/X = X – (1/30)X2
Y X
 MP = ∂TP/∂X
= 2X – (3/30)X2
= 2X – (1/10) X2
APP

0 X
MPP
o Given

o TP = X2 – (1/30)X3,
Y
o AP = TP/X = X – (1/30)X2
o MP = ∂TP/∂X = 2X – (1/10)X2 I
TPP
II

o At what levels of X does the MP

III
reach its maximum?

o MP reaches its maximum X

where ∂MP/∂X = 0 Y

o That is, where

o 2 – (2/10)X = 0
o Or, 0.2 X = 2 APP
o Or, X = 10
0 10 X
MPP
o Given

oTP = X2 – (1/30)X3, Y
oAP = TP/X = X – (1/30)X2 I
oMP = ∂TP/∂X = 2X – (1/10)X2 TPP
II

o At what levels of X does the AP III

reach its maximum?

o AP reaches its maximum

where ∂AP/∂X = 0 Y X

o That is, where

o1 – (2/30)X = 0
oOr, (1/15) X = 1
oOr, X = 15 APP

0 10 15 X
MPP
o Given,

oTP = X2 – (1/30)X3, Y
oAP = TP/X = X – (1/30)X2 I
oMP = ∂TP/∂X = 2X – (1/10)X2 TPP
II
o At what levels of X does the TP
reach its maximum? III

oTP reaches its maximum

where ∂TP/∂X = MP = 0 Y X
oThat is, where
oMP = 2x – (1/10)X2 = 0
oUsing the quadratic
formula of

APP
oX = 20
0 10 15 20 X
MPP
o Given

oTP = X2 – (1/30)X3, Y
oAP = TP/X = X – (1/30)X2 I
oMP = ∂TP/∂X = 2X – (1/10)X2 TPP
II
o What is the range of X values for
Stage II? III

o Stage II is the stage that

begins where AP is at its Y X
maximum and ends where TP
is at its maximum.

o Thus, the range of X values or

Stage II is 15 and 20.

APP

0 10 15 20 X
MPP
o Given

oTP = X2 – (1/30)X3,
oAP = TP/X = 2X – (1/30)X2 Y
oMP = ∂TP/∂X = 2X – (1/10)X2 I
TPP
o At what level of X does the Law II

of Diminishing Returns set in? III

o It sets in where MP reaches

its maximum.
Y X
o Thus at X = 10 the law of
Diminishing returns sets in.

APP

0 10 15 20 X
MPP
 FACTOR-FACTOR RELATIONSHIP
 In factor-product relationship, we studied the situation where
only one input is varied and all other variables are held
constant.
 But in most real world situations, two or more inputs are often
varied simultaneously.

 The manager must choose the particular combination of

inputs which would minimize the cost for a given output
level.

 Thus, the main objective here is MINIMIZATION OF

COST at a given level of output.
 F-F R/SHIP
 When two or more inputs are variables, a given amount of
output may be produced in more than one way, (possibility
of substituting one factor (X1) for another (X2) as product
level (Y) is held constant).

 There are many ways of combining these resources or production

technology in production process.

 The managerial problem here is to find out the least cost combination
of inputs for producing a given level of output
THAT MEANS….
FACTOR-FACTOR RELATIONSHIP

Q = f(X1, X2,/X3,X4, …., Xn)

Where Q = quantity of produce

X1,X2 = variable inputs

X3,X4, …., Xn = fixed inputs

SUMMARY: FACTOR-FACTOR
RELATIONSHIP
Deals with the resource combination and resource substitution.

Cost minimization is the goal of factor -factor relationship.

INPUT IS VARIED in quantity, while OUTPUT IS KEPT CONSTANT

Guides the producer in deciding ‘HOW TO PRODUCE’.

Explained by the principle of factor substitution or principle of

substitution between inputs.

Concerned with the determination of least cost combination of

resources.

The choice indicators are substitution ratio and price ratio.

 In the production, inputs are substitutable.

 Capital can be substituted for labor and vice versa etc.,

 The producer has to choose that inputs, practices which

produce a given output with minimum cost.

 The producer aims at cost minimization i.e., choice of

inputs and their combinations.
 IMPORTANT ECONOMIC PARAMETERS
OF F-F R/SHIP

1) ISO-QUANT:
 Iso-quant is also termed as Iso-product curve, equal
product curve or product indifference curve.
Definition:

 Represents all possible combinations of two resources

(X1 and X2) physically capable of producing the same quantity of
output.

 For e.g. an output y amounting 100 units can be produced

using different combinations of inputs x1, x2.
ISO-QUANTS …..

 The relationship between two factors and output can

not be presented with two dimensional graph.

 This involves three variables and can be presented in

three dimensional diagram giving a production surface.

 An iso-quant is a convenient method for compressing three

dimensional picture of production into two dimensions.
 PROPERTIES OF ISO-QUANT:
 Iso-quant slope downward =if quantity of input x1 is increased the
quantity of other input x2 is decreased to obtain the Same level of
output y.

 Iso-quants are convex to the origin. The absolute slope of Isoquant

decreases, as we move left downwards to right indicating diminishing
rate of technical substitution. Because diminishing MRTS each added
unit of one input replaces less and less than the previous unit.

 Iso-quants place above another represents higher output. Isoquants

place for higher level of output are placed further away from the
origin.

 Iso-quants are not intersecting. No two Iso-quants intersect each

other because the same combination of two input cannot produce
two different levels of output.
 2) MARGINAL RATE OF TECHNICAL SUBSTITUTION
(MRTS)

 It is the rate of exchange between two productive

resources which are equally preferred.

 The quantity of one input must be sacrificed or given up in

order to gain another input by one unit in process of
substitution.
 MRTS of x1 for x2 is written as;

Where ΔX1 = change in quantity of variable input X1

ΔX2 = change in quantity of variable input X2
 MRS of x1
Units of x1 Units of x2 ∆x1 ∆x2
for x2
1 12
1 -3 -3.0
2 9 1 -2 -2.0
3 7 1 -1 -1.0
4 6 1 -0.5 -0.5
5 5.5 1 -.25 -0.25
6 5.25
THREE POSSIBLE TYPES OF SUBSTITUTION
3) ISO-COST LINE
Is the curve of all combinations of two inputs that cost the same amount.

represents various combinations of two inputs that can be

purchased with the given outlay of funds.

Suppose you have Birr 400 fund and should spend on two inputs
(x1 and x2)

If Px1 is Birr 10 and Px2 is Birr 8.

If you spent 400 birr to purchase x1 input then you can purchase
40 units of x1 and 50 units of x2 to produce fixed output.
ISO-COST LINE
 LEAST COST COMBINATION (LCC)
 F-F concerned with determination of least cost combination of
resources.

 There will be many combinations of two resources that

produce the same level of output.

 The problem here is to find out that particular

combination of inputs, which produces a given quantity of
output with minimum cost.

 There are different methods of finding out the LCC

 1) TABULAR METHOD
 Given the input combinations and the prices of inputs, the total cost
of each input combination can be computed.
 And then, the combination which cost the least is selected.

x1 x2 x1 @ x2 @ Total cost
=TICx1+TIC
Units Units Birr 4/- Birr 2/-
x2
50 219 200 438 638
55 206 220 412 632
60 194 240 388 628
65 182 260 364 624
70 171 280 342 622

 Thus, 70 units of x1 and 171 units of x2 is the least cost combination.

 2) ALGEBRAIC METHOD
Step 1 = Compute marginal rate of technical
substitution
Input price ratio =

price of input being added

price of input being

replaced
 Feed Protein Concentrate Substitutio Price Ratio
Ration (x1) (X2) n Ratio (PR)
(SR)

(ΔX2/(ΔX1 (Px1/Px2)
)
A 30 325
3.0 2.0
B 35 310
2.0 2.0
C 40 300
1.2 2.0
D 45 294
0.8 2.0
E 50 290
Given: PX1 = B 0.10 per unit, and PX2 = B 0.05 per
unit
 DECISION RULE

 The least cost combination is where SR equals PR, or

when we move from ration B to ration C for a Px1 of Birr
0.10 per unit and a Px2 of Birr 0.05 per unit.

 Because SR and PR are equal for the change from ration

B to ration C, rations B and C also have the same cost.
DECISION RULE
Input Substitution Ratio = Input Price Ratio
SR=PR

If they cannot be exactly equal because of the

choices available in the table,

Get as close as possible without letting the

price ratio exceed the substitution ratio.
 3) GRAPHIC METHOD
 To find out optimum combination both Iso-quant and Iso-cost
are drawn on same graph.
 The point of tangency between Isoquant line and Iso-cost line
indicates least combination tangency slope (MRTS) of Iso-quant
equals.
 ACTIVITY
 Assume a Cobb – Douglas production function of ;

Y = 1/2 X11/2X22/5 and

Prices Px1 = Birr5, Px2 = Birr 4 and
Py = Birr 40.

1) Find the least cost combination of inputs at which profit is

maximized.

2) Compute the output level at optimal inputs combination.

 PRODUCT-PRODUCT RELATIONSHIP
 Also called enterprise combination

 The basic resources of farming are scarce

 However, these scarce resources have many alternative uses (crops and
livestock enterprises) .

 Thus, the farmers are faced with the management problem of “WHAT
TO PRODUCE”.

 Farmers have to decide whether to produce crops alone or livestock

alone or their combinations.

 The farmer should choose a combination of crop and livestock

enterprises that maximizes profits.
 P-P R/SHIP
 Deals with the allocation of resources among different crop and
livestock enterprises.

 The objective of p-p r/ship is profit maximization.

 In p-p r/ship , resources are kept constant and product

varies

 Substitution and price ratios are used as choice indicators

in the determination of optimum combination of
enterprises.
 P-P R/SHIP
 Algebraically the product-product relationship can be shown as:

Y1=f(Y2,Y3,Y4……….Y n )
 This expression reveals that a farmer is having an option of growing four or more
crops in the same season in his operational holding.

 Then, acreage proposed to be allocated under crop Y1 is a function of acreage

under crops Y2,Y3,Y4 and Yn.
 P-P R/SHIP
 Two products are produced by using one variable input.

 The relationship is often represented mathematically as:

(Y1,Y2) = f (X1/X2, X3, …..,Xn) or

X1 =f(Q1,Q2)
 Where X1= variable inputs
 X2,X3,…..,Xn =fixed inputs
 Y1, Y2= products.
 ECONOMIC PARAMETERS FOR P-P R/SHIP

Again we would have required a three-dimensional

space to represent the above relationship
graphically,

But it is instead represented in a two-dimensional

space known as production possibility curve
(PPC)
1) PRODUCTION POSSIBILITY CURVE/FRONTIER

PPC- is also known as Iso-resource curve or Iso-

factor curve,

Because, all the combinations of two products require

the same amount of resources.
 EXAMPLE: PPC/PPF
 Suppose a farmer has a limited input i.e. 5 acres of land.

 He has two alternatives i.e., the production of Y1 and Y2.

 The problem here is as to how to allocate this limited input between two
alternatives.

 The alternatives are using the entire 5 acres of land for the production of
Y1 alone or for production of Y2 alone.

 In between these to extreme possibilities, we have different options like

allocation of ;
 1 acre forY1 and 4 acres forY2,
 2 acres for Y1 and 3 acres for Y2 etc.
 If the entire area of 5 acres is allotted to Y2, 300 units of Y2, while
Y1 is zero

 Analogously, if the total area of 5 acres is allotted to product Y1,

300 units of Y1 but Y2 would be zero.

 If 1 acre is allotted to Y1, 100 units of Y1 and the remaining

4 acres for Y2 yielding 250 units.

 If 2 acres is allotted to Y1 and 3 acres to Y2 ,

 It yields an output of 150 and 190 units respectively.

POSSIBLE PRODUCTION LEVELS FROM THE GIVEN ACREAGE OF LAND

Area allotted between two Output

products in acres

Y1 Y2 Y1 Y2
0 5 0 300
1 4 100 250
2 3 150 190
3 2 200 100
4 1 250 50
5 0 300 0
PPC/PPF/PTC
 2) MARGINAL RATE OF PRODUCT SUBSTITUTION (MRPS)

 Is the slope of the PPC

 Shows the trade off between the two products.

 The rate at which one product is transformed into another

product. As a result, it is called transformation curve.

 It is also a frontier because the limited resources cannot help to produce

anything beyond PPC.

 It demarcates what is possible given the available quantity of

inputs.
 CHARACTERISTICS OF PRODUCTION POSSIBILITY CURVE

1) It is concave to the origin.

2) slope of production possibility curve indicates the

marginal rate of product substitution (MRPS), and

3) Change in input levels, shifts the production possibility

curve.
 ISO-REVENUE LINE
 It is a line, which defines all possible combinations
of two products, which would yield equal revenue.
 CHARACTERISTICS OF ISO-REVENUE LINE

1. Iso-revenue line is a straight line, as the output prices do

not change with the quantity of the output sold.

2. As the total revenue increases, the Iso-revenue line shifts upwards

and moves away from the origin.

3. The Iso-revenue lines are parallel to each other, since price ratio
remains constant, and;

4. The slope of the Iso-revenue line indicates the inverse price ratio
of the products. The slope is affected by price changes.
 EXAMPLE: ISO-REVENUE
 Suppose we wish to obtain total revenue of Br. 5,000, when price of Y1
(PY1) is Br. 10 and price Y2 (PY2) is Br. 20, then;

 The expected revenue of Br. 5,000 could be earned by producing

 500 units of Y1 or 250 units of Y2 .
 300 units of Y1 and 100 units of Y2 or
 100 units of Y1 and 200 units of Y2 would help to earn the same
revenue.

 By plotting these two extreme points of 500 units of Y1 and 250 units of
Y2 and by joining these two points, we get the Iso-revenue line
FIG: ISO-REVENUE LINE
 DETERMINATION OF OPTIMUM PRODUCT
COMBINATION

 To get the revenue maximizing combinations of two products,

two relevant questions need to be answered viz.,
1) what combinations should be produced
and
2) how can that combination be determined.

 To answer these questions, the following methods

need to be examined.
1) ALGEBRAIC METHOD
 2) GRAPHIC METHOD
 To determine the optimum combination of products through
graphic method, PPC and Iso-revenue line are
depicted on the same graph.

 The slope of PPC indicates the MRPS and the slope of

Iso-revenue line represents the inverse price ratio of
the products.

 The optimum combination products are at the

point where the Iso-revenue line is tangent to the
PPC.
FIG: OPTIMUM COMBINATION OF PRODUCTS
 RELATIONSHIP AMONG THE PRODUCTS
 These relationships are of different forms viz.,
1. Joint products,

2. Complementary products,

3. Supplementary products,

4. Competitive products and

5. Antagonistic products.
 TYPES OF P-P RELATIONSHIPS
 Competitive:output of one enterprise cannot be
increased unless output of the other decreases

 Supplementary: more output from one enterprise can be

added without a change in the level of the other
enterprise

 Complementary: as output of one enterprise increases,

output of the other increases also
 Produced/resulted from the same production process

 The production of one implies the production of the other

 Production of one without the other is not possible.

 In agriculture almost all products are joint products.

 The proportion of the joint products can be altered or manipulated through

research breakthrough in the long run.

 The examples are : paddy and straw, cotton lint and cotton seed, meat and
wool, etc.
PRODUCTION POSSIBILITIES FOR JOINT
PRODUCT
 2) COMPLEMENTARY PRODUCTS:
 The products are complementary, if an increase in one product causes an increase in the
other product, when the total quantity of inputs used on the two products are held constant
and vice versa.

 They do not compete for the resources.

 One of the products contributes an element of production required by another

thereby helping each other in production.

 An example; rice succeeding a legume crop. The legume fixes nitrogen thereby improving
the soil fertility for the next crop.

 Similarly, paddy and livestock are complementary as paddy crop provides straw to
livestock and livestock in turn makes the availability of farmyard manure to the
paddy crop.
 COMPLIMENT…
 Here these two contribute to their mutual production.

 The complementary products would become competitive, when large

quantities of resources are diverted to one product, affecting the
production of the other.

 The marginal rate of product substitution is POSITIVE.

 Y1 is complementary to Y2 between A and B, while Y2 is

complementary to Y 1 between C and D, but points B and C,
they become competitive.

 Thus, the farmers should produce both the products till they
become competitive.
FIG: COMPLEMENTARY PRODUCT
 3) SUPPLEMENTARY PRODUCTS
 If the quantity of one product can be increased without increasing or
decreasing the quantity of the other product.

 They are independent of one another. They do not compete for the resources.

 Instead they make better utilization of resources, which are being unutilized by
one enterprise.

 Crop production is seasonal in nature, and during off-season the resources are
slack.

 They can be better utilized by adding supplementary enterprises viz., a small

dairy unit or poultry unit.

 A farmer should take best advantage of the products by producing both of

them till they become competitive.
 SUPPLEMENT…
 The marginal rate of product substitution is zero.

 The product Y 1 can be increased up to AB without affecting the

production Y2.

 If it is further increased the two become competitive.

 It can be seen in the diagram that the two products are

competitive between the points B and C.
SUPPLEMENTARY ENTERPRISE
Output Substitution Ratio =

quantity of output lost

quantity of output gained
OUTPUT PRICE RATIO
Output Price Ratio =

price of output gained

price of output lost
DECISION RULE

output substitution ratio = output price ratio

If no available combination makes these

exactly equal, get as close as possible
without letting the price ratio drop below
the substitution ratio.
 4) COMPETITIVE PRODUCTS
 When increase or decrease in the level of production of one results in
decrease or increase in the level of production of another, given the
fixed amount of resources.

 The MRPS between the products is therefore, negative.

 Most of the decisions regarding the selection of products involve

competing products.

 The examples are maize and teff, barley and groundnut etc.

 In general, crops grown in the same season are competitive because of

limited resources.
 MARGINAL RATE OF PRODUCT SUBSTITUTION
 Like factors, products also substitute each other.

 The absolute amount, by which one product is

decreased in order to gain another product by a
unit is called marginal rate of product substitution.

MRPS of Y1 for Y2 implies that the amount of Y2 to be

given up in order to gain Y1 by one unit.
Combinatio Units of Units of Substitution Price Ratio
n number Output (Y1) Output (Y2) Ratio (SR) (PR)
∆Y2/∆Y1 Py1/Py2
1 0 4,600
0.75 2.00
2 800 4,000
1.00 2.00
3 1,400 3,400
1.40 2.00
4 1,900 2,700
2.00 2.00
5 2,300 1,900
3.00 2.00
6 2,600 1,000
5.00 2.00
7 2,800 0
 DECISION RULE
 The optimal combination of enterprises occurs as we move from combination 4 to
combination, where SR = PR.

 Because SR and PR are equal, combination numbers 4 and 5 would be equally

profitable.

 Moving from 4 to 5, the same amount of income is given up from Y2 to get more of Y1.

 In many cases, there will not be an exact equality of SR and PR.

 Thus, you should continue substituting Y1 for Y2 as long as PR >SR.

 i.e. the additional income will exceed the lost income, and the substitution will increase
income.
 CONSTANT RATE OF SUBSTITUTION
 Two products substitute at constant rate when a unit
increase in the production of one replaces the same amount of another
product throughout the process of substitution.

 In other words, a constant amount of replaced product is

sacrificed in order to gain added product by one unit.

 The PPC is linear when products substitute at constant

rate.
 TWO COMPETITIVE PRODUCTS SUBSTITUTING AT CONSTANT RATE

Combination Y1 Y2 ∆ Y1 ∆Y2 MRPS of Y1 for Y2

A 0 60

B 1 54 1 6 6/1=6

C 2 48 1 6 6/1=6

D 3 42 1 6 6/1=6

E 4 36 1 6 6/1=6

F 5 30 1 6 6/1=6
CONSTANT RATE OF PRODUCT
SUBSTITUTION
 INCREASING RATE OF SUBSTITUTION
 Two products substitute at increasing rate when increase in one
product requires larger and larger sacrifice in terms of
another product.

 This type of substitution occurs when the production function of

each independent product exhibits decreasing returns.

 Substitution of this nature is more common in agricultural production

as the diminishing marginal resource productivity is a general
situation in agriculture.

 PPC is concave to the origin when products substitute at increasing

rate.
TWO COMPETITIVE PRODUCTS SUBSTITUTING AT
INCREASING RATE

Combination Y1 Y2 ∆ Y1 ∆Y2 MRS of Y1 for Y2

A 0 75

B 8 60 8 15 1.88

C 16 44 8 16 2.0

D 24 26 8 18 2.25

E 32 0 8 26 3.25
 INCREASING CONT…
 Shifting from combination A to combination B, results in increase in
Y1 by 8 units and decrease in Y2 by 15 units.

 MRPS is 1.88.

 It means 1.88 units of Y2 are to be sacrificed to gain Y 1 by one

unit.

 When we shift from B to C, C to D, and D to E, the amount of Y2 to

be foregone is successively increasing as indicated by the
increasing MRPS
FIG. INCREASING RATE OF PRODUCT SUBSTITUTION
 DECREASING RATE OF SUBSTITUTION
 Two products substitute at decreasing rate when increasing
in one product requires lesser and lesser reduction in another
product.

 This type of substitution is observed when the production

functions of both the products exhibit increasing returns.

 This type of substitution is very rare in production process,

because increasing returns are seen in the 1st stage of
production which is irrational.

 The PPC is convex to the origin.

TWO COMPETITIVE PRODUCTS SUBSTITUTING AT DECREASING
RATE

Combination Y1 Y2 ∆ Y1 ∆Y2 MRS of Y1 for Y2

A 0 43

B 2 27 2 16 8

C 4 15 2 12 6

D 6 6 2 9 4.5

E 8 0 2 6 3
 Shifting from combination A to combination B results in increase in
Y1 by 2 units and decrease in Y2 by 16 units.

 It means 8 units of Y2 are to be sacrificed to gain Y1 by one unit.

 When we shift from B to C, C to D and D to E, the amount of

Y2 to be forgone is successively decreasing as indicated by the decrease
in marginal rate of product substitution.
FIG: DECREASING RATE OF PRODUCT SUBSTITUTION
OBJECTIVE-2

The End!