Production Economics: Marginal Principles & Input

Unit 2: Basic Production Economics Principles

Theme 4: Applying the Marginal Principles

• Discussion assumes resources/inputs are sufficient, but inputs are more realistically limiting
• Managers must decide how to allocate limited inputs amongst alternative uses.
• A limited input should be allocated among alternative uses to equalize the MVP (marginal value product) of the last unit used on each.
• Allocate subsequent increments of water to the crop with the highest MVP until MVP is equal across all crops to maximize profit.

Theme 5: Input Combinations

• Deciding how much of each input to use is important.
• Most products need two or more inputs.
• A problem arises in determining by how much one input can be substituted with another.
• Managers need to choose input combinations that produce a certain level of output at the lowest cost.
• An alert manager will continuously look for alternative input combinations to produce output at the least cost.
• First, determine whether it is physically possible to substitute one input for another, and then at what rate.
• An isoquant shows different combinations of two inputs that will result in the same level of output.
• The input substitution ratio refers to the rate at which one input will substitute for another.
  • Input substitution ratio = amount of input replaced / amount of input added
  • The numerator and denominator of the ratio refer to changes in the respective inputs.
• The input price ratio = price of input being added / price of input being replaced.
• The decision rule is that the Input substitution ratio = input price ratio
• Different combinations of lucerne and maize can produce 100kg of meat.
• Input substitution ratio = inverse price ratio.
• The goal is to find the ration that will allow for the production of meat at the lowest cost.

Theme 6: Opportunity Cost and Other Cost Concepts

• After studying this, it is expected is to be able to understand the importance of opportunity costs and its importance in decision making, the difference between long-run and short-run costs, the difference between fixed and variable costs, and calculate the different average costs.
• Opportunity cost is the value of the product not produced because an input was used for another purpose, or the income that would have been earned if the input had been used in its most profitable alternative.
• Real cost might not be its purchase price but opportunity cost.
• Opportunity cost is primarily an economic concept and not a cost found in a ledger.
  • Managers need to consider opportunity costs in decision-making.
  • Opportunity cost is based on the fact that every input has an alternative use (even non-use).
  • Once an input is used, it cannot be used for any alternative.
• If the first increment of water was applied to wheat, the opportunity cost is 1800 (referring to income from cotton).
• It means that water is not earning its maximum possible income since opportunity cost > return received from applying water to wheat.
• The costs include total fixed costs (TFC), average fixed costs (AFC), total variable costs (TVC), average variable costs (AVC), total cost (TC), and marginal costs (MC)
• Output: Important, as all costs are tied to output.
• Short Run is a period where at least one input is fixed.
• Long Run is a period where all inputs can be changed.
• Short run and long run are not expressed in terms of calendar time.
• Fixed costs are associated with owning a fixed input.
• Fixed costs are incurred even if the input is not used, do not change as the level of production changes in the short run, not under the control of the manager, and exist no matter how much or little of the input is used.
• Total fixed cost (TFC) sums all fixed costs like depreciation, insurance, and property taxes.
• Average fixed cost (AFC) is the total fixed cost per unit of output produced.
• AFC = TFC / output level.
• Since TFC is constant, an increase in output level will always cause a decrease in AFC.
• Under Variable costs, the costs are those that are under the manager's control. Include items such as seeds, fertilizers, water, and herbicides
• Total variable cost (TVC) is determined by: TVC = Px1 * X1 + Px2 * X2 + ,,, + Pxn * Xn.
• Average variable cost (AVC): Total variable cost per unit of output produced: AVC=TVC/Output level.
• The AVC may be either increasing or decreasing depending on the underlying PF and output level.
• AVC will initially decrease with an increase in output but will begin to increase from a point where MPP begins to decrease.
• Total Cost (TC) is made up of the Sum of TFC and TVC. To work out ATC, its total cost/total level or AFC + AVC
• Marginal Cost (MC) - the change in total costs due to change in the amount of output produced. MC = change in total cost/change in level of output. OR change in TVC/A change in level of output
• Average fixed cost is always declining, whereas the other two tend to create U-shaped curves.
• Although they may decline first, they generally reache a minimum, and then increase
• Note that MC curve crosses both the AVC and ATC at their respective minimum levels. As long as marginal value is below average value, the average value will be decreasing

Theme 7: Size

• The goal is to cover how fixed and variable costs are used to make productions decision over both short and long runs- in addition to understanding the concept of economies of size and scale
• In this case:
  • Only produce with the price is high than the Minimum AVC
  • If the price < min (AVC), loss for producting is larger than when not prodcing at all
• In the SHORT RUN we need to be aware if the Expected selling price is higher or lower that the Minimum ATC (or TC)
• In the LONG RUN (that losses incurred by producing will EVENTUALLY force a firm to be pushed from the market_ we need ot be aware if the selling price > ATC (or TR >) in order ot maximize profits.
• Economists are intreested in farm size and look at the relationship between both cos and size.
  • Questions to be answered including:
    • The most profitable farm size
    • If larger farms are more efficent that smaller firms, and will produce more cheeply
• Farm size is measured in Hectares, Gross margain, equity, # of livestock, total assists
• The advantages of assessing in this was is that its converted into a common denomoinator (Rands)
• Also look at % of costs vs % of output valie (and both must be in monetary terms)
• Can be Increasing (R>1) Constant (Ratio/=1) & Decearing (R less than 1)
• So profit is increasing
• Note - increasing in output is deacreasing and decreaing cost - as such per nit os decreaing of average - hence preovius points.
• Economies of scale exists when long run is decaring in increase in output
• Diseconomies of size exist when long run is increasing in crease in output