Production Economics: Marginality & Production Function

• Unit 2 covers basic production economics principles
• Themes 1-3 are part of Unit 2

Theme 1: Marginality and the Production Function

• Ecn knowledge provides managers principles and rules for decision-making
• Ecn serves as a continuation of the decision-making process
• When a problem is identified and defined, data is needed
• Ecn helps to find relevant data
• Ecn principles offer guidelines on how to process raw data for useful information
• Ecn principles are a set of rules ensuring correct decisions to maximize profit
• Decision rules are a result of Ecn principles
• Economists want to know what happens when they change factors under their control
• For instance, what happens to yield if fertilizer increases by 50%
• MARGINALITY is crucial in production economics
• Marginality refers to incremental change (increase or decrease) at the margin
• The term "marginal" can be substituted with "additional" or "extra"
• A marginal change in one factor causes a marginal change in something else
• Marginal change calculation involves the difference between the initial value and the new value after changing a factor
• "Δ" signifies "change in"
• The assumption is "ceteris paribus"
• Production function (PF) is a basic concept that shows the relationship between the input levels, which can be used to produce a product, and the respective output levels
• PF shows potential output with different variable input levels, ceteris paribus
• PF offers data to derive relationships between inputs and TPP
• Average Physical Product (APP) is output per unit of input
• APP is calculated by dividing output by the input level
• Column 3 in a table represents APP
• Marginal Physical Product (MPP) means "extra or additional"
• MPP is the extra output produced by adding one more unit of variable input
• MPP requires measuring input and output changes
• MPP is calculated by dividing the change in output by the change in input level
• MPP can be positive or negative
• MPP can be zero if an input level change does not affect the output level
• Negative MPP indicates excessive input usage in the production process
• Negative MPP is associated with declining output
• MPP is found in column 4 of a table
• PF, APP, and MPP functions can be shown graphically and graphs show the relationship between TPP, APP and MPP
• TPP increases at an increasing rate up to the input level where MPP is max
• MPP subsequently decreases until it reaches zero where TPP is at its maximum
• While MPP exceeds APP, APP increases with increased input level
• The law of diminishing marginal returns states that MPP will begin to decline as additional units of a variable input are used in combination with one or more fixed inputs
• The production function in figures and tables illustrates this law
• "Diminishing marginal returns" describes what happens to MPP with additional variable input units
• The law of diminishing marginal returns takes effect within Stage I
• Examples of diminishing marginal returns in agriculture include reduced additional output (or MPP) when adding seed, fertilizer, or water to a fixed land size for a crop.
• MPP decreases as the crop gets closer to its biological capacity to use the input

Theme 2: How Much Input to Use

• Determining how much variable input to use is an important use of information from the production function
• Farmers must choose the input level that will maximize profit, and thus, focusing on Stage II
• Price information is needed
• TPP, APP, and MPP are not sufficient to determine the optimum input level to maximize profit
• Marginal Value Product (MVP)
• MVP is the additional or marginal income you get from using one more unit of input
• MVP = ∆TVP / ∆ input level
• TVP (Total Value Product) = output price x amount of output
• MIC (Marginal Input Costs) is the change in TC (Total Costs) caused by using an extra input unit
• MIC = ∆Total Input Cost / ∆ input level
• Total Input Cost = Quantity of input used x the price of the input
• MIC remains constant for all input levels
• The additional cost of acquiring and using the input equals the price of the input
• MIC = input price
• A decision rule compares MVP and MIC to determine the optimal level of input
• MVP and MIC are both monetary values
• Profit is maximized when MVP = MIC
• If MVP > MIC, it is making additional profits by using it
• additional income from additional input exceeds additional costs from additional unit of input.
• If MVP < MIC, is is not a worthwhile investment
• additional income from additional input is less than additional costs from additional unit of input
• Profit is maximised when MVP equals MIC, provided the input is not free

Theme 3: How Much Output to Produce

• The discussion shifts from the "how much input to use" question to "how much output should be produced" to maximise profits
• Concepts of Marginal Revenue (MR) and Marginal Costs (MC) are needed
• Previous input and output data are used.
• Additional columns are created
• Marginal Revenue (MR) is defined as the change in income from selling an additional unit of output.
• There is a difference between MVP and MR
• MR = ∆TR / ∆ TPP
• TR is (Total Revenue) Output price x Amount of output
• Marginal Revenue (MR) remains constant.
• By, MR is the revenue with selling another unit of output
• Change in income should equal the product price that has been sold
• Provided the output price remains the same there should be a change in income and thus should (Assumption) remain the same
• Marginal Cost (MC) is the change in total cost for producing additional output
• MC = ∆Total input cost = / ∆ TPP
• (Total input cost = the Price of the input = x amount of input used )
• MC decreases gradually and then slowly increases
• Increase happens because it takes relatively more input to produce additional units of output
• There is a connection to the Law of diminishing marginal returns with additional units of input
• Decision rule: Analyse Marginal Revenue (MR) and Marginal Cost (MC) to determine the optimum level of output to produce
• As long as MR > MC, is it worthwhile to produce more output until you reach optimum output level
• Making additional output will increase profit
• Making < MR , MC additional output will decrease profit
• Profit is maximized at the point where marginal revenue equates to marginal costs (MR = MC)
• Income change from new unit = To the change in the input cost
• There is is only one optimum level of output , and the input combination for this optimum output lever must incorporate PF a