LECTURE 5 & 6- FARM MANAGEMENT PRINCIPLES

Why Use Economic Principles:

“A traveler without knowledge is a bird without wings.” – Sadi Gulistan (1258)

In this context it may be stated that two students without understanding the basic principles
of farm management came to contradictory different conclusions on a study conducted by them.
Each blames the absurdity of the others findings.

Hence, the principles guide the students on the scientific conduct of research inquiring
through the use of research methodology.

The economic principles guide the manager in setting the goals and preparing plans on the
basis of optimum resource allocation, resource substitution, resource combination and enterprise
combination. The knowledge of economic principles improves the decision making ability and
indicate the direction in which the manager should go to attain the objectives of profit maximization
and maximization of family satisfaction.

Economic Principles Applied to Farm Management:

1.Law of Diminishing Returns (Factor-Product Relationship)

2.Principle of Factor Substitution (Factor-Factor Relationship)

3.Principle of Product Substitution (Product-Product Relationship)

4.Principle of Equi-marginal Returns

5.Opportunity Cost Principle

6.Minimum Loss Principle

7.Principle of Comparative Advantage

8.Time Comparison Principle

1. LAW OF DIMINISHING RETURNS:

Statement of Law:

“If the quantity of one productive service is increased by equal increments with the quantity
of other resource services held constant, the increments to the total products may increase, but will
decrease after a certain point.”

This definition explain that the application of successive units of variable factor to the fixed
factors, add more and more to the total product till the point of inflection and thereafter add less and
less to the total output.

Factor-product relationship is a basic production relationship between the input and output.
This is mainly concerned with resource use and its efficiency. It guides the producer in deciding as
to how much to produce. The goal of this relationship is the optimization of resources. This
relationship is explained by the law of diminishing returns.
Scope of LDR:

It is of basic importance to the farmer in decision making on-

a. The level to which he can push production per hectare or per animal.
b. The level of using inputs per hectare/ per animal.
c. The proportioning of inputs to chose in production.
d. The size of farm to operate efficiently.

Limitations of Law:

1. It is a technical law relating to physical relationship between one variable input and output.
2. It comes into operation after a certain stage has been reached.
3. If the units of factors of production on the initial stage are inefficient and later efficient units
are employed, the law does not come into existence.
4. With the use of modern technology, the law is held back.

Reasons for operation of law in Agriculture:

1. Excessive dependence on Agriculture.

2. Less Scope for division of labour.
3. Less Scope for Mechanization.
4. Cultivation of Inferior lands.
5. Continuous Cultivation.

Three Stages of Production:

Input Level Output (TPP) APP ∆X ∆Y MPP

X Y (Y/X) (∆Y/∆X)
1 15 15 - - -
2 38 19 1 23 23
3 66 22 1 28 28
4 96 24 1 30 30
5 120 24 1 24 24
6 126 21 1 6 6
7 126 18 1 0 0
8 120 15 1 -6 -6
9 90 10 1 -30 -30
10 50 5 1 -40 -40
Relationship between MPP & TPP:

1. When TPP is increasing, MPP will be positive.

2. When TPP is constant or maximum, MPP will be zero.
3. When TPP decreases, MPP will be negative.
4. When MPP moves upward, TPP increases at increasing rate.
5. When MPP starts declining, TPP increases at decreasing rate.
6. When MPP goes negative, TPP decreases at increasing rate.

Relationship between MPP & APP:

1. When MPP is increasing, APP is also increasing. So long as MPP is above APP, the APP
keeps increasing,
2. When MPP curve goes below APP curve, APP starts declining.
3. When MPP=APP, APP will be at maximum.

2. PRINCIPLE OF FACTOR SUBSTITUTION:

Farmer as a manager, has to make an important operational management decision i.e. how
to produce? It implies the choice of methods of production or technology or type of combination of
resources. This involves factor-factor relationship. The principle of factor substitution guides the
farmer-manager in choosing the most appropriate method of production or technology that produces
a given level of output with least cost.
 A producer generally aims at choosing the most efficient method of production. A technique
of production is efficient, when it produces a given level of output with minimum cost. To achieve
this, the producer substitute cheaper resource for dearer resource. It means the use of more quantity
of less expensive resource and less quantity of more expensive resource.

Statement of Law:

“The principle of factor substitution says that it is economical to substitute one resource
(added resource) to another resource (replaced resource), as long as the reduction in the cost,
resulting from decreased use of replaced resource is more than the increase in the cost due to
increased use of added resource.”

The two cost aspects are compared with the help of principle of factor substitution, to find
out least cost combination of resources.

Decrease in Cost > Increase in Cost

i.e. Marginal Rate of Technical Substitution > Price Ratio

MRTS > PR

Least cost Combination is at the point where,

MRTS = PR

Suppose following are some combinations of two inputs that will produce the same level of
output. We can find out the least cost combination by algebraic method. Price per unit of X1 is Rs.
4 and of X2 is Rs.2.

X1 X2 ∆X1 ∆X2 MRTS (∆X2/∆X1) PR (PX1/PX2)

50 219 - - - -
55 206 5 13 2.60 2.00
60 194 5 12 2.40 2.00
65 182 5 12 2.40 2.00
70 171 5 11 2.20 2.00
75 165 5 6 1.20 2.00

There are 6 combinations of inputs which can produce a given level of output. To find the
least cost combination, we compare the MRTS and inverse price ratio. The least cost combination
will be where MRTS and PR are equal. But in above table no any combination fulfill this criteria,
therefore we find the combination whose MRTS and PR are closely equal to each other. In above
table, the combination of 70 units of X1 and 171 units of X2 is the least cost combination of inputs
because MRTS and PR of this combination is nearly equal.
3. PRINCIPLE OF PRODUCT SUBSTITUTION:

The basic resources of farming viz., land, labour and capital are scarce. However, these
scarce resources have many alternative uses. Scarce resources can be used in producing different
crops and livestock enterprises. Therefore, 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 such a combination of crop and livestock enterprise that
maximizes profits.

Product-product relationship deals with the allocation of resources among different crop and
livestock enterprises. The objective of product-product relationship is profit maximization.
Agricultural production is characterized by risks and uncertainties. To fight risks and uncertainties,
the farmers produce several crop and livestock enterprises on their farms. This opportunity of
choosing among different alternative enterprises poses an important management problem viz. what
to produce? This involves product-product relationship and is explained by the principle of product
substitution. This principle guides the producer in the determination of optimum combination of
enterprises that maximizes profits.

Statement of Law:

“The principle of product substitution says that if the inputs are constant, it is economical to
substitute one product for the other, if the returns from the first are more than that of the second.”

In the process of substitution, when we shift from one combination of products to another,
the output of one product increases, while that of other decreases, because the input is kept
constant.

From the product whose level of output decreases, there is a decrease in returns. On the
other hand, from the other product, whose level of output increases, there is an increase in returns.

Thus if Y1 is being increased and Y2 is being replaced, increase the production of Y1 so

long as

Decrease in Returns < Increase in Returns

i.e. Marginal Rate of Product Substitution < Price Ratio

MRPS < PR

Profit maximizing combination of enterprises will be where,

MRPS = PR
Determination of Optimum Product Combination

Price of Wheat (PY1)= Rs. 4.20/ Kg, Price of Paddy (PY2)= Rs. 6.00/ Kg

Product Wheat (Kg) Paddy (Kg) Increase in Decrease MRPS of PR

Combination Returns in Returns Y1 for Y2
Y1 ∆Y1 Y2 ∆Y2 (∆Y1*PY1) (∆Y2*PY2) (∆Y2/∆Y1) (PY1/PY2)
A 0 - 60 - - - - -
B 20 20 56 4 84 24 0.20 0.70
C 40 20 50 6 84 36 0.30 0.70
D 60 20 41 9 84 54 0.45 0.70
E 80 20 30 11 84 66 0.55 0.70
F 100* 20 16* 14 84* 84* 0.70* 0.70*
G 120 20 0 16 84 96 0.80 0.70

As we shift from combination A to B, the output of Y1 is increased by 20 units, while that

of Y2 reduced by 4 units. Given the prices, there is an increase in the return of Y1 to the tune of Rs.
84 and decrease in the return of Y2 by Rs. 24. The process of substitution of Y1 for Y2 continues
till the increase in the returns from Y1 is equal to decrease in the returns of Y2. The Optimum
Combination of products is found at combination „F‟ i.e. 100 units of Y1 and 16 units of Y2.

Types of Enterprise / Product Combinations

1. Joint Enterprises. Example: Wheat and straw

2. Complementary Enterprises. Example: Cereals and pulses
3. Supplementary Enterprises. Example: dairy enterprise
4. Competitive Enterprises. Example: Paddy and sugarcane for water
5. Antagonistic Enterprises. Example: Paddy cultivation and Aquaculture

Joint Enterprise:

These are produced through single production process. As a rule the two are combined
products. Production of one (main product) without the other (by-product) is not possible. The level
of production of one decides the level of production of another. All farm commodities are mostly
joint products. e.g. Wheat and straw, paddy and straw, cotton seed and lint, milk and manure, etc.

Complementary Enterprise:

Complementarily between two enterprises exists when with a change in the level of
production of one, the other also changes in the same direction. That is when increase in output of
one product with resources held constant, also results in an increase in the output of the other
product. The two enterprises do not compete for the resources but contribute to the mutual
production by providing an element of production required by each other. The MRPS is positive.
Ex.: Cereals and pulses, crops and livestock, etc.
Supplementary Enterprises:

Supplementarity exists between enterprises when increase or decrease in the output of one
product does not affect the production level of the other product. They do not compete for resources
but make use of resources when they are not being utilized by one enterprise. The MRPS is zero.
Ex.: small poultry or dairy or piggery enterprise is supplementary on the farm.

Competitive Enterprises:

This relationship exists when increase or decrease in the production of one product affect
the production of other product inversely. That is when increase in output of one product, with
resources held constant, results in the decrease in output of other product. Competitive products
compete for the same resources. The MRPS is negative. Ex.: Paddy and sugarcane competition for
water.

Antagonistic Enterprises:

Two products may be detrimental to each other because of disease or similar factors. When
this is true, only one of the products should be produced. Ex.: Paddy cultivation and Aquaculture.

4. PRINCIPLE OF EQUI-MARGINAL RETURNS:

Under the condition of unlimited resources, the law of diminishing returns helps in
determining the most profitable level of resource use. In reality, most of the resources like land,
irrigation, capital, etc, with most of the farmers are limited. The principle of equi-marginal returns
provides guidelines and ensures that allocation of a limited input is done in such a way that profit is
maximized from each unit of input.

Statement of Law:

“The limited resources should be allocated among alternative uses in such a way that the
marginal value product of the last unit of resource is equal in all uses.”

How the limited inputs should be allocated among the enterprises is shown through the
following example.

Amount of liquid capital Marginal Value Product/ unit of ‘000’ Rs.

used
Paddy Sugarcane Cotton
First 1000 Rs. 2000 (5) 3200 (1) 2200 (4)
Second 1000 Rs. 1400 3000 (2) 1800
Third 1000 Rs. 1200 2500 (3) 1400
Fourth1000 Rs. 1100 1600 1000
Fifth 1000 Rs. 1000 1200 800
Total 5000 Rs. 6700 11500 7200

Any limited input should be allocated in that use where it brings in the greatest MVP. The
limited availability of capital (here 5000 Rs.) must be allocated among the three crops viz.,
Sugarcane, Cotton and Paddy in the following manner based on MVPs. The first dose of Rs. 1000
has the potential of yielding MVP (added returns) of Rs. 2000, Rs. 3200 and Rs. 2200 from Paddy,
Sugarcane and Cotton respectively. So, first dose of capital is invested on sugarcane, which brought
in the maximum MVP among the alternatives.

To apply the second dose of capital, the three opportunities are first dose of paddy (Rs.
2000), second dose of sugarcane (Rs. 3000) and first dose of cotton (Rs. 2200). Among these three
opportunities for the second dose of Rs. 1000, Sugarcane is yielding highest MVP. In the same
manner third dose for Sugarcane, fourth for Cotton and fifth for Paddy are allocated.

Following the principle of equi-marginal returns, 3000 Rs. Should be allocated to Sugarcane
and Rs. 1000 each to Cotton and Paddy. By allocating capital in such manner we will get the MVP
of Rs.12900. Any other allocation of capital among the crop enterprises other than above will not
help the farmer to obtain maximum returns. (If we are allocating all capital on Paddy we will get
Rs. 6700, similarly from Sugarcane we will get Rs. 11500 and from Cotton we will get Rs. 7200.
These all are less than the Rs. 12900).

5. OPPORTUNITY COST PRINCIPLE:

If an input is used in a particular production process, it has no alternative use at that

particular point of time. This mean that the input will be losing income from the alternative use and
this income foregone by this input from the alternative use is called opportunity cost.

“By definition, opportunity cost is the income that could have been received, if the input had
been used in its most profitable alternative use.” Alternatively, it is the value of product not
produced because the input was used for another purpose.

The concept of opportunity cost has a bearing on the decision-making process of the farmer,
particularly in decision related to input use. The opportunity cost is referred to as the real cost of an
input. Real cost of an input is not the purchase price of the input. It is the income earned by the
input in its alternative use, which is the next best opportunity. If returns from the current use of the
input are less than its opportunity cost, then the decision is to be changed.

Example:

If a farmer has Rs. 1000, at his disposal, he has three options i.e., investing on sugarcane, or
cotton or paddy. As Rs. 1000 is spent on sugarcane which is giving a MVP of Rs. 3200. The farmer
is foregoing the other two options by spending on sugarcane. Between the two, cotton is giving
greater MVP than paddy. The farmer is sacrificing Rs.2200 from cotton which is the next best
alternative to sugarcane, which is the opportunity cost.

6. PRINCIPLE OF COMPARATIVE ADVANTAGE:

It is true that many crop and livestock enterprises can be raised over diversified soil types
and climatic conditions, but with differences in yields, costs and returns. This difference in yields,
costs and returns leads to specialization in the production of farm commodities by individual
farmers or regions.

We observe that wheat farming is predominant in UP, Punjab and Haryana, rice farming in
AP, West Bengal, TN, and Assam, cotton farming in Maharashtra and TN, sericulture in Karnataka,
apple cultivation in Himachal Pradesh, sheep farming in Rajasthan, poultry farming in AP and TN.
Thus, regional specialization in the production of crops and livestock enterprises is better explained
by the principle of comparative advantage. The relative yields, costs and returns are to be
considered as the criteria for explaining the principle.

In the production of farm commodities there are two kinds of economic advantage.

1. Absolute advantage
2. Relative or Comparative advantage

The size of the margin between costs and returns from using the productive inputs
represents the absolute advantage. If this margin is larger for one farm commodity in one region
compared to another, we say that the first region has an absolute advantage in producing that
commodity.

Particulars Region A Region B

Groundnut Sunflower Groundnut Sunflower
Gross Income (Rs./Acre) 5000 5010 7300 2500
Total Costs (Rs./Acre) 4700 4320 6500 2450
Net Income (Rs./Acre) 300 690 800 50
B:C Ratio 1.06 1.16 1.12 1.02

Suppose farmers in region A and region B are producing two farm commodities viz.,
groundnut and sunflower. The net income/acre for groundnut is Rs. 300 in region A and Rs. 800 in
region B. The net income/acre for sunflower is Rs. 690 in region A and Rs. 50 in region B. Region
A has an absolute advantage in sunflower because the size of the margin between costs and returns
is greater than that for region B. Region B has an absolute advantage in groundnut production for
the same reason.

To explain the relative or comparative advantage, let us compare region B with region C. in
both regions, farmers are growing redgram and groundnut.

Particulars Region B Region C

Redgram Groundnut Redgram Groundnut
Gross Income (Rs./Acre) 5600 7300 2300 3300
Total Costs (Rs./Acre) 5200 6500 2000 3100
Net Income (Rs./Acre) 400 800 300 250
B:C Ratio 1.08 1.12 1.15 1.06

From table it is seen that region B has a greater absolute advantage in growing both redgram
and groundnut than region C. Farmers in region B can earn profits by growing both the crops. But
in order to earn maximum profits, farmers in region B should allocate larger acreage under
groundnut alone as it is related to comparative advantage. Similarly, farmers in region C can make
profits by growing both the crops but they have relative advantage in growing redgram. The farmers
can make greatest profits by cultivating redgram as, B:C ratio being 1.15 for redgram and 1.06 for
groundnut.

7. MINIMUM LOSS PRINCIPLE:

In any business activity, the details of costs and returns provide an idea of profitability. Cost
of production refers to the expenses incurred in producing a unit quantity of the product in a
particular time period. The costs in farming in the short run can be divided into two categories viz.,
fixed costs and variable costs. Fixed costs are those costs, which do not vary with the level of
output. Fixed costs are incurred even in the absence of production. Variable costs are those costs,
which vary with the level of output. There are no variable costs, when there is no production.
Variable costs are important in the decision making in the short run as the objective of the farmer is
to recover these costs.

The point of optimality is obtained by the equality of MR and MC, which is the profit
maximizing condition. But in reality, the farmers incur loss instead of profit because MR (selling
price) may not cover cost per unit of output. Then the farmers continue the farming with an
objective of minimizing losses.

The minimum loss principle explains, as to how, the producer minimizes losses under
adverse price environment.

If selling price is more than ATC, profits are expected by the producer and the objective is
profit maximization. To do this the producer has to produce till MR=MC.

If selling price is less than ATC, but more than AVC, loss is expected. The objective here is
to minimize the loss. To accomplish the task he has to continue the production till MR=MC. In this
situation loss is less than fixed costs.

If selling price is less than AVC, and losses are expected, loss can be minimized by stopping
the production temporarily.

In the long run if selling price is less than ATC, continuous losses are incurred. In this
situation, the producer should stop the production permanently.

The principle is explained further with the help of hypothetical data.

Cost and returns in sunflower cultivation

Sr. Particulars Selling price Selling price Selling price

No. >ATC <ATC, but >AVC <AVC
1 TVC 4700 4700 4700
2 TFC 2700 2700 2700
3 Total Cost (TC) 7400 7400 7400
4 Output (Quintals) 9.5 9.5 9.5
5 AVC 494.74 494.74 494.74
6 AFC 284.21 284.21 284.21
7 ATC 778.95 778.95 778.95
8 Price per quintal 1150 750 450
9 Gross Income 10925 7125 4275
10 Net Income (over TC) 3525 -275 -3125
11 Net Income (over TVC) 6225 2425 -425

In sunflower the total variable costs per ha. are Rs. 4700; total fixed costs are Rs.2700 and
resultant total costs stood at Rs. 7400. The output obtained is 9.5 quintals per hectare.

With the price being Rs. 1150 per quintal, gross income amounted to Rs. 10925. Net
income, which is the surplus over total costs, came to Rs. 3525. In this situation the farmer is able
to obtain profits in sunflower cultivation.

Now, assuming that the price has fallen down to Rs. 750, the gross income recorded is Rs.
7125, which is less than the total costs of Rs. 7400. However, the gross income covers the variable
costs of Rs. 4700 netting the farmer with an amount of Rs. 2425.

In case, the farmer decides against cultivation of sunflower, as he is not generating surplus
over total costs, he would be incurring loss to the extent Rs. 2700 representing the fixed costs. As
against this if he goes ahead with the cultivation of sunflower, the loss would be to the extent of Rs.
275 only, which is the minimum loss.

8. TIME COMPARISON PRINCIPLE:

Investment in agriculture is of two types. the first type involves operating investment such
as seed, feed, fertilizers, etc., and the second one is concerned with capital assets such as land,
machines, projects, etc.

Analysis of these investments involves not only the comparison of costs and returns
associated with it, but also the timings of occurrence of costs & returns. The costs & returns from
investments in operating resources occur with a production period of a year or less. The marginal
principles are used to determine the optimum level of operating resources & there is no need to
bring in time element here.

But, capital investment made in agricultural project is made in different time period and the
returns are also spread over time. In order to assess the returns from investment, available
alternatives must be weighted for different lengths of time in respect of costs and returns i.e.,
recognition of time value of money.

Money has time value for the following reasons.

Earning power of money: Whenever there are many opportunities for investment, then money
possesses earning power. The earning power is represented by opportunity cost of money (rate of
interest).

Inflation: Purchasing power of money varies inversely with the price level. A rupee earned a year
from now is less valuable than a rupee earned today.
Uncertainty: Investment deals with future & future is uncertain. Investments are made with the
expectation of receiving a stream of benefits in the future.

Since, capital expenditure involves cash and benefits over time, it is necessary to adjust for
the time value of money for conducting a meaningful investment analysis. The adjustment for the
time value of money is made through compounding and discounting.

Compounding:

“Compounding is the procedure to find the future value of a present sum, given the earning
power (interest rate) of money & the frequency of compounding.” The future value includes the
original investment, the interest it earns and the interest on the accumulated interest. Compounding
is the process used to determine costs and returns at the end of the planning horizon.

The future value of present investment in the project is calculated by using the well- known
formula of compound interest:

Where,

FV = Future value of present sum invested in the project,

P = Present Value,
i = Interest rate in per cent, and
n = Number of years.

Discounting:

“Discounting is the procedure to find the present value of future sum.” The present value of
future sum is the current value of investment to be received in the future. This present value is
worked out through discounting process in which the future sum is discounted back to the present
time to find out its current or present value.

The present value of single payment in the future is found out with the following formula.

Where,

PV = present worth of future money,

F = money value in future,
i= rate of interest,
n = project life period in years.