Farm Management, Production and Resource Economics (AEC-307)

B.K.Bera
Farm Management comprises of two words i.e. Farm and Management. Farm means a piece of
land where crops and livestock enterprises are taken up under common management and has
specific boundaries. Farm is a socio economic unit which not only provides income to a farmer
but also a source of satisfaction to him and his family. It is also a decision making unit where the
farmer has many alternatives for his resources in the production of crops and livestock enterprises
and their disposal. Management is the art of getting work done out of others working in a group.
Management is the process of designing and maintaining an environment in which individuals
working together in groups accomplish selected aims. So, farm management is a science which
deals with the proper combination and operation of production factors such as land, labour and
capital and selection of crop and livestock enterprises to bring about a steady and maximum return
to the farmers.

Farm management is a branch of agricultural economics which deals with the business principles
and practices of farming with the objective of obtaining the maximum possible returns from the
farm as an unit through optimum allocation of scarce resources having alternative uses.
It is a science of organisation and the management of the farm enterprise fro the purpose of
securing the greatest continuous profit (Warren).

The art of managing a Farm successfully, as measured by the test of profitableness is called farm
management. (L.C. Gray).
Farm management may be defined as the science that deals with the organisation and operation of
the farm in the context of efficiency and continuous profits. (Efferson).
Farm management is a branch of agricultural economics which deals with wealth earning and
wealth spending activities of a farmer, in relation to the organisation and operation of the individual
farm unit for securing the maximum possible net income. (Bradford and Johnson).
Farm management vs. Management of farms
Farm management is different from management of farm by a farm manager who manages a
government farm as an agronomist. Mainly supervising and handling the day-to-day operations of
a farm is the function of a manager. But farm management is much more than that in which the
main emphasis is on the decision-making function of evaluating and choosing between alternative
strategies. Basically the farm management study is undertaken with the following objectives:
To study the input output relationship in agriculture and determine the relative efficiency of
various factor combinations.
To determine the most profitable crop production and livestock raising methods.

To study the cost per hectare and per quintal.

To evaluate the farm resources and land use.
To study the comparative economics of different enterprises.
To determine the relation of size of farm to land utilization, cropping pattern, capital investment
and labour employment.

To study the impact of technological changes on farm business.

To find out ways and means for increasing the efficiency of farm business through better input-
output relationship and proper allocation of resources among different uses.
Farm management vs. other sciences:
Farm management is applied economics in the context of fundamental definitions of economics
which involves three elements—scarce resources, their alternative uses and the objective of profit-
maximisation. But the basic information on the multiple (alternative)uses to which the scarce
resources can be allocated is supplied by other physical and biological sciences. The research in
these sciences should continuously generate data on alternative technologies and practices which
profitability can be tested on actual farm situations. In short, other disciplines provide the bricks
and materials and farm management uses them to raise the building structure. The role of farm
management is to integrate and synthesise the diverse pieces of information collected from many
other disciplines into an optimum package which can be applied on the farm. Agricultural scientists
mostly emphasize on maximisation of of yield rather than optimum level of resource use and
income. For that reason, the economic ceiling is generally below the technical ceiling. Thus the
physical and biological sciences provide the framework of production possibilities to which the
limited resources of the farmer can be put, the social sciences place certain restrictions on some
alternatives and resource use and the farm management deals with the selecting the alternatives to
be adopted with the objective of maximizing profits and utility functions from the farm business
as a whole on a continuous basis.
Agricultural economics and farm management:

Agricultural economics problems that can be reasonably scaled down to the level where the
farmers get involved in decision making come in the purview of farm management. Evaluation
and appraisal of farm resources and their uses for studying or improving efficiency is a farm
management question, but when such resources appraisals are made for developing a policy on
agricultural taxation, subsidies, price policy etc. fall within the ambit of agricultural economics.
As for example, in the field of agricultural credit, how much to borrow, when and from where to
borrow, what should be the repayment schedule, etc. are management questions, but a study of the
structure or the efficiency of agricultural credit institution is not within the framework of farm
management. Similarly, when and where, what and how to buy and sell is a farm management
question, a study of the marketing structure, supply-demand relations, and emerging trend in them
is mainly deals in agricultural marketing, although they have a bearing on individual farm
decisions. So, farm management is an applied discipline that finds its identity in relation to the
whole set of established social institutions and to the structure of farming in a country.
Farm management and production economics:
Farm management is an integral part of production economics. It is often difficult to distinguish
between the two. It is generally accepted that while farm management is concerned with economic
efficiency at the farm level, agricultural production economics deals with allocative efficiency in
resources in agriculture as a whole. Farm management is an intra-farm study, production
economics is an inter-farm study.

Sl. No. Agricultural production economics Farm management

1 It is a science in which the principles of It is a science of organisation and operation
choice are applied to the use of factors of farm with a view to earn a steady and
of production, e.g. land , labour, capital maximum profit on continuous basis
and management in farming industry.
2 It is a specialised branch of agricultural It is an integral part of agricultural
economics. production economics
3 It is an applied field of microeconomics It is also a part of microeconomics as it is
based on the theory of farm. concerned with the problems of individual
farm.
4 It deals with the allocative efficiency of It deals with the economic efficiency at the
the use of resources in agriculture. farm level.
5 It is an inter-farm study. It is an intra-farm study

Basic farm management decisions:

A farm is a package of physical, technical and economic resources which are scarce and farm
management is a decision making process. As these resources can be put to many uses and this
involves decision –making with regard to their best use. These decision in the terminology od
agricultural production economics comprise the theory of farm-firm. A firm is a business
organization—such as a corporation, limited liability company (LLC), or partnership—that sells
goods or services to make a profit. Firm is a unit of production that employs factors of production
(or inputs) to produce goods and services under a given state of technology. A farm is an area of
land that is devoted primarily to agricultural processes with the primary objective of
producing food and other crops; it is the basic facility in food production. The farm- firm will be
regarded as a managerial unit in which labor and physical capital are applied to land in order to
produce primary farm products. 1 It basically produces non-differentiated (i.e. , homogeneous)
products. The typical farm firm combines laborer, supplier of capital goods, and manager in a
single person. The farm manager has to take decisions on several aspects for profitable operation
of the farm. Decisions have to be taken regarding production, marketing and administration. These
three segments are interlinked and decision making is also interlinked.
1. Production decisions: Basically the farmer has to decide the following;
A. What to produce or what combination of different enterprises to follow- The farmer has to
decide the crops and allied enterprises that he wishes to produce in the farm. It depends on many
factors like soil type, water availability, other resources that the farmer can mobilize, agro-climatic
factors in the region and above all the needs of the market. This involves the use of product-product
relationship.

B. How much to produce - The area under a particular crop, size of poultry / livestock enterprise
etc., influences the quantum of output. The size of enterprises directly influences the expenditure
for cultivation and the farmers should be able to meet them from his own or borrowed resources.
This involves the use of factor- product relationship.
C. What method of production (production practices of what type of quality of inputs and their
combination) should be used? This involves the use factor-factor relationship.

D. When to produce - The timing of release of output in the market is important since generally
there is a glut in the market during harvest season and it leads to fall in price and eventually the
low profit / loss to the farmer. Natural factors also influence the choice of cultivation of crops
during a season.
E. How to produce - The farmer has to decide the choice of technology for crop production. The
farmer could go for organic farming or integrated approach using both organic and inorganic
inputs. The choice and level of different inputs, the mode and timing of their application influence
the yield.
In the case of perennial crops like fruit trees, the decisions have a long term impact on productivity
and returns.
2. Managerial Decisions

Managerial decisions in a farm include human resource management (hiring and supervision of
casual and permanent labour), utilization of funds, accounts and record maintenance, financial
transactions, accessing information required for farm management etc.

3. Marketing Decisions

Marketing decision includes buying of inputs and selling of outputs. Buying decisions address the
questions of when to buy? where and how to buy and how much to buy?. These decisions are
important in determining the profitability of the farm business. Similarly the farmer is also
confronted with the questions of when, where and how, to sell his produce? Marketing decisions
play a crucial role in making the farm business a success or failure.
Scope of farm management:
Farm management comes under Micro economics. It concentrates on the study of individual farm;
hence, it comes under Micro- economics. Farm Management covers the aspects, like efficiency of
the crop kind of crops to be grown, the doses of fertilizers to be given, the implements to be used
etc. The subject of farm management covers selection, size and appraisal of farm, appraisal of farm
resources, investment decisions, enterprise relationships, planning the crops, farm labour and
livestock, farm power machinery and equipment, costs returns on individual enterprises, complete
budgeting, risk and uncertainty and marketing of farm produce.
The farm management subject covers the aspects such as research, teaching and extension.

A) Research: The economic problems faced by the farmers needs to be studied. The data are to be
recorded. In farm management we study the problems of the cultivators critically and give solution.
In research, we cover the following points.
Input output co-efficiency
Comparative economics of various enterprises
Formulation of standard farm plan, optimum cropping pattern for different areas and types of
farming.

Develop suitable models of mechanization & modernization.

Evaluation of April prices.
B) Teaching: Farm Management is a younger discipline. Almost in all Agril Universities, this
course is taught at undergraduate level as a compulsory subject.
C) Extension: The results of the farm management should be known by the cultivators. They
should be trained through demonstrations.. Short courses in Farm Management for progressive
farmers in various types of farm enterprises needs to be conducted.
Thus, research, teaching and extension help for improving the agricultural income and ultimately
the standard of living of the cultivators.
Importance of Farm Management
Modern business management principles can assist the farmer or farm manager, no matter how
small his farm may be and however small his capital. This is because of the two major tasks facing
today’s farm managers, which are:
(a) How best to incorporate new technologies into the farming enterprises; and
(b) How to be sufficiently flexible, mentally and financially, to adjust the management of
resources to meet changing costs and prices and varying climatic conditions.
If proper management principles and techniques are applied by farmers, it helps them to meet these
and other challenges with some good level of success.
There are real advantages in utilizing ideas of farm management along with new technical
advances and capital. All things being equal, there are always wide differences in net farm incomes
per hectare between those farms where modern management ideas are utilized and those where
they are not. Some dramatic improvements have been made on farms, which have engaged
management specialists to assist in their technical and economic planning. Most farmers who have
used management advice have recorded increase in profit, relative to farmers who have not done
so. When the reason for the poor financial performance of a farm is analyzed, it is frequently found
that: activities (e.g. crops and animal productions) are not being carried out in the best way;
different activities are not well coordinated and; wrong activities are being conducted. This will
frequently stimulate the farmer to take a keener interest in the technical aspects of how he carries
out his farming activities, it may also arouse his interest in new activities, which can increase his
net income.
Types of farming: Broad two classification of farming are as follows:

Subsistence Farming
Subsistence Farming– This is farming which is done for consumption of the farm owners, can be
either Primitive or Intensive. Here the only aim is to fulfil the needs of the farmer and his family.
Primitive subsistence farming is the type of subsistence farming that is typically done on small areas
of land with traditional tools like hoe, dao, digging sticks etc. This is rather the most natural method
of growing crops, because, the natural environment like heat, rain, wind and condition of the soil
contribute to the growth of crops. Primitive farming further includes:
Shifting cultivation: In this primitive method, farmers clear the cultivated land, after harvesting the
crops and burn the land. As a result, they maintain the fertility of the soil, so whoever uses the land
next can get a good yield. This method is known by different names in different regions of India.
Shifting cultivation is also practised in some countries in South America and South East Asia

Nomadic herding: This kind of farming method involves herders and farmers travelling from place
to place with their flocks of animals. And, the herders also source wool, meat, hide and dairy
products from the livestock. Nomadic herding is very common in Rajasthan, Jammu & Kashmir
with herders rearing sheep, goats, yaks, and camel.
Intensive subsistence farming is quite in contrast to primitive farming, farmers practice intensive
farming on wider areas of land, use modern machinery and tools and add chemical fertilizers for better
crops.
Commercial agriculture is the production of crops for sale and is designed to produce crops for
widespread distribution (supermarkets), larger markets, and export. It also extends to limited
distribution (local produce stands) and any nonfood crops such as cotton and tobacco. It contributes
substantially to the gross domestic product of a country.

Basis for Subsistence farming Commercial farming

comparison

Meaning The farming practice in which crops The farming practice, in which the
are raised for personal consumption, it farmer grows crops for the purpose of
is known as subsistence farming. trade, it is called commercial farming.

Nature Labor intensive Capital intensive

Area It is practiced in small area. It is practiced in large area.

Productivity It is enhanced through the use of It is enhanced through higher doses of

manures. modern inputs.

Crops grown Food grains, fruits and vegetables Cash crops and cereals

Method of It depends on monsoon. It uses modern irrigation methods.

irrigation

Cultivation Traditional methods are used. Machines are used.

Classification of farming based on farming practices

1. Specialized Farming (> 50% income by single enterprise.):

The farm from which 50% or more income is derived from a single enterprise viz. crops, livestock,
dairy, poultry, etc., such farm is called specialized farm and farming is called specialized farming
or there is only one enterprise
Merits: i. Better use of land: Only one crop shall be grown that is best suited to that land and not
to grow different crops,, whether they are suitable of not.

ii. Better use of capital: The specialized machinery and implements should be used for such crop.
iii. Better knowledge of the crop: When the farms repeat same crop every year, they become
familiar with all the problems associated with the cultivation of the crop and the chances of crop
failure is less.
iv. Better management: Farms become more efficient in the management to organize and allocate
the resources.
v. Better use of labour: The efficiency of labour increases as the whole work is divided among
workers according to their interest and over time, they become specialized which leads to increase
in production.
vi. Better utilization of farm machinery: There are some machines especially suited for operations
associated with the cultivation of certain crop which can be used optimally.
vii. Better knowledge of marketing: As the farmers are taking up the same crop year after year,
they have gather lot of knowledge regarding marketing, particularly behaviour of prices.
Demerits: i. More risk: As there is only one crop, the declining prices or crop damage due to
infestation of diseases and pests can put the farmer in trouble, i.e. may incur losses.
ii. No crop rotation: Crop rotation is required to maintain the soil fertility. The growth of single
crop and its repetition reduces the fertility to a large extent.
iii. Resources: The productive resources i.e. land; labor and capital are not fully utilized.
iv. Income: Irregular income of the farm as they get income only once or twice in a year
v. Resources remain utilised: Proper utilization of assets (machinery and equipments) is not
possible because of specialization.

vi. Lack of Knowledge: Due to specialization of a single enterprise, the knowledge about other
enterprises become limited.
vii. Food: Does not help in supplying all the food needs of the family members of the farmer
2. Diversified farming (< 50% income by single enterprise):
A diversified farm is one that has several production enterprises or sources of income, but no single
source of income should produce more than 49% of income. The practice of producing different
types of crops /live stocks or both at the same farm at the same time.
Merits: i. Best use of land: Diversified can be more productive as different crops can be taken up
depending on the level of soil fertility across the farm,
ii. Rotation of crops: It helps maintain and improve soil fertility,
iii. Loss crop failure: If there is more than one crop, there is less danger of infestation of diseases
and pests.
iv. Income throughout the year: As the farmers grow different crops or take up different
enterprises, it will provide stable income throughout the year and the loss from one enterprise will
be compensated by the income from others.
v. More employment: The workers will be engaged throughout the year as the different crops have
different sowing and harvesting time along with other related operations.
vi. Full use of capital: Variation in growing seasons leads to variation in investment period. So,
the diversified farming provides the scope for the best use of capital.
vii. Proper use of by-products: By-product of one crop can be utilized for the other crops leading
to less wastage and more production and income,

Demerits: i. Loss of fertility: When the crops are repeated throughout the year one after the other,
the fertility of soil goes on declining and to maintain the soil fertility large amount is to be spent,
that increases cost of production,
ii. Inefficient marketing: As te farmer has to sell different crops at different time periods, he may
not be familiar with the behavior of prices of all crops. The imperfect knowledgr of marketing
affects adversely to the production and income of the farm,

iii. Non-utilization of specialized machinery: Area under individual crop being small in diversified
farm, the specialized machinery helpful for the production of certain crop can not be used which
increases the cost of production,
iv. Less marketable surplus: Different crops are produced in small quantities, the larger part of
which will be consumed by farm family resulting less marketable surplus and low income,

v. Proper planning for each of the individual crop being difficult, it leads to mis-utilization of
resources,
vi. Diseconomies of small scale farming: As large number of crops are taken up in farm, area under
individual crop is small and the diseconomies of small scale farming is realized in diversified
farming.

3. Mixed Farming [Crop Production + livestock raising (10% income)]:

Mixed farming is one where crop production is combined with the rearing of the livestock. If a
farm produces at least 10 % (at most 49%) of produce from livestock along with crops, the said
farm would be called as mixed farm. Here, in case of mixed farming, the meaning of livestock is
cow and buffalo only.
4. Dry Farming:
Dry farming is done in areas having average annual rainfall of < 50 cm.
Types of farming depending on management of farms:
1. Family Farming:

Family Farming (also Family Agriculture) is a means of organizing agricultural, forestry, fisheries,
pastoral and aquaculture production which is managed and operated by a family and predominantly
reliant on family labor, including both women’s and men’s. The family and the farm are linked,
co-evolve and combine economic, environmental, reproductive, social and cultural functions. In
India, farming is just a way of life and most of the farming is family farming. Farmers follow
Agricultural Practices in their own way and managers and organizers of their farm business. Entire
farm family members make decisions.
2. Cooperative Farming (Joint agriculture operation by farmer on voluntary basis):
In this type of farming all the members have the right of ownership in the business. The members
voluntarily pool their resources for running the business and there is no pressure other than
cooperative members. All the members are free and can leave the society at any time without
losing the ownership right of the land and resources booked by them.
The income is distributed according to the share of land, labour and capital of the members. This
farming type is further classified as,
(a) Cooperative Joint Farming Society:
The society represents the most comprehensive type of cooperative farming society. A joint
cooperative farming society comes into existence when the members pool their land and other
productive assets and carry on all the pre-sowing the pooling and post harvesting functions besides
the cultivation of the pooled land on cooperative basis.
It purchases various inputs from the market and arranges for the marketing of the produce. It also
seeks financial assistance from outside agencies to carry on these activities.

(b) Cooperative Better Farming Society:

In cooperative better farming society, the members do not cultivate their land jointly. Each member
cultivates his own land. However, they co-operate with each other for pre-sowing and post
harvesting operation. For instance, they purchase various agricultural inputs like seeds, fertilizers,
insecticides, services of machinery etc. on cooperative basis.
They sell the crops jointly. A cooperative better farming society may also arrange for financial
assistance for carrying on these activities. The members pay for the service rendered to them by
the society.

(c) Cooperative Tenant Farming Society:

This is a society which purchase or leases in land from the Government or some private persons
and then in turn leases out the land to its members. The members cultivate the land and pay the
rent falling to their share, to the society.
The society also renders various other services to its members and charges from, its members for
the service so rendered. The profits earned by the society are distributed among its members
according to some agreed formula.
(d) Cooperative Collective Farming Society:
This type of society involves pooling of their land by the members on a permanent basis. A member
who joins this society cannot ever withdraw his land from the society. He can only transfer his
land to some other person who will now become a substitute member of the society.
The functions of this society are similar to those performed by a cooperative joint farming society.
The member get their wages and profits according to the labour and land respectively contributed
by them. It is obvious that such a society is formed in contravention of the general principles-of
cooperative i.e. voluntary membership with a right to withdraw from the society at any time.

3. Capitalistic Farming:
In capitalistic farming the investment of land and capital is done by big business person or
capitalist. Wages are paid to the laborers employed. Intensive farming and improved methods of
cultivation are adopted. Farms are generally mechanized. Workers are better paid. The profit or
loss of the business is borne by the capitalist or businessperson.
4. Corporate Farming:

It has the characteristics just like capitalistic farming, but the right of ownership is on the basis of
shares taken by the member. Profit is distributed according to share of members. Workers are
generally better paid.
5. State Farming:
Government carries out state farming. Farm managers are employed for conducting day-to-day
agricultural operations. The farm may be mechanized or un- mechanized depending upon the size
of the farm. The Government provides finances as well as other facilities and also fixes the policy
to be adopted. The profit or loss is entirely borne by the Government.
6. Collective Farming: It is also called Khol-khoz. Collective members surrender their land,
livestock and implements to society. Members elect a managing committee, which is
responsible for allocation of work, distribution of income and marketing of surpluses.
Agricultural production can be increased only by two ways:
Extensive Farming:
When more land is brought under cultivation in order to increase output, it is termed as extensive
cultivation or extensive farming. In extensive farming, it is the only land, which is increased to get
more yield, other factors remain unchanged.
Intensive Farming:
Under such farming, in contrast to extensive farming, more labour and capital is used in the same
plot of land to get more yields. The focus of intensive farming is to produce maximum output per
unit of land. It is common in India as well as South East Asian countries such as Thailand.

Size of the farm:

The term ‘agricultural holding’ indicates average size of agricultural land held by the farmers in
India.
There are four different concepts of holding:
(a) Economic holding,

(b) Basic holding,

(c) Optimum holding, and
(d) Family holding.
Economic holding indicates that particular size of holding which will provide necessary support
to the peasant family. In this connection Keating observed that economic holding is one “which
allows a man the chance of producing sufficient to support himself and his family in reasonable
comfort after paying his necessary expenses.”
Considering the quality of soil and climatic condition and irrigation facilities, the size of economic
holding varies between different regions. Although Keating suggested 40-50 acres as the size of
economic holding for South Bombay, but M.L. Darling suggested that 10-12 acres would be the
size of economic holding in Punjab.
The basic holding is smaller than economic holding and it offers only subsistence living to farmers.
Optimum holding is defined by the Agrarian Committee as three times of economic holding.
The family holding (introduced by Five Year Plan) implies an area which is equivalent to either a
plough unit or a unit of average family having a pair of bullocks. Land reforms panel observed that
a family holding should provide an annual income worth Rs. 1200 to an average farmer family.

Size of Agricultural Holding in India:

There are five kinds of Land Holdings in India, depending on various sizes as follows:

Size class Area (in ha) No. of Total operated Average operational
holding area holdings
 1 Marginal holdings: 1 .0 or less 99858 37960 0.38
(68.52) (24.16)
2 Small holdings: 1 to 2.0 25777 36435 1.41
(17.69) (23.19)
3 Semi-medium 2 to 4.0 13776 37168 2.70
holdings
(9.45) (23.65)
4 Medium holdings: 4 to 10.0 5485 31367 5.72
(3.76) (19.96)
5. Large holdings: Above 10.0 831 14212 17.10
(0.57) (9.04)
6. Total/average All 145727 157142 1.08
(100.00) (100.00)
(Figures within parentheses indicate % to total)
In India, the size of agricultural holding is quite uneconomic, small and fragmented. The estimated
average size of holding in India is expected to decline from 1.5 hectares in 1990-91 to 1.08 hectares
in 2015-16. The marginal holdings were 59.7 per cent in 1990-91 which have increased further to
68.52 per cent in 2015-16 having operational area of 24.16% of the total cultivated area with an
average of 0.38 ha /family. If we take those holding less than one hectare as uneconomic, then the
table shows that about 68.52 per cent of holding can be considered as uneconomic and the
remaining 41.9 per cent of the total holding are economic. The marginal and small farmers
constitute 86.21 % of the total holdings and the area operated by them is only 47.35% of the total
holding with an average of 1.20 ha during 2015-16.
Causes of Sub-Division and Fragmentation of Agricultural Holding:
With the growth of the size of families, the agricultural holdings in India are gradually being sub-
divided among the heirs on the death of the owner of the land. In this way, generation after
generation the land is being subdivides and fragmented as well.
Under such a situation a member of the family gets one tiny plot at one place and another tiny plot
at another place leading to a peculiar problem of growing sub-division and fragmentation of
holding.

The following are some of the important causes of growing sub-division and fragmentation of
agricultural holding in India:
(i) Increasing Pressure of Population:
With the rapid growth of population, in the country, the pressure of population on land is
increasing. In view of near absence of the growth of alternative occupations, people started to put
much pressure on agriculture leading to continuous sub-division of land.

(ii) Laws of Inheritance:

In India, the laws of inheritance made provision for equal share of the ancestral property among
the children. Due to the application of this law there is a continuous split in the size of farms with
every new generation.

(iii) Fall of Joint Family System:

Under the system of joint family there was no need to sub-divide the size of agricultural holding.
But under the impact of growing industrialisation and urbanisation, the joint family system is
breaking up rapidly leading to a sub-division of agricultural holding in the country.
(iv) Decline of Village Handicrafts and Industries:

Due to destruction of village handicrafts and industries, artisans were forced to discard their
ancestral occupations and started to depend on agriculture. This has added the dimension of the
problem.
(v) Rural Indebtedness:
High degree of rural indebtedness is another cause which is supplementing to this problem of sub-
division of holding. Unscrupulous village moneylenders are charging exorbitant rate of interest
and adopting unfair practices and in the process gradually grab the land of the poor cultivators. In
this way, a part of a land is passing away into the hands of money lenders leading to increasing
sub-divisions of land holding.
(vi) Psychological Attachment of Land:

Indians are very much psychologically attached to land and they are not mentally prepared to
accept payment in lieu of land. The type of mentality has raised the problem of sub-division and
fragmentation of agricultural holding.
(vii) Crop Sharing:
In India, many big land owners lease out their land to tenants instead of cultivating their own. In
order to avoid trouble, these big land owners deliberately divided the land among the number of
tenants and avoid land reform laws. Thus, a large operational holding is deliberately reduced to a
number of small uneconomic operational holding.
4. Problems of Sub-Division and Fragmentation of Agricultural Holding:
Continuous sub-division and fragmentation of agricultural holding has been resulting in series of
problems.

These are as follows:

(i) Adoption of Modernisation Process Difficult:
The growing sub-division and fragmentation of agricultural holding make the adoption of modern
method in agricultural operation quite difficult. Mechanisation of agriculture is difficult in
uneconomic holding.
(ii) Wastage of Land:
Due to sub-division of holding, a good amount of land (about 3 to 5 per cent) is being wasted for
drawing boundaries and hedges between huge numbers of tiny plots. In Punjab, about 6 per cent
of the land is wasted due to this reason.

(iii) Difficulties in Management:

Fragmentation of agricultural holding creates difficulties to the farmers to manage the agricultural
operation smoothly. A considerable wastage of time and resources is resulting from transporting
agricultural inputs to different fragmented lands.
(iv) Litigation:

Small and fragmented farms indulged into frequent boundary disputes. All these quarrels over
boundaries result in increasing volume of litigation in the rural areas.
(v) Low Productivity:
Due to continuous sub-division of holding, the size of land becomes so small that the farmer cannot
adopt new techniques of cultivation and instead of they depend on traditional methods resulting
low productivity and low return.
(vi) Disguised Unemployment:
Smaller size of holdings cannot provide full time job to all the members of farmer’s family. Thus,
in the absence of alternative occupations, disguised unemployment started to occur in the rural
areas.

To ensure farmer-centric agricultural development, land consolidation efforts for good quality and
efficient farming needs to be undertaken.
NGOs, farmer associations and the extension wing of the agricultural ministry at the grass root
level should educate small and marginal farmers on the benefits of land consolidation which will
reap benefits in scaling up of their operations and increasing profitability.
Solutions

1.Cooperative farming: Cooperative farming is a method wherein farmers pool their resources in
certain areas of agricultural activity for mutual benefit which will facilitate mechanized farming
resulting improvement in productivity and reduction in cost of production..
2.Contract Farming and Collaborative Farming initiatives: Though contract farming does not
directly help in preventing fragmentation, the need of contractual requirements can be a tool for
farmers to collaborate for joint cultivation.
For example, farmers could plough their pooled farm lands with tractors (instead of animals) as
most of the contracts are designed for raising a specific variety of the same crop. This would help
the farmers also to reduce input costs and, ipso facto, have better price realization.
The joint activities could range from ploughing to harvesting operations and beyond. Since
contract / collaborative farming ensure better management of farms and farmers, it can be a healthy
tool in arresting further fragmentation of land holdings.
3.Corporate farming: Large corporate and MNCs that are into agricultural supply chain often try
to integrate and consolidate their product supply chains to have better control on costs and ensure
supply security. We see examples of companies taking over large parcels of land across the globe
to cultivate and produce food and non-food crops. Similar models should be allowed and
encouraged in India, which will increase farm productivity and bring in desired efficiencies.
Factors determining size of a firm
There are various economic as well as non-economic factors that influence the size of a business
unit. The relative importance of the factors varies with the products manufactured, industry in
which the firm operates etc. Size is primarily determined by the goals and objectives of the
organization and influences the efficiency of operations. The following factors determine the size
of the firm.
Resource availability: The extent of resources that are available and that can be arranged by the
entrepreneur determines the size of the firm. In case the entrepreneur is able to raise more
resources, he can opt for a larger sized firm. Conversely if the resources that are available and
arranged are less, the organizations have to settle for a smaller sized firm.
For e.g. though both Cavin Kare and HUL are both in the FMCG industry, HUL’s size is larger
when compared to Cavin Kare. One reason being that HUL has more resources available when
compared to Cavin Kare

2. Requirement of capital: Certain businesses require huge investments and therefore have to be
set up as large scale units. For e.g. Iron and Steel mills require huge investments in machinery,
similar is the case with cement plants, power generation etc. Therefore in such cases, firms have
to be set up as large scale units.
3. Nature of industry: In case the final product produced is complex, or machinery required for
manufacturing is of a large size e.g. aircraft manufacturing, iron and steel mills, boiler
manufacturing, power generation plants, manufacture of ships, rail engines etc, only large size
firms are suitable.
4. Nature of product: If the product manufactured is large, the size of the firm will be of a higher
size e.g. heavy machinery. Smaller size is preferred in case of less durable, less standardized and
fashionable products (e.g. handicrafts).

5. Nature of demand: If the demand for the product is high and expected to grow further in the
future, the size of the firm would increase. For e.g. to meet the increased demand for its cars,
Hyundai has set up a second car manufacturing plant, Nokia is planning to increase the number of
cell phones manufactured in India to meet the high demand for handsets. In case demand for a
product is showing a declining trend, the size of the firm would not be increased e.g. scooters,
floppies, typewriters etc.
6. Market size: In case the size of the market is large, then a large sized firm would be preferred.
Firms which are marketing their products not only in their home country but also internationally
would prefer large size e.g. Pepsi, Coke, Nike, Intel, RayBan, Hewlett Packard etc. Those firms
which market their products only in the local market have limited market size and therefore would
prefer to operate with a smaller size.
7. Ability of entrepreneur: If the entrepreneur is intelligent, motivated and innovative, he would
tap emerging opportunities and the firm would grow. For, e.g. Azim Premji inherited a company
which was producing vegetable oil. But today Wipro is in the vegetable oil business, consumer
care products, lighting, hardware, software (among the top 3 companies), BPO etc. The reason for
the phenomenal growth is the vision, ability and enterprising spirit of Azim Premji.
8. Economic environment: Economic environment plays a significant role in influencing the
value of the firm. In case the economy is in a boom condition, and purchasing power is increasing,
the entrepreneurs would be induced to increase the scale of operations. Whereas in case the
economy is passing through a recession or depression, the size of operations would remain small.
In India, the FMCD companies (LG, Samsung, Onida, Videocon etc.), are planning to increase
their sales. They are confident of increased sales because of growing middle class and better
purchasing power.
9. Availability of inputs of production: In case of productive factors such as raw materials,
labour, power, land are available in abundance, entrepreneurs can choose large scale operations.
In case inputs are not available in required quantities then the size of the operation would be small.
For e.g. because of the abundant availability of English speaking skilled manpower, IT, BPO and
KPO businesses are expanding in India. Due to abundant availability of iron ore mines in Orissa,
many companies such as POSCO, Tata Iron and Steel Co., etc are planning to set up their plants
in that state.
10. Government policy: The government has reserved certain items for manufacture by the small
scale industry (SSI). Therefore the size of such firms would be small in order to enjoy protection
and government privileges.
11.Estimates of future: If an industry is expected to perform well in the future, then entrepreneurs
would be ready to set up large sized businesses to meet future demand. For e.g. with the increase
in employment and purchasing power the demand for automobiles, housing, consumer durable are
expected to increase. Therefore business units engaged in these businesses are encouraged to
increase their size.
12. Market availability: If the market for the product is restricted to a particular locality or State,
the size of the firm would be small. But if the market is national or international, a large size firm
would be set up.
13. Profitability: If increase in production is expected to yield only low returns, the firm size
would remain small. In case increase in firm size, is expected to yield higher profits, the firm size
would be increased to a large sized firm.

Factors determining the economic size of holding: The following factors determine the
economic size of the holding
i. Fertility of the soil: If the land is more fertile, then the smaller area can give more of
production and income to the family to lead a comfortable life and vice-versa.
ii. Method of cultivation: The improved method of crop production can provide more
production from smaller area resulting higher income sufficient to live a decent life and hence,
economic size of holding. But traditional crop production techniques will not give desired level of
output from the same area resulting lower income and hence non-economic holding size.
iii. Nature of the crops: Cultivation of high valued horticultural /commercial crops will give
more income compared to foodgrains from the same area. So, the larger area is required to make
the farming economic in case of foodgrains than commercial crops.
iv. Irrigation facilities: If the area is irrigated, the smaller area can be economic than relatively
large tract non-irrigated area.
v. Type of the farming: If the mixed or diversified farming is practiced, the smaller area can
be economic as it will provide stable income throughout the year.
vi. Employment: If the farmer is having a full employment on the farm or he is having some
subsidiary occupation in his spare time, then the small size of the farm can become economic size.

vii. Organisation of the holdings: Small size can be economic size if it is a family farm, but if
the farm is a cooperative or corporate, then larger area is required to make it an economic holding
size.
But land is not the only one condition for the economic size of the farm, adequate availability of
inputs; reasonable prices for outputs etc are also to be fulfilled to make a farm economic size.

Principles of farm management:

Some of the economic principles that help in rational farm management decisions are:
1. Law of variable proportions or Law of diminishing returns: It solves the problems of how much
to produce ? It guides in the determination of optimum input to use and optimum output to
produce.. It explains the one of the basic production relationships viz., factor-product relationship
2. Cost Principle: It explains how losses can be minimized during the periods of price adversity.

3. Principle of factor substitution or Least cost combination: It solves the problem of ‘how to
produce?It guides in the determination of least cost combinations of resources. It explains factor-
factor relationship.
4. Principle of product substitution: It solves the problem of ‘what to produce?’. It guides in the
determination of optimum combination of enterprises (products). It explains Product-product
relationship.
5. Principle of equi-marginal returns: It guides in the allocation of resources under conditions of
scarcity.
6. Time comparison principle: It guides in making investment decisions.
7. Principle of comparative advantage: It explains regional specialisation in the production of
commodities.
8. Principles of opportunity cost: It is a concept wherein the earning from next best alternative is
sacrificed.
Concept of production function

Production is a process of physical transformation of goods and services, called inputs into goods
and services called output. The production function refers to the relationship between the input of
factor services and the output of the resultant product. Economists are directly interested to
establish a physical relationship between products and inputs and also to develop a functional
relationships to measure the response of the supply of products to changes in costs and returns. A
simple measure of the relationship between output and inputs can be the average product. The
yield per acre which is the most widely used indicator of resource productivity is an instance o f
measuring the production relationship in terms of average product. Though used extensively, yield
per acre has serious limitations. To achieve optimum allocation of resources it is necessary to know
the marginal and not average product. Marginal products can be known only if full technical
relationship between output and inputs is known which leads to the development of the concept of
production function.
Production Function is a technical relation between the quantities of various factors of production
or inputs on the one hand and the amount of product or output which they yield on the other hand.
Production function is the technical relationship between inputs & output indicating the amount of
output that can be produced with each and every set or combination of the specified inputs
(Halcrow). It is a mathematical function that relates the maximum amount of output that can be
obtained from a given number of inputs – generally capital and labor. A production function always
assumes as given, a state of knowledge and technology.
A production function may be expressed in three forms:
(a) It can be expressed in the form of an arithmetic table where first column shows the input of the
factors and the last column shows total output of the product as has been depicted below.

In the above table, fertilizer is the variable input (applied to a fixed price of land with other fixed
inputs). Total corn yield is increasing (column 2) as more units of fertilizers are applied.
(b) The production function can also be illustrated geometrically by means of a simple graph as
shown in Fig. 1. Input level is measured along the horizontal axis and the total output upon he
vertical axis.
The points on the curve OT indicate different quantities of output associated with particular levels
of the input used.
(c) The production function may be shown through an algebraic expression in which output is a
dependent variable and input, the independent variable.

In algebraic form, it can be expressed as:

Y =f(x),
where Y represents the output, x, the input and ‘f’ means is a function of, or ‘depends upon, or is
determined by’. Here, it is assumed that output depends upon a single factor. However, it must be
understood that in actual life, agricultural output (and for that matter, any output depends upon a
variety of factors, such as seeds, amount of fertilizers used, irrigation, nature of soil and so on.
This can be written as:
Y = f (x1, x2, x3………………….. xn) + u

This means that output depends upon all factors represented by x1, x2 etc., and also the level of
unknown or uncontrollable factors represented by u. It is not feasible to consider all controllable
factors simultaneously in any one study.
If there are more than two, or n different inputs and some are fixed in suplly, the production
function might be written as
y = f (x1, x2/ x3, ..., xn)

The inputs x3, ..., xn will be treated as fixed and given, with only the first two inputs allowed
to vary.

Types of Production Function:

A production function expresses a unique relationship between total output and the various inputs.
Generally, the total output increases with an increase in inputs. Like any other function, all such
functions where total output increase as the inputs increase, are known as increasing production
functions,
There are also situations in the real world where an increase in inputs, instead of bringing about
an increase in the total output, may decrease it. Such a production function will be known as
decreasing production function.
It is necessary to explain these two types of functions in some detail:

(A) Increasing Production Function:

From his point of view, it is important to know whether the rate of increase in production in
response to successive equi-proportional changes in all inputs taken together (expressed in terms
of returns to scale) or to successive changes in the amount of single input taken in isolation
(expressed in terms of returns to a variable factor), is itself increasing, is constant or is decreasing.
In other words, we are deeply interested in knowing whether the marginal returns to scale or the
marginal returns to a variable factor are increasing, constant or decreasing.
We may note here that in case of productions planning, it is the marginal returns to a variable
factor which are the main focus of attention. As such, in the paragraphs that follow, we shall be
explaining the increasing production function by categorizing it into parts, on the basis of constant,
increasing, and decreasing marginal returns to a variable input (For this purpose, we consider
change in production in response to change in one input only. We assume other variable inputs to
be constant for simplification. At a later stage, we shall see that analysis pertaining to one input
can be easily extended to over other inputs also).
(i) Increasing production function with constant marginal returns to the variable input. In this
function, the total production increases by the same magnitude for each additional unit of input
used. For example, consider the following hypothetical relationship between fertilizers used and
the total yield of wheat.

Graphic representation of this function will be a linear increasing function as shown in Fig. 2.
The diagram shows that each successive dose of 10 Kg. fertilizers makes a contribution of 60 kgs.
Of wheat to the total output. We rarely come across this type of relationship in agriculture.

(ii) Increasing production function with increasing marginal returns on the variable input:
In this case, every successive dose of input brings about an increasing addition to the total output
i.e., the output increases at increasing rate when more and more units of an input are used. This
type of relationship generally emerges when the fixed factors being used in production are having
an excess capacity and use of additional units of the variable input results in a better utilisation of
these fixed factors. The following table shows this type of production function.

Graphically this functional relation appears in the form of a curve. The curve becomes steeper as
the input increases. Fig. 3 shows the increasing production with increasing marginal returns to the
variable input. The curve that emerges in case of such a production function is concave upwards
or convex downwards to X-axis as shown in the following diagram.
This type of relationship has been observed in agriculture but only over fairly short ranges of
production.
(iii) Increasing production function with decreasing marginal returns to the variable factor:

In this case, though the total production increases as the input increases, each successive increase
in output brought about by an additional dose of input declines. In other words, marginal returns
to the input, though positive are declining. The following schedule shows his type of increasing
production function.

Diagrammatically, the curve representing this type of production function will be concave down
wards or concave upwards with regard to X-axis. Fig. 4 shows this curve.

We find that as each successive increase in output due to the use of an additional dose of input is
declining, the curve becomes flatter as it moves towards the right.
(B) Decreasing Production Function:
A decreasing production function is one in which the total output declines when the input increase.
In terms of marginal returns to the variable factor, one could say that it is negative (less than zero).
The decreasing production function could also be divided into three categories on the basis of
increasing, decreasing or constant rate of decrease in output. However, no rational producer will
ever operate in a situation (or stage) of decreasing production function i.e., where the total
production declines as the input is increased.

The table 5 shows the decreasing production function: Here, we have started with the 11th dose of
fertilizers and not with the first dose. This is because it will be rather unrealistic to assume, that
after the very first dose of fertilizers, the output starts decreasing.
The decreasing production function implies a line or a curve with negative slope. The curve can
The following diagram shows the decreasing production function:

be concave or convex to the origin depending upon whether the output declines at an increasing
rate or at a decreasing rate when more and more doses of an input are used.
Production function can be of four types:
Continuous function: The doses or levels of input and out can be split up into small units, e.g.
fertilizers can be applied to o hectare of land in different quantities ranging from a Kg to 100 Kg
and response of yield to different doses can also be measured in different quantities.
Discontinuous function (Discrete production function): Such a function is obtained for input
factors or work units which are used in whole numbers, e.g. one ploughing or number of
ploughings.
Short-run production function: Production function which relates to factors and products where
some resources are fixed.
Long-run production function: Those input-output relations which permit variation in all factors.
Different forms of algebraic production function:
Linear production function: Y= a+bX1+ cX2

Cobb-Douglas production function Y =A X1  X 2 

Quadratic production function = y = a + bx ± cx2

Cubic production function= y = a + bx + cx2 ± dX3

Square root production function= Y= a+b√x1+cX2

Choice indicators, physical and economic efficiency measures, elasticity of production:
A choice indicator is a yardstick or an index or a criteria indicating which of the two or more
alternatives is optimum or will maximize a given objective or end e.g. price ratios, substitution
ratios etc. It is the criteria based on which one enterprise will be selected from two or more
alternatives.
Some concepts:
Total physical product(TPP): Total output measured in physical terms is called total physical
product.
Average physical product(APP): APP at a particular level of input is measured by dividing the
total physical product by the number of units of input applied at the corresponding level of output.
𝑁𝑜.𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 Y
APP = =
𝑁𝑜.𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓𝑖𝑛𝑝𝑢𝑡 X

Marginal physical product (MPP): Addition to the total output by application of one additional
unit of input.
𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 𝛥𝑌
MPP= = (‘Δ’ or delta means change in or addition)
𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑝𝑢𝑡 𝛥𝑋

Elasticity of production: It is a measure of responsiveness of output to an increase in input. It is

measured as the percentage or proportionate chage in output in relation to percentage pr
proportionate change in input.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 𝛥𝑌 𝛥𝑋 𝛥𝑌 𝑋 𝛥𝑌 𝑌 𝑀𝑃𝑃
Ep = = ×100 / ×100 = × = / =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑝𝑢𝑡 𝑌 𝑋 𝑌 𝛥𝑋 𝛥𝑋 𝑋 𝐴𝑃𝑃

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡

= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡

Total value product(TVP) = When total output is measured in monetary term, it ia called total
value output. If it is obtained from input ‘X’, then it is denoted as TVPx.

TVPx = TPPx × Py ( ‘ Py’ is the price of the product ‘Y’)

Average value product (AVP): It is obtained by dividing the total value product by units of input.
 𝑇𝑉𝑃
AVPx = or, AVPx = APPx × Py
𝑋

𝛥𝑌
Marginal value product (MVP)= MPP × Py or, MVP = × Py
𝛥𝑋

Factor-product relationship
The problem of how much to produce in farm management is addressed by facto-product
relationship. There can be three types of input-output relationships in the production of a
commodity, where one input is varied and the quantities of all other inputs are fixed. The objective
of factor-product relationship is to determine the optimum quantity of the variable input that will
be used in combination with fixed inputs in order to produce optimal level of output. The nature
of such relationship can be one or a combination of the types of given as follows:
A. Law of constant returns (Constant marginal productivityt)
B. Law of increasing returns (Increasing marginal productivity)
C. Law of decreasing returns Decreasing marginal productivity).

A. Law of constant returns (Constant marginal returns)

In constant returns, each additional unit of the variable input, when applied to the fixed factors
produces an equal amount of additional product, i.e. the amount of product increases by the same
magnitude for each additional unit of input. Being linear relationship, the production function is
expressed as a straight line and is not very common in agriculture. In Fig-6, the input is measured
along X-axis and output is measured along Y-axis.
Constant marginal productivity

Doses of Output(Y) Marginal Marginal Marginal productivity

fertilizers(X) input (ΔX) output (ΔY) Marginal rate of
return(ΔY/ ΔX
5 20 0 0 4.0
10 40 5 20 4.0
15 60 5 20 4.0
20 80 5 20 4.0
25 100 5 20 4.0
30 120 5 20 4.0

In the following table, The change in fertilizer doses (ΔX) at each stage is 5 units which causes 20
units of output change (ΔY) at each corresponding level. So, the rate of change (ΔY/ΔX) which
measures the marginal rate of return is 4.0 units at all level, i.e. remains constant. By plotting these
values in a two dimensional diagram (input along X-axis and
 100

50

0
0 10 20 30 40

output along Y-axis), we get a straight line production function. At any point on the line, the slope
is determined by (ΔY/ΔX) which is constant (4.0) over the entire range and is expressed as follows:
ΔY1 ΔY2 ΔY3 ΔY4 ΔYn
= ΔX2 = ΔX3 = = − − − − − =ΔXn
ΔX1 ΔX4

Law of increasing returns:

Here for each additional or marginal unit of input results in a larger increase in output than the
preceding unit, i.e. increasing returns from the input.

Increasing marginal productivity

Doses of Output(Y) Marginal Marginal

Marginal productivity/
fertilizers(X) input (ΔX)
Marginaloutput (ΔY)
rate of
return(ΔY/ ΔX
5 20 5 0 0
10 30 5 10 2.0
15 45 5 15 3.0
20 67 5 22 4.4
25 95 5 28 5.6
30 125 5 30 6.0
Each successive units of input add more and more to the output than previous one and the marginal
productivity measured by (ΔY/ΔX) increases at all level showing increasing marginal

y
200
0
0 10 20 30 40

productivity. If the data is plotted in a graph, it takes the shape of a curve which is convex to the
origin and goes steeper and steeper with addition of inputs. The ratio of (ΔY/ΔX) will go on
increasing as more and more units of input are added. This can be expressed as follows:
ΔY1 ΔY2 ΔY3 ΔY4 ΔYn
< < < < − − − − −<
ΔX1 ΔX2 ΔX3 ΔX4 ΔXn

Law of decreasing returns:

Here, each successive doses of input adds less to the output than the previous one.
 Doses of Output(Y) Marginal MarginalMarginal productivity
fertilizers(X) input (ΔX) output (ΔY)
Marginal rate of
return(ΔY/ ΔX
5 20 0 0 0
10 40 5 20 4.0
15 58 5 18 3.87
20 73 5 15 3.65
25 83 5 10 3.32
30 90 5 7 3.0
Adding less and less to the output by the successive doses of input is known as law of decreasing
returns which is experienced in almost every practical situation of agriculture after certain stage.
100

80

60

40

20

0
0 10 20 30 40

If the above relationship is plotted in a graph, the curve will take a shape which is concave to the
origin and the slope of the curve representing the marginal productivity of factor decreases
progressively from 4.0 to 3.0 as the level of input increases from 5 to 30 units.
ΔY1 ΔY2 ΔY3 ΔY4 ΔYn
> ΔX2 > > > − − − − −>
ΔX1 ΔX3 ΔX4 ΔXn

Elasticity of production and production function:

The elasticity of production, also called output elasticity, is the percentage change in the
production of a good by a firm, divided by the percentage change in input used for the production
of that good, for example, labor or capital.
The elasticity of production shows the responsiveness of the output when there is a change in one
input.
It is defined as de proportional change in the product, divided by the proportional change in the
quantity of an input.
If elasticity of production is equal to 1.0 (Ep=1.0) throughout, it indicates constant returns, i.e. one
per cent increase in input is always accompanied by one per cent increase in output.
If elasticity of production is greater than 1.0 (Ep >1.0) throughout, it indicates increasing returns,
i.e. one per cent increase in input is always accompanied by more than one per cent increase in
output.

If elasticity of production is less than 1.0 (Ep< 1.0) throughout, it indicates decreasing returns, i.e.
one per cent increase in input is always accompanied by less one per cent reduction in output.
Relationship between Total, Average and Marginal products:
Three basic productivity relationships can be expressed simultaneously by defining the nature of
production function (total product curve) in relation to average and marginal product. So, if we
know the total production function, we can establish the relationship among these three.
Relationship between total, average and marginal products

Fertilizer Total Change in Change in Average Marginal Remarks

Input (X) product input total product product product
(Y) (ΔX) (ΔY) (Y/X) (ΔY/ ΔX)
0 0 - 0 -
1 2 1 2 1.00 2 Total product
2 6 1 4 3.00 4 increasing at
3 11 1 5 3.60 5 increasing rate
4 17 1 6 4.25 6 Increasing at
5 23 1 6 4.60 6 constant rate
6 27 1 4 4.50 4 Increasing at
7 30 1 3 4.28 3 decreasing rate
8 32 1 2 4.00 2
9 33 1 1 3.66 1
10 33 1 0 3.30 -1
11 32 1 -1 2.91 -1 Decreasing at
12 29 1 -3 2.41 -3 decreasing rate
Relationship between total and marginal products
When total product (TP) is increasing, the marginal product (MP) is positive throughout its range.
When TP is at its maximum, MP will be zero,

If TP starts decreasing at increasing rate, MP will be negative,

As long as MP moves upward direction or increases, TP increases at increasing rate,
When MP remains constant, TP increases at constant rate,
When MP starts declining or slopes downwards, TP increases at decreasing rate,
When MP=O (zero), or MP curve crosses X-axis, TP will be at maximum.

Relationship between marginal products (MP) and Average products (AP):

When MP keeps increasing or in moving upward from the beginning, the AP curve also keeps
moving upward, below MP,
As long as MP curve remains above AP curve, AP curve keeps increasing,

When MP curve is below AP curve, APP curve starts declining and MP is less than AP
If APP does not change with additional input used, the marginal product is equal to APP, i.e.
MP=APP,
When APP is maximum, MP equals to APP and from here onwards AP will start to decline. MPP
curve must intersect APP from above at its highest point, because at this point both are equal and
change from greater to less.

Summary of Relationships
Marginal physical products (MPP) and Total products (TP)

When MP increases = TP increases at increasing rate

MP is constant = TP increases at constant rate
MP decreases = TP increases at decreasing rate
MP is zero = TP is maximum
MP is below zero and negative = TP decreases at increasing rate

MP is maximum = Inflection point on TP

Average physical product (APP)and Marginal physical products(MPP)
When MP > AP = AP is increasing
When MP< AP =AP is decreasing
MP equals AP =AP is maximum

Law of variable proportion

The law of variable proportions states that as the quantity of one factor is increased, keeping the
other factors fixed, the marginal product of that factor will eventually decline. This means that
upto the use of a certain amount of variable factor, marginal product of the factor may increase
and after a certain stage it starts diminishing. When the variable factor becomes relatively
abundant, the marginal product may become negative.

Definition
“If the quantity of one productive service is increased by equal increments, with the quantity of
other resource services held constant, the increments to total product may increase at first but will
decrease after a certain point” – E.O.Heady
“An increase in capital and labour applied in cultivation of land causes in general, less than
proportionate increase in the amount of product raised, unless it happens to coincide with an
improvement in the arts of agriculture” - Marshall.
As the amount of variable resource used in production of a product is increased, the output of the
product will at first increase at an increasing rate, then increase at a decreasing rate and finally a
point will be reached, where further application of the variable resource will result in a decline in
the total output of production.
In short, marginal product of variable input will first increase, then decrease and finally become
negative.
Assumptions: The law of variable proportions holds good under the following conditions:
Constant Technology:
The state of technology is assumed to be given and constant. If there is an improvement in
technology the production function will move upward.
Factor Proportions are Variable:
The law assumes that factor proportions are variable. If factors of production are to be combined
in a fixed proportion, the law has no validity.
Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and amount with
every other unit.
Short-Run: Short run refers to a period of time in which the supply of certain inputs (e.g. plant,
building and machines, etc.) is fixed or inelastic. In short run, therefore, production of a commodity
can be increased by increasing the use of variable inputs, like labour and raw materials. The law
operates in the short-run when it is not possible to vary all factor inputs.
Three stages of production function:
The input-output relationship showing total, average and marginal productivity can be divided into
three regions in such a manner, that one can locate the portion of the production function, in which
the production decisions are rational.

Stage –I extends from ‘O’ to A when the AP reached the maximum level and MP becomes lower
than AP and Stage –II ranges from this point of maximum APP to the point of maximum TP or
MP becomes zero (from A to B). The third stage (Stage-III) (from B onwards) starts from this
stage to over the entire range of declining TPP.
Characteristics of Stage-I:
It starts from the point of origin up to the point where MPP remains greater than APP,
APP increases through this region indicating the efficiency of all the inputs, if the variable input
keeps increasing,
TPP increases at increasing rate,
Stage-I ends when AP is maximum or MPP =APP,
Elasticity of production (Ep) is more than unity, because MPP is greater than APP, up to maximum
average product. When APP is maximum, Ep is one,
Point of inflection: Point of inflection occurs in stage-I, where the rate of increase in output start
to fall off and the production function becomes concave downwards. When MPP is maximum, the
corresponding point on TPP is called the point of inflection. Inflection point indicates the change
in curvature of TPP curve.
Characteristics of Stage-II:

It starts when MPP is decreasing and is less than APP, i.e. APP > MPP,
Ends when TPP is maximum and MPP is zero,
Starting point of this stage is when MPP=APP and Ep is one,
TPP is increasing at decreasing rate,
Optimum point of input use is in this rational region.
If the producer wants to maximize their output, he must operate in region-2 (Stage-II) of production
function,

Elasticity of production is less than one, but greater than zero between maximum APP and
maximum TPP.
Characteristics of Stage-III:
TPP decreases, but it is still positive
MPP crosses zero point and becomes negative,

It is not profitable zone, additional quantity of input reduces TPP,

Ep is less than zero as TPP declines,
Double loss---Irrational zone
Reduced production
Unnecessary additional cost of production

Irrational and rational stages of production function

Irrational production exists if there is any possibility for the rearrangement of resources, either to
get a greater product from the same level of input or to get the same product with smaller amount
of resources. In stage-I, the average productivity of variable resources keep increasing and profit
can always be increased. Instead of reducing the application of variable resources to fixed factors
in stage-I, the farmers can always obtain more product and profits from the same resources. In
stage –III, the average product decreases further, marginal product becomes negative and total
product is decreasing, showing inefficient use of resources.
Therefore, the farmer should stay between the points of maximum average product and zero
marginal product (maximum total product), where Ep is less than one but greater than zero which
indicates the stage-II. The optimum level of resource use must fall in this region of economic
relevance. The optimum point of resource use or the profit maximizing amount of product can be
decided only with the help of choice indicator, i.e. factor-product prices.
Alternative line of thought
A rational producer will not like to operate in stage-I, because in this stage AP is continuously
rising, if he stops it means he is not taking full advantage of consistently rising productivity.

The firm can earn more profit by hiring more variable output and increasing his AP.
So more can be earn if a rational producer wants to earn more, and hence he will not like to operate
in this stage. A rational producer will not like to operate in stage III too, because in this stage MP
is negative, thus producer can increase his TP by employing less of the variable factor, as more of
variable factors result in decrease in output. So a rational producer will not incur expenditure in
employing additional factor if it result in decrease in output. Farmers will not like to operate in
this stage. By the process of elimination, we come to the conclusion that a rational producer will
operate in stage II, as here TP is maximum and MP is Zero.

Limitations of the law:

Improved methods of cultivation: New techniques of crop production can bring about increasing
returns. But when these techniques reach saturation without further improvements, the law must
operate.
New soils: When a virgin soil is brought under cultivation, the additional return from successive
dose of labour and capital may increase for time in the beginning.
Insufficient capital: Under limited capital conditions, sometimes the farmers operate in stage-I, a
gradual increase in capital application yields more than proportionate return. Later, the decreasing
return sets in.
Profit maximizing criteria:

Two methods are available for defining maximum profits;

Profit from the use of factor is maximized when the marginal product is equated to the price ratio,
and
Profits are maximized for the fixed unit if the marginal value productivity of factor is equal to
marginal cost of the factor.

Suppose, a farmer produces an output, ‘Y’ by using an input, ‘X’ and the farm is operating under
perfect condition. The product and factor market is assumed to be purely competitive and the prices
of output and input are represented by Py and Px. The total revenue (TR) obtained from the sale of
the output ‘Y’ is the same as Y×Py which is sometimes referred to as the total value of the product
(TVP). Similarly by multiplying the amount of input ‘X’ by price Px, we get the total factor cost
(TFC) which is equal to X * Px. Profit (Π) is the total value of the product (TVP) less the total
factor cost (TFC). The profit function for the farmer can be written as:
Π =TVP-TFC= Y×Py - X * Px
Figure above illustrates the TVP function, the TFC function, and the profit function, assuming that
the underlying production function is of the neoclassical form. The profit function is easily drawn,
since it is a graph representing the vertical difference between TVP and TFC. If TFC is greater
than TVP, profits are negative and the profit function lies below the horizontal axis. These
conditions hold at both the very early stages as well as the late stages of input use. Profits are zero
when TVP = TFC. This condition occurs at two points on the graph, where the profit function cuts
the horizontal axis. The profit function has a zero slope at two points. Both of these points
correspond to points where the slope of the TVP curve equals the slope of the TFC curve. The first
of these points corresponds to a point of profit minimization, and the second is the point of profit
maximization, which is the desired level of input use.
The slope of the profit function can be expressed ( ‘Δ’ using notation) as Δ Π / ΔX. Hence
𝚫𝚷 𝚫 𝑻𝑽𝑷 𝚫 𝑻𝑭𝑪
= -
𝚫𝐗 𝚫𝐗 𝚫𝐗

The slope of the function is equal to zero at the point of profit maximization (and at the point
𝚫 𝑻𝑽𝑷
of profit minimization). Therefore, the slope of the TVP function, , must equal the slope of
𝚫𝐗
𝚫 𝑻𝑭𝑪
the TFC function , , at the point of profit maximization.
𝚫𝐗

The VMP (value of marginal product ) or MR (Marginal revenue) is another term for the slope of
the TVP function under a constant product price assumption. In other words, VMP is another name
𝚫 𝑻𝑽𝑷
for, . Since TVP = TPP*Py, the
𝚫𝐗

VMP must equal ΔTPP * Py / ΔX. But , ΔTPP / ΔX = MP. Therefore, VMP or MR must be equal
to MP * Py .
The marginal factor cost (MFC), sometimes called marginal resource cost (MRC or MC), is
defined as the increase in the cost of inputs associated with the purchase of an additional unit
of the input. The MFC is another name for the slope of the TFC function. Note that if the

input price is assumed to be constant at Px, then MFC = Px.

The points where the slope of TVP equals the slope of TFC corresponds either to a point
of profit minimization or a point of profit maximization.
So, the equilibrium point, VMP or MR will be equal to MFC , which is now equal to price of MFC
or MC, i.e. price of the input, Px.
Δ𝑇𝑃𝑃 ΔY
Hence, VMP or MR = * Py = * Py = Px (MFC) (Where, ΔTPP = ΔY )
ΔX ΔX

ΔY Px Δ𝑇𝑃𝑃 ΔY
Or, ΔX = ( = )----------------------(1)
Py ΔX ΔX

Px
Or, MP = Py

i.e. marginal product is equal to factor-product price ratio.

So, the first condition of profit maximization is at the point where marginal product is equal to
factor-product price ratio.
If we rearrange the equation (1), we will get the following expression:
ΔY Px
=
ΔX Py

ΔY * Py = ΔX ∗ Px ----------------- (2)

VMP = MC
MR=MC
Value of added output = Value of added input
Marginal revenue = Marginal cost (Second condition of profit maximization).
Again, The marginal cost of an increment of output is determined by dividing the addition to total
cost from using one more unit of resource by increase in output, i.e.
ΔX∗ Px ΔY ∗ Py
= MC, and =MR --------------------(3)
ΔY ΔX

ΔY Px
From equation (1), =
ΔX Py

Or, ΔX ∗ Px = ΔY ∗ Py
 ΔX∗ Px
Or, = Py
ΔY

Or, ΔX ∗ Px = Py ( If ΔY is equal to one)

i.e. marginal cost is equal to the selling price of output.

Again, ΔY ∗ Py = ΔX ∗ Px

Or, ΔY ∗ Py = Px ( If ΔX is equal to one)

i.e. marginal value product or marginal revenue is equal to factor cost.

Most profitable level of production (optimum level of resource use)

The optimum level is defined by the level, which gives the maximum profit from the resource use,
i.e. maximum margin of total returns over total costs, or the level where the value of added output
is equal to value added input (Equation-2).
The following are a set of rules for profit maximization. The total value of the product

function is given as
r = h(x)
or, r = TVP
The cost function is given as
c = g(x)

or, c = TFC
Profits are defined by
∏ = r- c
Or, ∏ = h(x) - g(x)
Or, ∏ = TVP -TFC

The first order conditions for profit maximization require that ∏ is to be differentiated w.r.t. ‘x’
and the equation is set equal to zero.
d∏ /dx = h’(x) –g’(x) = 0
= dr/dx -dc/dx = 0
= dTVP/dx - dTFC/dx = 0

= VMP -MFC = 0
Or, VMP = MFC
 𝑉𝑀𝑃
𝑜𝑟, =1
𝑀𝐹𝐶

The second derivative test is often used to ensure that profits are maximum, not minimum at this
point. The second- derivative test requires that profit is maximized at that point where the slope of
the curve is negative, i.e. the curve is moving down wards. Positive slope indicate upward moving
curve, i.e. profit is minimum.
d2∏/dx2 = h’’(x) – g’’(x) < 0
h’’(x) < g’’(x)
d2TVP/dx2 < d2TFC/dx2

dVMP/dx < dMFC/dx (as dTVP/dx =VMP and d TFC/dx =MFC or MC)
The slope of the VMP function must be less than the slope of MFC. This condition is met if
VMP slopes downward and MFC is constant.
Production cost and their relationship:
There are two major categories of costs, i.e. fixed and variable costs. Fixed costs are those which
do not change with the change in the magnitude of output and would be incurred even if no output
is produced. Variable costs are those which undergo change with the change in the magnitude of
output and incurred only if production is carried out.Variable costs are the relevant costs in making
production decisions and the fixed costs have no bearing on production decisions, once they are
incurred. Although, in the long run all inputs are variable and hence there are no fixed costs.

Cost Relationship

Variable Output Variable Fixed Total Average Average Average Marginal

input (X) (Y) costs@ costs costs variable fixed total cost costs
Rs.10/ @Rs40/ (VC+FC) Costs costs (∆VC÷Y)
unit unit (VC÷Y) (FC÷Y)
0 0 0 40 40 - - - -
1 10 10 40 50 1.00 4.00 5.00 1.00
2 28 20 40 60 0.71 1.43 2.14 0.55
3 42 30 40 70 0.71 0.95 1.67 0.71
4 52 40 40 80 0.71 0.77 1.54 1.00
5 60 50 40 90 0.77 0.67 1.33 1.25
6 66 60 40 100 0.83 0.61 1.36 1.67
7 70 70 40 110 0.91 0.57 1.51 2.50
8 75 80 40 120 1.11 0.55 1.67 5.00
Total costs (TC): It is the sum of total fixed costs and total variable costs.
Total variable costs (TVC): It represents sum of all expenditure on variable inputs for any level of
output. They are short-run costs because the farmer has control of all the variable inputs. It is also
called out-of pocket costs.
Total fixed costs (TFC): Sum of expenditures which will be incurred irrespective of output level.
These are relatively long-run costs.
Marginal costs (MC): It the additional cost necessary to produce one more unit of putput. It
completely depends on the nature of the production function and the unit cost of the variable input.
No fixed is a part of the marginal costs because they are neither increased nor decreased by
additional production.
Average variable costs (AVC): It is worked out by dividing total variable costs by the amount of
output. AVC varies with the level of production. It is inversely related to average physical product,
i.e. when APP is increasing, AVC is decreasing, when APP is maximum, AVC is minimum.
When AVC is decreasing, the efficiency of the variable input is increasing.
The efficiency is maximum when AVC is at a minimum.
The minimum efficiency is decreasing when AVC is increasing.
Average fixed costs (AFC): It is worked out by dividing total fixed costs by the amount of output
and as output increases, AFC decreases.
Average total costs (ATC): It is computed by two ways:
By dividing the total costs by the total output,
By adding AFC and AVC.
The shape of the ATC depends on the shape of the production function. ATC is often referred as
the unit cost of production, the cost of producing one unit of output. ATC decreases as output
increases.
TC= TFC+TVC
ATC= (TC ÷ Total output) or AFC+AVC
TFC= Sum of fixed costs
AFC= TFC÷ No. of output units

TVC= (TC- TFC) or sum of all variable costs

AVC= TVC÷ No. of output units
Change in total variable costs or TVC
MC= Marginal physical product

Algebraic Relationship among different costs

TC=TVC + TFC
TVC=Px1*X1
 TVC+TFC AVC AFC
ATC= = +
𝑌 𝑌 𝑌

TVC Px1∗ X1 1
AVC = = = Px1 * 𝐴𝑃𝑃𝑥
𝑌 𝑌

TFC
AFC =
𝑌

d(TC) d(TVC+TFC)
MC = =
dy 𝑑𝑌

d(TVC) d(TFC)
= +
𝑑𝑌 𝑑𝑌

d(Px1∗X1) d(TFC)
= +
𝑑𝑦 𝑑𝑌

1
= Px1 *
𝑀𝑃𝑃𝑥1

Per unit cost curves

In price and output analysis, per unit cost curves are used extensively. As far as the total fixed cost
curve is concerned, it remains constant for all units of output, but we have to incur variable costs,
when output increases. Total variable cost is zero when out is zero, and increases with increase in
output. In the following figure, TC, TVC and TFC are the total cost, total variable cost and total
fixed cost curves respectively. TC lies above the TFC as it is the summation of TVC and TFC.

In the next figure, the average variable and average fixed costs curves are shown. The total fixed
cost being the fixed for all units of output, average fixed cost is falling in the shape of a rectangular
hyperbola. AVC curve is at first falls and then rises, as there emerge the diseconomies of large
production. By adding the two costs, average fixed and average variable, we get the average cost
per unit of output. At first average cost is high due to large fixed cost and small output. As output
increases, the fixed cost thinly spread over the larger number of output produced and the average
cost falls accordingly. When diminishing returns set in the variable costs, average costs start
increasing. The lower end of the curve turns up and gives it a U shape.

Marginal cost is the addition to total cost caused by a small increment in output. MC also falls first
due to more efficient use of variable factors as output increases, and then it slopes upward as
further addition to the output interfere with the most efficient use of variable factors.
Relationship between Marginal and average costs: AVC continues to decline as long as the
marginal cost is below it, but it starts rising at the point where MC crosses AVC. MC always rises
more sharply than the AVC curve. Similar relation holds between MC and ATC. An increase in
variable costs will increase the marginal cost and ATC. But increase in fixed cost will increase the
ATC and not the marginal cost. The level of output, changes in the prices of the resources,
improvement in the techniques of production, and changes in the size of the farm and equipment
are the factors that will affect the costs.
When MC is less than ATC, ATC is falling, and when MC is greater than ATC, ATC is rising. At
the point of intersection where MC equals ATC, ATC curve have just at the minimum point and
afterwards starts to rise.
Deriving Marginal and Average cost curves from total cost curve:
To get the ATC and MC for a given point P on the TC curve, draw a straight line from P to the
origin O. Then ATC at the point P equals the value of tangent of the angle (POQ) that the straight
line makes with the X- axis. It is equal to PQ/OQ. Similarly we can know the corresponding ATC
at different points of the TC curve. By joining all these points we get a U shaped average curve.
 Figure : Derivation of AC-MC curves from total cost curves
To know the MC at the point P, we draw a tangent to the curve TC at the point. Then MC
corresponding to the TC at P is given by the value of the tangent of the angle that RP makes with
the X-axis. In this case, it is equal to the value of the tangent of angle PRQ and this equals PQ/RQ,
which is the same as PM/LM. Similarly, we can know the MC at different points of the TC curve.
A cost function is a mathematical relationship between cost and output. It tells how costs change
in response to changes in output and is determined by factor prices and production function. Cost
functions re two types:

Short-run cost function: Some inputs are fixed in amount and production is increased only by
varying the quantities other inputs (variable).
Factor –Factor relationship:
In the factor-product relationship, our discussion was restricted to the use of two resources to
produce a single output , where the production function was of the nature,Y =f (X1, / X2,X3----Xn).
Where X1 is variable factor and all other factors were held constant. But we know that the
producers use more than one factor to produce a product, e.g. to produce rice, farmers use seed,
fertilizers, insecticides machines, human labour etc. and also in different combinations. In any
production process the producer should choose various combinations of all the factors of
production within the limitations of his investment capacity. The economic level of output from a
combination of fixed factors depends on the manner in which the variable resources are combined.
So a farmer must choose a particular combination of inputs which would minimize the cost for a
given level of output by substituting or combining two or more resources in the production. The
objectives of factor-factor relationships are :
1. Minimization of cost at a given level of output and
2. Optimization of output from the fixed factors through alternative resource-use
combinations.
We start the study with two variable resource combinations keeping others constant. The
production function can be expressed as:
Y = f(f (X1, X2,/X3, X4----Xn),
Where X1, X2, are variable inputs and X3, X4--------Xn, are held constant to produce a given level
of output, Y. Optimization of output or profit maximization actually involves the cost minimization
in the use of variable resources. Out of large number of input combinations, only one combination
will provide the maximum output with least cost. Our objective is to find the optimum or least
cost combination of two or more resources in producing a given level of output.
Iso-quants or iso-products:
Iso-quant is the line connecting all possible combinations of two inputs that would produce the
same level of output. It represents those combinations which

Input Input (X1) Input (X2)

combination
A 1 12
B 2 8
C 3 5
D 4 3
E 5 2
F 6 1.5
G 7 1

will allow the production of an equal quantity of output so that the producer will be indifferent
between them. ‘Iso’ means equal and quant means quantity. An isoquant shows various
combinations of two factors that will enable a producer to produce a same level of output. In other
words, each point of an isoquant will represent a technology and as we move from one point to
another on an isoquant we switch across technologies. Let us
15

10

5 Series1

0
0 2 4 6 8

discuss with the following hypothetical data and the corresponding graph where X 1 and X2 are
plotted along X-axis and Y-axis respectively..
All the input combinations of X1 and X2 shown in the table lie on the iso-products curve and give
equal quantity of output and the maps showing different levels of output or different iso-quants is
known as iso-product contour, which in turn indicates the shape of production surface.
Characteristics of Iso-quant Curves:
Convex to the origin: It means that the producer is willing to sacrifice fewer and fewer units of
capital for every additional unit of labour and vice versa.

They do not intersect each other, since each line refers to a different quantity of output.
Sloping downwards to the right : An iso-quant slopes downward from left to right or is negatively
sloped, and it implies that if a farm increases the quantity of a factor X 1, the quantity of factor X2
must be decreased in order to maintain the same level of output.
A higher Iso-quant Denotes a higher Level of Output: The greater its distance from the point of
origin, higher the level of output.
The slope of the iso-quant denotes the rate of substitution between the two resources.
Marginal Rate of Technical Substitution (MRTS); It determines the rate at which two resources
can be substituted, i.e. how much the use of one resources can be reduced in order to add additional
unit of the other resources in such a way as to maintain the same level of output. The rate at which
one input can be replaced by one unit of the other input in order to keep the output level unchanged.
The slope of the iso-quant curve determines the marginal rate of technical substitution (MRTS)
and the slope is given by number of units of replaced resources, divided by the number of units of
added resources.
∆X2 number of units of replaced resource
MRTS= =
∆X1 Number of units of added resource

∆X1
MRS of X1 for X2 is denoted as ∆X2

∆X2
MRS of X1 for X2 is denoted as ∆X1

Input X1 X2 ∆ X1 ∆ X2 MRTS = ∆ X1
∆ X2 Output
Combination
A 1 12 1 4 4/1=4 40
B 2 8 40
1 3 3/1=3
 C 3 5 1 2 2/1=2 40
D 4 3 40
1 1 1/1=1
E 5 2 40

∆ X2
In the above table, we substitute X1 for X2 , hence the MRTS is ∆ X1 for 40units of output. In
combination A, when we increase one unit of X1, the amount of X2 needs to be replaced is 4 units
and the MRTS is 4. Likewise, for every unit increase of X1, the units of X2 to be substituted changes
from 4 units to 3 units and then to two units and lastly to one unit. That means, MRTS diminishes
as more and more of X2 is substituted by every one unit addition of X2, but the output level remains
the same, i.e. at 40 units.
Elasticity of substitution:
Different factors of production are used in the process of production in different proportion in
order to get maximum profit. If the composition of the factors of production is not profitable, there
will be shift of resources from one use to the other so as to increase the profitability by increasing
or decreasing outlay in one resource or the other.
A change in the price of one factor keeping all other prices constant will require a readjustment of
factor proportion. This is due to the fact that change in the price of one factor destroys the
equilibrium condition of the equality of price ratios between the two factors and the marginal rate
of technical substitution. Elasticity of substitution measures the relative extent to which one factor
will be replaced by the other, whenever there is change in their relative prices. For example, if
capital (K) becomes cheaper, the producer will substitute capital for labour (L).
On the other hand, if wages (price of labour) fall, the producer will use relatively more labour than
capital. The manner and the rate at which the two factors will be substituted for each other will
depend upon the marginal rate of technical substitution between the factors and change in their
relative prices.
Elasticity of factor substitution is defined as the proportionate change in the factor- proportions to
the proportionate change in the marginal rate of technical substitution, so that the output remains
the same as one moves along an iso-quant. It measures the strength of substitution effect.
Therefore,

Where MPk and MPL indicate marginal product of capital and labour respectively
Intuitively, elasticity of factor substitution can also be thought of as a measure of the degree of
ease with which one factor is substituted for the other. It can also be conceived as a measure of
similarity of factors of production from a technological point of view.

Where, PK and PL refer to the price of capital and labour respectively.

The sign of the elasticity of substitution is always positive (unless σ = 0) because the numerator
and denominator change in the same direction.
Substitutes and complementary resources:
Substitutes: Factors can be substituted for each other, in so far different combinations can be used
to produce the same level of output. So, when one factor is reduced in quantity, a second factor
must always be increased to main the same output level, e.g. Machinery for labour, higher output
can be obtained from intensive use of fertilizers and from extending cultivated area.
Complements: Inputs which increase the output only when combined in a fixed proportion are
known as complements, e.g. tractors and human labour.
 I
Perfect substitutes and iso-quant Perfect complements and iso-quant
Perfect relationships:
Perfect substitutes: Perfectly substitutable factors replace each other at a constant rate, regardless
of the level of output or of the proportion in which they are combined, e.g. family and hired labours,
different brands of fertilizers, home grown seed and purchased seeds. With perfect substitutes, iso-
product curve is a straight line, intersecting the axes.
Perfect complements: Show contrasting characteristics to perfect substitutes, in that no
production results, if either factor is used separately. Factors can be combined in certain fixed
proportion, e.g. Tractor hours and labour hours.

Imperfect relationships: Although perfect factor relationship are not by themselves of great
significance in agriculture, the more common shape of iso-product curves for agricultural factors
is the convexity towards the origin. Over the middle portion of such curves are good substitutes,
but tends to approach a complimentary relationship at either extreme.
Types of resource combinations (Types of factor-factor combination)

The shape of iso-quant and production surface will depend upon the manner in which the variable
inputs are combined to produce a particular level of output. There can be three such categories of
input combinations. They are:
i. Fixed Proportion combination of inputs
To produce a given level of output, inputs are combined together in fixed proportion. Iso-quants
are ‘L’ shaped and factors are perfect complements. It is difficult to find examples of inputs which
combine only in fixed proportions in agriculture. An approximation to this situation is provided
by tractor and driver combination. To operate another tractor, normally we need another driver.
As for example, suppose to produce 50 units of output, we require OA amount of X2 and OC
amount of X1. Similarly, if input X2 is increased to OB while X1 is held at OC, the output remains
at 50 units. An increase inX1 to OD keeping X2 constant does not add to the total product. However,
a simultaneous increase in X1 to OD and X2 to OB results in a doubling of the product, as the
factors are held in fixed proportion.
ii. Constant rate of substitution: When the rate of replacement of one resource by the other resource
does not change as the added input increases in magnitude. Linear iso-product lines characterise
resources which substitute at constant rate. If one unit of X 1 substitutes for two units of X2,
conversely one unit of X2 substitutes for 0.5 units of X1 and always remain constant.
The slope of the iso-product contour is constant, i.e.
∆1X2 ∆2X2 ∆3X2 ∆nX2
= = ---------------=
∆1X1 ∆2X1 ∆3X1 ∆nX1

Fixed proportion combination of input Constant rate of substitution Decreasing rates of

substitution
Varying rates of substitution: The amount of one input (X1) required to substitute for one unit
of another input (X2) at a given level of production increases or decreases as the amount of X1 used
increases. Hence there can be either increasing or decreasing rate of substitution. Substitution at
increasing rate is not commonly available, but decreasing rate is more common in agriculture. In
this case, the slope of the iso-product curve becomes less steep as more of X1 is used relative to
X2. The MRS of X1 becomes smaller and smaller as X1 continuously replaces X2 with constant
output. Each unit of added unit X1 substitutes less of X2 than the previous one.
∆1X2 ∆2X2 ∆1X2 ∆nX2
> > --------------->
∆1X1 ∆2X1 ∆1X1 ∆nX1

Thus, in decreasing rates of substitution every subsequent increase in the use of one factor replaces
less and less of the other factor.
Iso-cost lines (Equal cost lines, Price line or Outlay line): The iso-cost line illustrates all the
possible combinations of two factors that can be used at given costs and for a given producer’s
budget. In simple words, an iso-cost line represents a combination of inputs which will cost the
same amount. It shows different combinations of factors that can be purchased at a certain amount
of money. For example, a producer wants to spend Rs. 300 on the factors of production, namely
X and Y. The price of X in the market is Rs. 3 per unit and price of Y is Rs. 5 per unit.

As shown in Figure-10, if the producer spends the whole amount of money to purchase X, then
he/she can purchase 100 units of X, which is represented by OL. On the other hand, if the producer
purchases Y with the whole amount, then he/she would be able to get 60 units, which is represented
by OH.

If points H and L are joined, a straight line is obtained, which is called iso-cost line. All the
combinations of X and Y that lie on this line, would have the same amount of cost that is Rs. 300.
Similarly, other iso-cost lines can be plotted by taking cost more than Rs. 300, in case the producer
is willing to spend more amount of money on production factors.

The slope of the iso-cost line is expressed as the ratio of the price of one input to the price of other
input. Assuming that the price of a unit of X is Px and that of Y is Py, the amount that can be
𝑀 𝑀
purchased with M amount of money is 𝑃𝑥 and 𝑃𝑦 respectively. The slope of the iso-cost line is
𝑂𝐻 𝑂𝐸 𝑜𝑝
given by 𝑂𝐿 , or, or, , i.e.
𝑂𝐹 𝑜𝑡

𝑀 𝑀 𝑈𝑛𝑖𝑡𝑠 𝑜𝑓 𝑌
/ 𝑃𝑥 =𝑈𝑛𝑖𝑡𝑠 𝑜𝑓 𝑋
𝑃𝑦

𝑀
𝑃𝑦 𝑀 𝑃𝑥 𝑃𝑥
𝑀 = 𝑃𝑦 × =𝑃𝑦
𝑀
𝑃𝑥

Properties of iso-cost lines:

i. Distance of the iso-cost line from origin: Under constant price situation, each possible
total outlay has a different iso-cost line. As outlay increases, the iso-cost line moves
higher and higher, farther away from the origin.
ii. The slope of the iso-cost line indicates the ratio of factor prices.
Change in price of a factor-input
When price of factor changes, the iso-cost line moves from its original position. The direction in
which the iso-cost line will swing depends upon the factor whose price has changed.

Case I: Change in price of labor:

a. If the price of X changes from Rs.5/ to Rs10/ unit, then the iso-cost line will be as
follows:
 (a) (b) (c)

b. If the price of X1changes from Rs.10/ to Rs 4/unit, the iso-cost line will be as follows and
if the price of both X and Y changes, the line will be as fig. (a) and (b).
Principle of cost minimization:
The problem is one of how resources are to be combined for the fixed technical unit, if
output is to be expanded from zero to the most profitable level (factor-product relationship
with variable resources combined in a least-cost manner (factor-factor relationship) for
each level of output. It is possible only by means of choice indicator and the relevant choice
indicator for profit maximization is the factor price ratio.
The principle of cost-minimisation (least –cost combination of resources) can be defined
as “ if two or more factors are employed in a production of a single product, cost is at a
minimum when the ratio off factor prices is inversely proportional to marginal rate of
substitution of factors.”
Algebraic expression of cost-minimisation:
i. Compute the marginal rate of substitution:
∆𝑿𝟐 𝑵𝒐.𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝑿𝟐 𝒓𝒆𝒑𝒍𝒂𝒄𝒆𝒅
i.e. =
∆𝑿𝟏 𝑵𝒐.𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝑿𝟏 𝒂𝒅𝒅𝒆𝒅
𝑃𝑥1 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑎𝑑𝑑𝑒𝑑 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠
ii. Compute price ratio: 𝑃𝑥2 = 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑑 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠

∆𝑿𝟐 𝑃𝑥1
iii. Work-out the least-cost combination by equating: ∆𝑿𝟏 =𝑃𝑥2 (for MRS of X1 for X2)

Cost of adding X1 is equal to the reduction in cost from X2.

𝑃𝑥1 ∆𝑿𝟐
< ∆𝑿𝟏 = Cost can be reduced by using more of X1 and less of X2.
𝑃𝑥2

𝑃𝑥1 ∆𝑿𝟐
> = Cost can be reduced by using more of X2 and less of X1.
𝑃𝑥2 ∆𝑿𝟏

This can be written as Px2 *ΔX2 = Px1 *ΔX1.

If at any point on the iso-quant, Px2 *ΔX2 > Px1 *ΔX1, then cost of producing the given level of
output could be reduced by increasing the use of X1 and decreasing X2 because the cost of added
unit of X1 is less than the cost of replaced units of X2 and vice-versa
Graphic method:
Since the slope of the iso-cost line indicate the ratio of factor prices and that of iso-quant curve
represents the MRS, the point of factor combination at minimum cost for a given level of output
is at the point of tangency of these iso-lines,
∆𝑿𝟐 𝑃𝑥1
i.e. ∆𝑿𝟏 =𝑃𝑥2. --------(1)

This equality defines the condition which applies at the point of Least Cost Combination of inputs.

Any movement down the iso-product curve results from partial withdrawal of X2 and a
compensating increase in X1 (to maintain output constant). The change in output, in absolute
terms, results from compensating addition of X1. Therefore,
∆𝑿𝟐 MPPx1
ΔX2 * MPPx2 = ΔX1 *MPPx1 or, = -------(2)
∆𝑿𝟏 MPPx2

∆𝑿𝟐 𝑃𝑥1
We know that the least-cost combination is =𝑃𝑥2.
∆𝑿𝟏

From Eq.(1) and (2),

MPPx1 𝑃𝑥1
= 𝑃𝑥2.
MPPx2

 MPPx1 * Px2 = MPPx2* Px1

MPPx1 MPPx2
 =
𝑃𝑥1 𝑃𝑥2

In other words, economic combination of factors is achieved when the return from the marginal
rupee spent on one factor is equal to return from the marginal rupee spent on the other

factor (Equi-marginal principle).

Hypothetical example:

One way to determine the Least –cost combination is to estimate the cost of all possible
combination and then select the one with minimum cost. Suppose, there are five combinations
which can produce 25 units of output the details of which is given below:
 X1 X2 Cost of X1 Cost of X2 Total expenditure on X1 & X2 to
@Rs.2/unit @Rs.4/unit produce 25 units of output
12.0 1 24.00 4.00 28.00
8.0 2 16.00 8.00 24.00
6.5 3 13.00 12.00 25.00
5.0 4 10.00 16.00 26.00
3.0 6 6.00 24.00 30.00
Out of the above combinations, the least-cost combination of inputs is 8 units of X1 and 2 units
of X2,i.e. at the rate of Rs.24/ to produce 25 units of output.

Here, the relevant choice indicator for profit maximization is the factor-price ratio and is obtained
by equating the ratio of MRS with the inverse price ratio.

Fixed rate of substitution: Here only one resource combination is possible because the factors
must be combined in the manner dictated by this extreme technique of production. The only
economic question is whether the marginal value of the product is greater than the marginal cost
of the factors combined.

Constant rate of substitution:

If two factors (X1 at the price Rs.2/unit and X2 at price Rs.4/unit) substitute at constant marginal
rates, only one of the two combinations will give the least-cost combinations to produce a given
output. The given output should be produced exclusively with X1 and none of X2 or, entirely with
X2, none of X1.Inthe following example, the two resources substitute each other at constant rate of
4.0 or 0.25. The cost of producing 100 units of output is minimum when 50 units of X 1 and none
of X2 (situation-1) is used or, when the price of X1 is Rs.10/unit and X2 is Rs. 2/unit, the same
amount of output can be produced with X2 alone and none of X1. (situation-2).In the third situation,
any one of the given factor combinations can be used, which results in same cost, and the
substitution ratio equal to the price ration for all the combinations. In situation-1, the substitution
is greater than price ratio; then X1 should always be used by replacing X2 as 10 units of X1 with
a total cost of Rs.40/, replaces 40 units of X2 with total cost of Rs.80/. In

X1 X2 ∆𝑿𝟐 ∆𝑿𝟏 Cost of 100 units of Y with factor prices per unit of
∆𝑿𝟏 ∆𝑿𝟐 X1 @Rs.4 / and X1 @Rs.10 /and X1 @Rs.16 /and
X2 @ Rs.2/ X2 @ Rs.2/ X2 @ Rs.4/
0 200 −40 10 400 400 800
= = 0.25
10 −40
10 160 360 420 800
−40 10
= = -0.25
10 −40
20 120 320 440 800
−40 10
= - 4.0 = - 0.25
10 −40
30 80 280 460 800
−40 10
= - 4.0 = - 0.25
10 −40
40 40 240 480 800
 50 0 −40 10 200 500 800
= - 4.0 = - 0.25
10 −40

situation-2, X2 resources should be used (Rs. 80/ as total cost) at the expense of X1 resource
costing Rs. 100, because the substitution ratio is less than price ratio.

Decreasing rates of substitution:

In the following table, when X1 and X2 resources are priced at Rs1.60 and Rs.1.00/ respectively,
they substitute at decreasing rate and the minimum cost of combining these two resources is at
Rs.83/ when the price ratio is 1.60 which is equal to the substitution ratio in the range 1.70 to 1.10.
Similarly, when the price ratio is 1.50, the minimum cost of combining X1 and X2 is in the range
of 1.10 to 0.90 of substitution ratio’s ,i.e. the inputs should be combined between 40 and 50 units
of X1 and 24 and 15 units of X2.

X1 X2 ∆𝑿𝟐 Cost of 100 units of output with factor prices

∆𝑿𝟏 at X1 @Rs.1.60 and X2 X1 @Rs.2.10 and x2 @Rs.2.00
@Rs.1.00
10 70 -- 86.00 161.00
20 52 -1.80 84.08 146.00
30 35 -1.70 83.00 133.00
40 24 -1.10 88.00 132.00
50 15 -0.90 95.00 135.00
Iso-clines, Ridge lines and Expansion path: The term isocline is used to refer to any line that
connects points of the same slope on a series of isoquants. Isocline is a locus of points on various
successive iso-quants at which MRS or slope are equal. It connects all input combination

which have same substitution rates for various output levels. The line shows that the resources
should be used as long as the MVP is greater than MC of the resources used. All isoclines converge
at the point of maximum output if the maximum exists.

Ridge lines: The ridge lines are the locus of points of iso-quants where marginal product of one
of the factors is zero. It represents the points of maximum output from each input, given a fixed
amount of other input. Ridge lines denote special type of iso-clines, joining points of equal slopes
via iso-pro-product curves. In the areas outside ridge lines, factors are complements, since both
the factors are required in larger quantities to increase output.

The upper ridge line implies zero MP of capital and the lower ridge line implies zero MP of labour.
Production techniques are only efficient inside the ridge lines. The marginal products of factors
are negative and the methods of production are inefficient outside the ridge lines. Suppose, curves
О A and OB are the ridge lines on the oval-shaped iso-quants and in between these lines on points
G, J, L and N and H, К, M and P economically feasible units of capital and labour can be employed
to produce 100, 200, 300 and 400 units of the product. For example, ОТ units of labour and ST
units of the capital can produce 100 units of the product, but the same output can be obtained by
using the same quantity of labour ОТ and less quantity of capital VT. Thus only an unwise
producer will produce in the dotted region of the iso-quant 100.

Fig-B
Fig.A
The dotted segments of iso-quants form the uneconomic regions of production because they
require an increase in the use of both factors with no corresponding increase in output. If points G,
J, L, N, H, К, M and P are connected with the lines OA and OB, they are the ridge lines. On both
sides of the ridge lines, it is uneconomic for the firm to produce while it is economically feasible
∆𝑋2
to produce inside the ridge lines. In fig.B, MRS of X1 for X2, i.e. ∆𝑋1 is zero, as none of X1 is
replaced. Between X2 inputs of OR and OS, the MRS is zero. So between ridge lines, the MRS is
∆𝑋2 ∆𝑋1
less than zero, i.e. ∆𝑋1 or ∆𝑋2 must be negative.

Expansion path: Each level of output or iso-product curve will have its own particular least-cost
combination of factors. There can be numerous isoclines for different possible combinations of
input prices and all these sets of prices of inputs do not prevail at any particular given time. A farm
manager has to consider only one set of input prices which he may think to be the most appropriate
for the planning periods to a given level of output. The iso-cline dependent upon this set of prices
is called expansion path.

If all the least-cost combination points are joined to each other, the result is an expansion line.
Since with factor –price ratio constant for each level of output, the MRS between factors is the
same for each level of output (tangency of isoclines), thus the expansion path is an isoclines. Of
the so may isoclines, the isoclines which is considered to the most appropriate over a production
period is known as expansion path.

In the figure above, let Q,’ would be the equilibrium point for producing 80 units of output. This
is because at point Q,’ iso-cost line is tangent to isoquant curve of IP’. Similarly, the equilibrium
point for producing 100 and 120 units are Q.” and Q,'”, respectively. When the points Q, Q’, Q”,
and Q.'” are joined, a straight line is obtained, which is called expansion path or scale line.

This line is termed as scale line because producer needs to adjust its scale of production according
to this line to achieve the output he/she desires. On the other hand, this line is also termed as
expansion path because the producer needs to expand his/her output by following this path when
the prices of factors remain constant. Producers would prefer to move along the scale line to
increase the output to get maximum output at least cost with fixed factor prices. Output should be
expanded along expansion line, as long as the marginal value product is greater than the marginal
cost of the resources added.

Product-product relationship
Product-product relationship deals with the allocation of given resources between
competing enterprises. It involves the problem of combination of crops to be grown on the limited
area of the farm by using limited quantities of factors of production. The cultivator generally faced
with the questions of:
a. How much of what to produce?
b. What combination of enterprises is to be produced?
c. How inputs be allocated among selected enterprises?
d. In case of factor-factor relationship, we held the output constant and choose different
combinations of inputs to produce a certain level of output, but in product-product
relationship, we held factor use constant and choose among various combinations of
products.
The objectives of product-product relationships are:
a. Profit maximization with a given resource allocation, when two or more products are being
produced;
b. To determine the best combination of products for a given outlay of resources.
Algebraically the relationship can be written as
Y1=f (Y2) ---------------for one product
Y1= f (Y2,Y3,Y4,-----Yn) –-----------for more than one products.
Sine, the quantity of resources is constant, while the products are variable, the function can be
written as:

Y1 =f (X1, X2, X3---------Xn) or, simply, Y1 =f(Y2)

Y2= f (X1, X2, X3---------Xn) or simply, Y2 =f (Y1)
The general equilibrium condition for a given level of inputs requires the knowledge of the two
relationships:
a. Production possibility curve and
b. Iso-revenue line

Production possibility curve (PPC):

It represents all the possible combinations of two products that can be produces with a given
amount of resources. It also known as transformation curves, iso-resource curves, iso-factor
curves, iso-cost curves or iso-outlay curves etc.The term ‘iso’ means equal, equal resource or line
indicates the possible combinations of two products, when an equal quantity of resources is
available for the two products. These iso-lines are also called opportunity curves, since they
indicate the opportunities or possibilities in the production of two enterprises when resources are
constant. The term iso-cost or iso-outlay curves refer to a given quantity in the form of money or
value.

The shape of the PPC depends on the type of product relationships involved. When two products
substitute at constant rate, the curve is always a straight line (Fig-a), when two products substitute
at increasing rate, the curve is always concave to the origin (fig.b) and when two products
substitute at decreasing rate, the curve is always convex to the origin (fig.c). The slope of the PPC
indicates the rate at which the two products are substituting.

(a)Substitution at constant rate (b)Substitution at increasing rate(c)Substitution at decreasing rate

The PPC can be drawn from either production function or from total cost curves.
From production function:

Suppose 10 acres of land (x) is available to produce two products Y 1 and Y2 assuming all other
inputs used to produce Y1 or Y2 are highly specialised and fixed. The farmer now has to decide
how much of land is to be allocated for production of each crop as the amount of land that can be
used to produce Y1 depends on the amount of land used in producing Y2, i.e. Y1 = f(Y2).

Land in Acre(x) (Input) Product (Y1) in quintal Product (Y2) in quintal

1 10.00 8
2 17.00 16
3 23.00 24
4 28.00 32
5 32.00 40
6 35.00 48
7 37.00 56
8 38.00 64
9 38.50 72
10 38.80 80
The total land area can be used for production of either Y1 or Y2 or a combination of them as in
above figure. Now we have to allocate the total land to these two crops in such a manner so that
the maximum of one is obtained for any level of the other. Such combinations are as follows:

Production possibilities for 10 acres of land Physical output of

Y2 Y1 Y1 Y2
10 0 0.00 80
9 1 10.00 72
8 2 17.00 64
7 3 23.00 56
6 4 28.00 48
 5 5 32.00 40
4 6 35.00 32
3 7 37.00 24
2 8 37.00 16
1 9 38.50 8
0 10 38.80 0
100 PPC with 10 acres of land for producing Y1 and y2

80
60
Y2

40
20
0
-20 0 20 40 60 80 100
Y1

Plotting these two functions on a graph, we will get the following PPC with 10 units of input.

Marginal Rates of Production Substitution (MRPS):

It is defined as the number of units of product that will be foregone in order to produce an extra
unit of another product keeping the use of production factors and the technology being used
constant. It means the rate of change in quantity of one product as a result of one unit increase in
quantity of other product given the amount of input use constant.
𝛥Y2 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 𝑜𝑓 𝑌2
The MRPS of Y1 for Y2 will be = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 𝑜𝑓 𝑌1
𝛥Y1

𝛥Y1 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 𝑜𝑓 𝑌1

And for Y2 of Y1, = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 𝑜𝑓 𝑌2
𝛥Y2

Production possibilities for 10 acres of land Marginal change in output MRPS

Y1 Y2 ΔY1 ΔY2 ΔY2 ΔY1
ΔY1 ΔY2
0.00 80 10 8 0.8 1.25
10.00 72
7 8 1.14 0.87
17.00 64 6 8 1.33 0.75
23.00 56
5 8 1.60 0.63
28.00 48
4 8 2.00 0.50
32.00 40 3 8 2.67 0.38
35.00 32
2 8 4.00 0.25
 37.00 24 1 8 8.00 0.125

37.00 16
0.50 8 16.00 0.062
38.50 8 0.30 8 26.67 0.037
38.80 0
Computations are similar to marginal rates of input substitution and marginal rates of product
substitution discussed earlier. This indicates the number of units of Y 1 sacrificed for each unit of
Y2 gained, as resources are shifted to Y2 and vice-versa. As the amount of Y1 increases, the amount
of Y2 sacrificed increases due to decreasing marginal returns displaced by the production function.
The slope of the PPC can be found out by drawing a tangent at a particular point on the PPC which
is equal to MRPS.

Elasticity of product substitution:

Elasticity of product substitution (Eps) measures the percentage or proportionate decrease in

output of one product (Y2) associated with a given percentage or proportionate increase in other
product (Y1).
ΔY2 ΔY1 ΔY2 Y1
Eps = / or, × Y2
Y2 Y1 ΔY1

As the Elasticity of product substitution of Y1 for Y2 increases, the opportunity line has a greater
curvature towards the axis, or an opportunity line with a high elasticity will have a much sharper
curvature than the one with low elasticity.

Iso-revenue line: The choice indicator for a farm product-product relationship is provided by an
iso-revenue curve. It indicates the ratio of prices for the two competing products. It defines all
possible combinations of two commodities which would provide an equal revenue or income. An
iso-revenue line for any total revenue can be easily draw by determining the extreme points on the
axes of coordinates and connecting these points with a straight line.It indicates all possible
combinations of two products which will provide same level of revenue or income.

Y2

Y1
In the figure above, AB is an iso-revenue line. The slope of the line is given by OA/OB , where
OA is the amount of fruits and OB is the amount of vegetables being sold which earns R units of
revenue. Assuming that the relative prices of vegetables and fruits are PY1 and PY2 respectively,
the quantity OA= R/Py2 and OB= R/Py1. The slope of iso-revenue line can be derived as follows:
OA
Slope of iso-revenue line= OB

R R R Py1 Py1
/ => × => = price ratio.
Y2 Y1 Py2 R Py2

Iso –revenue line for different level of income:

The price ratio or the slope of the price line remains the same so long as relative prices of the
products remain the same and the price line will not change their position and will run parallel to
each other. If the price of vegetables is Rs.25/Kg and that of fruits are rs.50/Kg and the farmer
wants to get revenue of Rs.2000, he can do so either by producing 80 Kg of vegetables or 40 Kg
of fruits or any combination below these quantities. Connecting these two maximum points we
will get an iso-revenue line. Any point on that line indicates the possible combination of two
products which will generate an equal revenue or income. Thus the iso-revenue line provides the
choice indicator for economic efficiency of product combinations.

Characteristics of Iso-revenue line:

i. Iso-revenue line is a straight line as the output price do not change with the quantity sold,

ii. The amount of revenue determines the distance of iso-revenue line from the origin. As total
revenue increases, the iso-revenue lines move away from origin,

iii. The slope of the iso-revenue line is equal to price ratio of the products,

The iso-revenue line and iso-cost line appear same on a graph and slopes of both are
determined by the relevant price ratios, but they are used for different purposes. The goal under
factor-factor relationship is to attain the lowest possible iso-cost curve for a given level of output
of a product, whereas, the objective of product-product relationship is to achieve the greatest
possible revenue from a given quantity of resources.

Enterprise relationship and their combination:

The enterprise physical relationship may be:

1. Joint product enterprises

a. Fixed proportions
b. Variable proportions

2. Competitive enterprises with

a. Constant rate of substitution

b. Increasing rate of substitution

c. Decreasing rate of substitution

d. Other combinations of independent products

3. Complementary enterprises

4. Supplementary enterprises

5. Antagonistic enterprises

1. Joint products:

Production of two or more products through a single production process and using same raw
materials and one of the products cannot produced alone is known as joint product enterprises.
Joint products are two or more products that are generated within a single production process; they
cannot be produced separately and incur undifferentiated joint costs.

Examples of join products include:

Paddy-straw

Milk – butter, cream, cheese

Crude oil – fuel, gas, kerosene

To be considered a joint product, each product must be of roughly equal economic importance. If
the two products have considerably different market value, the more valuable product considered
a main product, and the secondary product is known as a by-product, e.g. paddy and straw. If the
secondary product has no saleable value, it is considered spoilage, waste, or scrap. Joint products
in fixed proportion refer to products which are to be produced only in inflexible proportion which
are most commonly found in chemical compounds.

2. Competitive enterprises: Competitive enterprises are those which compete for use of the
limited resource and output of one enterprise can be increased only through a sacrifice in the
production of the other. They can be of different types depending on nature of competition.

a.Constant rate of substitution: Here, for each one unit increase in one product, a constant amount
of another product must be decreased. If the production functions for two or more products are
linear, the PPC (opportunity curve) are also linear. A linear PPC indicates that the MRS of one
product for the other is at constant rate. It exists in the presence of linear production function, only
units of resources shifted back and forth are homogeneous. Heterogeneity gives rise to increasing
substitution rates. Two independent products with linear production function give rise to linear
PPC , but linear production functions are not necessary for constant rates of substitution of
products. PPC may be linear and indicate constant rate of substitution, when (i) one of the
production function has an elasticity greater than one, the other has an elasticity less

Linear production function

Constant resource productivity Linear production possibility curve

than one, ii) both production function has stages of increasing and decreasing returns.

b. Increasing rates of substitution: This exists when resources are held constant, successive
increases in output of one product bring increasing reduction in the output of the other products. It
is always true when the production function for each independent product is one of decreasing
resource productivity (fig. a).

a. Decreasing resource productivity b. Increasing resource productivity c. Increasing rate of

substitution

Since substitution between two products is at increasing rates, the PPC is concave to the origin
(Fig-c) The MRS explain the degree of curvature of PPC. Increasing rates of substitution in
agriculture is due to the following reasons:

i. Factor-product condition of diminishing marginal productivity

ii. Non-homogeneity in quality of limited resources

 iii. Quasi –supplementary conditions---resources are non-homogeneous in respect to time
and concave PPC relate to the seasonality of production.

c. Decreasing rates of substitution: When one product is substituted for another, smaller
and smaller quantities of the other product is sacrificed for each unit increase of the former.
PPC for products produced under condition of increasing returns gives rise to diminishing
rates of substitution. Since the elasticity of both the production function of

Fig:- A. Decreasing rates of substitution

Y1 and Y2 (Fig-b) is greater than one throughout, the rate of substitution necessarily declines as
one product is substituted for another and the curve becomes convex to the origin (Fig-A). These
types of Production function is found particularly in small farms where the capital is extremely
limited and production of any one product cannot be extended to a point where ranges of increasing
returns have been exhausted. These also exist where production takes place on large scale basis
and products are competitive.

d. Other combinations of independent products:

i. Combinations of increasing returns product and a constant return product gives a convex
opportunity curve (decreasing sacrifice).

ii. When constant return product is compared with an decreasing return product, concave curve
results (increasing sacrifice).

iii. Combination of decreasing return product with increasing return product may give
linear, convex or concave curves, depending on the production coefficient for the two products.

Iv. Combination of constant return product with one of both increasing and decreasing
returns gives an opportunity curve with both convex and concave portions.

3. Complementary enterprises: Two products are said to be in complementary

relationship, when an increase in output of one results in an increase in output of the other, with
resource amount held constant. In other words, a shift of resources from a first crop to a second
crop will increase rather than decrease the output of the first. There are two reasons:
 a. One enterprise may contribute an element of production--- a joint product of the first
required by a second enterprise.
b. One enterprise may contribute an increment with the other, as the proportions of non-
usable joint products change with varying levels of output from a fixed technical unit.
c. One enterprise may divert surplus resources from a second product due to the operation
of the law of diminishing returns.

The first one, is the most important in agriculture; legume and grass crops may contribute elements
required in the production of other crops by increasing fertility, improving the soil structure,
preventing soil erosion and controlling insects, etc. When enterprises are complementary, the
PPCs are of the general nature as shown below:

Fig: B. Complementary relationship

The product Y1 is complementary with product Y2 until the production of Y2 reaches a maximum
of OG and output of Y1 reaches to OH. The products then become competitive and Y1 substitutes
for grain at increasing rate. A different opportunity curve exists for each level at which resources
are held constant.

4. Supplementary enterprises: Two products are in supplementary relationship when the output
of one product can be increased with neither a gain nor a sacrifice in another product, with
resources constant. i.e., enterprises which do not compete with each other but add to the total
income. For example, on many small farms a small dairy enterprise, or a poultry enterprise or a
small bee-keeping enterprise may be supplementary to the main crop enterprise, because they
utilize surplus family labour and shelter available and perhaps even some feeds which would
otherwise go to waste. Supplementary relationship arises mainly out of time and is to be found
especially where:

a. Enterprises can be produced only during a distinct and limited period of the year;

b. The resources employed give off a flow of services over all time periods.

Supplementary enterprises may be produced simultaneously, whenever the flow of services of

resources is concerned and one product does not completely exhaust there. Let us take another
example. Period of labour force utilization in agriculture is seasonal and when it is under-
employed, advantage can be taken of this slack labour to engage in livestock or poultry or off-farm
work. Taking part-time jobs with little or no effect in the main farm production, this relationship
is supplementary and secondary sources of income is a supplementary one.

Fig: C. Supplementary relationship

The supplementary range is denoted by the linear portions of curve AB and indicates that
approximately 20 units of Y1 can be produced without any sacrifice in Y2, while roughly 15 units
Y2 can be produced without a decrease in Y1.Beyond linear portions, the PPC takes on a slope
greater than zero and less than infinity and the two commodities are competitive. The resource
services which provides the basis for supplementarity between enterprises are not interchangeable
in the sense that all units can be withdrawn from one enterprise and used for the other.

5. Antagonistic enterprises:

Antagonism is expressed when the production function for two independent products changes as
the two enterprises are produced in the presence of each other. It is the opposite of complementary
relationship.

Summary of enterprise relationships:

∆Y1 ∆Y2
/ or < Zero Competitive
∆Y2 ∆Y1

∆Y1 ∆Y2
or = Zero Supplementary
∆Y2 ∆Y1

∆Y1 ∆Y2
or > zero Complementary
∆Y2 ∆Y1

If the MRS is less than zero, output of one product must be sacrificed as output of other product is
increased and the two products are competitive. If the MRS is equal to zero, one product can be
increased in quantity without a sacrifice in the other and the two products are supplementary. If
MRS is greater than zero, an increase or decrease in one product is accompanied by an increase or
decrease in the other product and the two products are complementary.

Determination of optimum product combination:

The optimum combination of two enterprises with given resources can be made only if the choice
indicator is known. The product price ratio provides the choice indicator for profit maximisation.
Maximum profit is attained, with the costs or resources fixed in quantity, when the marginal rate
of product substitution is equal to the inverse of the product price ratio, i.e.
∆Y2 Py1
=
∆Y1 Py2

∆Y2
Where Is the marginal rate of product substitution (MRPS) and Py1 and Py2 is the prices of
∆Y1
product Y1 and Y2 respectively.

On the other way, ∆Y1× Py1 =∆Y1× Py1

i.e. the point of maximisation, the marginal value product of a unit of resource allocated to Y 1 is
equal to the marginal value product of a unit of resource allocated to Y 2.
∆Y2 Py1
In short, when < Py2 Profits can be increased by substituting Y1 for Y2.
∆Y1

∆Y2 Py1
And when > Py2 Profits can be increased by substituting Y2 for Y1
∆Y1

The optimum product combination can be achieved when the slope of the iso-revenue line and the
slope of the PPC are equal or where the iso-revenue line is tangential to the PPC, the two slopes
are equal and therefore, it is the point of optimum product combination. Substitution of Y1 for Y2
is always profitable, as long as the slope of the opportunity curve is less than the slope of the iso-
revenue curve. Substitution of Y2 for Y1 is always profitable, when slope of the opportunity line
is greater than the slope of the iso-revenue line. At the point of tangency, the ratio of the marginal
cost of two products is equal to the ratio of their marginal value products.

Tabular method:

Calculate the net revenue from many combinations and locate the one which promises the highest
returns.

Determination of optimum product combination

Suppose total resources available are700 units of X and price of Y1-Rs.7/quin. and for
Y2=Rs.10/quin. The optimum revenue of Rs880/ is obtained from the product combination of
either 30 units of Y1 and 67 units of Y2 or 40 units of Y1 and 60 units of Y2.
 Y1 Y2 ∆Y1 ∆Y2 ∆Y2 Py1× Py2× Total
∆Y1 Y1 Y2 Revenue
0 78 - - - 0 780 780
10 76 10 2 2/10=0.5 70 760 830
20 72 10 4 4/10=0.4 140 720 860
30 67 10 5 5/10=0.5 210 670 880
40 60 10 7 7/10=0.7 280 600 880
50 48 10 12 12/10=1.2 350 480 830
60 28 10 20 20/10=2.0 420 280 700
70 0 10 28 28/10=2.8 490 0 490

Fig: Optimum product-product combination

Ridge lines and Isocline: Ridge lines can be used to separate the range of product competition
from ranges of complementarity. The ridge lines are also called border lines. It is also called
isoclines, since the slope of the iso-resource curves are identical at the point of intersection.

Fig: Ridge lines and isoclines

In the above figure, OA and OB are called the ridge lines. Line OA intersects PPC (production
possibility curve) where they are horizontal and line OB intersects where the curve is vertical. On
line OA, MRPS of Y1 for Y2 is zero and on line OB the MRPS of Y1 for Y2 is infinity. Portion of
the PPC within the border lines have negative slope indicating competition. Portion outside the
border lines have positive slope indicating compementarity.
Expansion path: As increasing amounts of resources become available, a cultivator may wish to
expand output. The pattern of expansion which would be followed can be indicated an expansion
line. This line is derived by joining up all the points of tangency between the iso-revenue lines and
the PPC.

∆Y2 Py1
At all points on the expansion path, ∆Y1 = Py2

The highest point is located somewhere along with expansion path specified by the points of
tangency, with prices indicated by the iso-revenue lines.

Returns to scale:

Economic theory gives two types of factor-product relationship in a production function:

a. Proportionality relationship
b. Scale relationship

Proportionality relationship involves the short-run production functions, of which one or more
factors are fixed. Scale relationship involves long-run production function of which no factors are
fixed. The term returns to scale refers to the changes in output as all factors change by the same
proportion (Koutsoyiannis). The returns to factor are often confused with returns to scale. The
returns to scale means that the behaviour of production or returns when all the production factors
are increased or decreased in the same ratio simultaneously. On the other hand, returns to factor
refers to the output or return generated as a result of change in one factor keeping the other factors
unchanged and it is short –run concept.

In returns to scale, necessary factors of production are increased or decreased to the same extent,
so that whatever the scale of production, the proportion among the factors remains the same. The
output does not change strictly according to the change in the scale, but one can observe the same
three stages, i.e.

i. Increasing returns (product increases by greater proportion than factors): For example, if the
amount of inputs are doubled and the output increases by more than double, it is said to be an
increasing returns to scale. When there is an increase in the scale of production, it leads to lower
average cost per unit produced as the firm enjoys economies of scale.
ii. Decreasing returns (product increases by a smaller proportion than factors): For example, if a
firm doubles inputs, output increases by less than double. In case of decreasing returns to scale,
the firm faces diseconomies of scale.

iii. Constant returns ( product increases by same proportion). For example, if a firm increases
inputs by 100%, output increases by same proportion,the firm is said to exhibit constant returns to
scale. The constant scale of production has no effect on average cost per unit produced.

In constant returns to scale when inputs are doubled, the putout also also become doubled (from
100q to 200q), whereas in case of increasing returns to scale, with the doubling of input use, output
has moved from 100q to 300q registering an increase of 200q. In decreasing returns to scale, with
the doubling of input application, production has increased from 100q to 150q, i.e. an increase of
only 50 q, less than the proportionate increase in factors.

Returns to scale is frequently measured by fitting the least square Cobb-Douglas production
function to input-output data and then adding up the exponents, which are production elasticities
of the inputs. If the sum of elasticities is less than unity then it is decreasing returns; if sum is
greater than unity, it is increasing returns and if the sum is equal to unity, it is constant returns to
scale.

Consider the following Cobb-Douglas production function:

Y= aX1b1X2b2-----Xnbn

Where, Y=Total output, X1, X2---Xn are inputs and b1,b2---bn are coefficients. The returns to scale
of this function is given by ∑𝑛𝑖=1 bi. Thus the increasing, constant and decreasing returns to scale
are indicated accordingly as this sum is greater than, equal to and less than unity respectively.

Law of Equi-marginal returns:

The law of equi-marginal returns is derived from the law of equi-marginal utility which states that
a person can get maximum utility with his given income when it is spent on different commodities
in such a way that the marginal utility of money spent on each item is equal. The consumer can
get maximum utility by allocating limited income among commodities in such a way that last
dollar spent on each item provides the same marginal utility. Algebraically,

The condition for a consumer to maximize utility is usually written in the following form:
M.Ux, M.Uy
= = M.Um
𝑃𝑥 𝑃𝑦

Mux, MUy and MUm denote the marginal utility obtained from commodity X , Y and money
respectively and Px and Py indicates the prices of Commodity X and Y
M.Uy M.Ux,
So long as 𝑃𝑦
is higher than 𝑃𝑥
and MUm, the consumer will go on substituting Y for X until
the marginal utilities of both X and Y are equalized.

This principle can be applied in farm management decision making regarding allocation of
resources to alternative enterprises in order to maximise profit from limited capital.

The law of equi-marginal return states that “the profits are maximized by using the resource in
such a way that the marginal returns from the resources are equal in all cases.”

The law of Equi-marginal returns is concerned with the allocation of the limited amount of
resource among different enterprises.

Table: Addition to Income from the Marginal (added) amount of Rs.500

Added Returns (Rs.) from

Amount of Money Spent
Sugarcane Wheat Cotton

500 800 750 650

1000 700 650 560

1500 650 580 550

2000 640 540 510

2500 630 520 505

3000 605 510 500

 Total Returns(Rs.) 4025 3550 3275

Net Profit (Rs.) 1025 550 275

Avg. Returns per Rupee at Rs. 3000 1.34 1.18 1.09

In other words, this law suggests that the limited available resources should be invested keeping
in view that how much marginal (added) returns we are getting from that enterprise and not how
much we are getting average returns. This has been illustrated with the help of following example.

A farmer has Rs.3000 and wants to grow sugarcane, wheat and cotton that are suitable for his farm
situation. What amount of money should be spent on each enterprise to obtain highest profit?

From above table it is found that the investment of Rs.3000 yields maximum average returns from
sugarcane enterprise. But if a farmer is investing his amount of Rs. 3000 keeping in view the added
returns, the profit he can earn as indicated below.

Stage Amount of Money Added Returns

Spent on (Rs.) from

1st 500 Sugarcane 800

2nd 500 Wheat 750

3rd 500 Sugarcane 700

4th 500 Cotton 650

5th 500 Sugarcane 650

6th 500 Wheat 650

Total 3000 4200

Net Profit 1200

Thus, investment keeping in view the added return would be.

1st Rs. 1500 On Sugarcane Added Returns Rs. 2150

 2nd Rs. 1000 On Wheat Added Returns Rs. 1400
3rd Rs. 500 On Cotton Added Returns Rs. 650

Total 3000 4200

Thus, the total returns and net profits Rs.4200 and Rs.1200 respectively are greater than the returns
and net profit Rs.4025 and Rs.1025 respectively. Hence for maximization of returns resource
allocation should be done in view of added returns rather that average returns.

Practical Utility: This law guides the farmer to plan his budget for the preparation of his cropping
scheme. It also provides guidance to the adoption of diversified or specialized farming. It also
enables to determine the enterprise relationship complementary or competitive.

Opportunity Cost:

The next best alternative use sacrificed for taking up one activity or enterprise. When we decide
to do one thing, we are deciding not to do something else. To ensure that we make the right
decisions, it is important that we consider the alternatives, particularly the best alternative.
Opportunity Cost is the cost of a decision in terms of the best alternative given up to achieve it.

Opportunity Cost and Workers:

Undertaking one job involves an opportunity cost. People employed as teachers might also be able
to work as civil servants. They need to carefully consider their preference for the jobs available.
This would be influenced by a number of factors, including the remuneration offered, chances of
promotion and the job satisfaction to be gained from each job. If the pay of civil servants or their
working conditions improve, the opportunity cost of being a teacher will increase. It may even
increase to the point where some teachers resign and become civil servants instead.

Opportunity Cost and Producers:

Producers have to decide what to make. If a farmer uses a field to grow sugar beet, he cannot keep
cattle on that field. If a car producer uses some of his factory space and workers to produce one
model of a car, he cannot use the same space and workers to make another model of the car at the
same time.

In deciding what to produce, private sector firms will tend to choose the option which will give
them the maximum profit. They will also take into account, the demand for different products and
the cost of producing those products.

Production Possibility Curves:

A good way to illustrate opportunity cost is to use a production possibility curve (PPC). In fact, a
PPC can also be called an opportunity cost curve. Its other names are a production possibility
boundary (PPB) and a production possibility frontier (PPF).
A PPC shows the maximum output of two products and combinations of these products that can
be produced with existing resources and technology. Fig. 1 shows, that a country can produce
either 100 units of manufactured goods or 150 units of agricultural goods or a range of
combinations of these two goods.

A country may decide to produce 80 units of manufactured goods and 75 units of agricultural
goods. If it then decides to produce 100 units of agricultural goods, it will have to switch resources
away from producing manufactured goods.

The diagram shows the reduction of output of manufactured goods to 60 units. In this case, the
opportunity cost of producing 25 extra units of agricultural goods is 25 units of manufactured
goods.

Law of comparative advantage

The concept of comparative advantage is associated with, i) Resource productivity and ii) cost of
production of enterprise. The principle (law) of comparative advantage directs a farmer in the
selection of crop and live stock enterprise in the production of which available resources have the
greatest relative/comparative advantage and not just absolutes advantage. This leads to the
establishment of different farming system existing in a particular area. The main factors involved
in the law are simply an extension and applications of principles of specialization and
diversification. There are two types of advantages – on the maximum net returns per hectare basis,

1) Absolute advantage. 2) Relative or comparative advantage.

Absolute advantage: Net return per hectare , i.e. Total returns – Cost of production.

Crop: Paddy

Particulars Region -A Region-B

Total income (Rs/ha) 9500.00 9375.00
Total expenditure(Rs) 7425.00 7350.00
 Net return/ha(Rs) 2275.00 2025
Return/rupee(Rs/ha) 1.32 1.28
Return is greater than 132% 128%
cost by

Crop: Sugarcane

Particulars Region -A Region-B

Total income(Rs/ha) 10000.00 12000.00
Total expenditure(Rs/ha) 4875.00 5500.00
Net return/ha(Rs/ha) 5125.00 6500.00
Return/rupee 2.05 2.18
Return is greater than cost by 205% 218%
From the above table, it is seen that the region-A has absolute advantage in production of paddy
and the region-B has an absolute advantage of sugarcane on the basis of net income and return
/rupee investment.

Comparative advantage: The following table gives idea about these two theories.

Table: Net returns of different crops in a region.

Sr. No. Crop Account Bajara Groundnut Cotton

1. 1 Total income (Rs.) 3500 5000 9000

1. 2 Total expenses (cost) 2000 2500 3000

1. 3 Net returns ( Rs) 1500 2500 6000

1. 4 Returns per rupee 1.75 2.00 3.00

1. 5 % returns 175% 200% 300%

From the above figures, it can be said that farmers of that region can make profit by growing any
of the three crops as they can get absolute advantages to the tune of Rs.1500, 2500 and 6000 from
bajara, Groundnut and cotton respectively. But for making the greatest profit they will have to
allocate the largest possible area under cotton alone as it has given the maximum relative returns.
Thus if a cultivator wants to earn greatest possible returns he should produce those crops in which
their relative advantage is greatest. The specialized or diversified farming depends largely on this
principle e.g. fruits & vegetables are grown largely in the vicinity of the big Cities.

Farm business Analysis

Farm business analysis is a technique based on computation and interpretation of a variety of
efficiency measures for the farm under study. The results of the analysis is then compared with the
standard derived from a group of a similar size and type. The subject of farm business analysis is
dealt with under different names, e.g. Farm Records and Accounts and farm book keeping.

Farm accountancy: It is defined as the art as well as science of recording in books the business
transactions in a regular and systematic manner, so that their nature, extent and financial effects
can be readily ascertained at any time of the year.

Farm book keeping is a system of records written to furnish a history of the business transactions,
with special reference to its financial side (Adams).

The main objective of Farm records and Accounts is to provide control over the business and
improve the management.

to evaluate the performance of the business at a particular point of time;

to identify the weakness of the business;

to remove the hurdles and improve the business; and

to prepare financial documents like balance sheet and income statement so as to acquire
credit, design farm policies and prepare tax statement. of the farm.

Characteristics of good farm record system:

Easy to keep and be up to date

Provide needed information for analysis

Provide the information when needed and serve a definite purpose

Permit the analysis of the information needed.

B. Advantages of Farm Records and Accounts:

a) They are the means to increase the farm income.

b) They are the basis for diagnosis and planning.

c) They show the ways to improve the managerial ability of the farmer.

d) They are useful for credit acquisition and management.

e) They provide database for conducting research in agricultural economics.

f) They form the basis for designing government policies - land policy, price policy, national farm
policies, etc.

C. Problems in Farm Accounting

a) As Indian farmers carry out only subsistence nature of farming, recording is not essential to
them.

b) Indian farmer acts as an owner, manager and labourer. Hence, recording becomes complex.

c) Illiteracy and lack of business awareness of farmers prohibit them to have farm records.

d) Fear of taxation prevents farmers from recording and accounting the information.

e) Forecasting becomes complicated because of very high risk and uncertainties involved in
farming.

System of Book keeping: Traditional book keeping was performed using one of two systems:

Single entry system; The single-entry bookkeeping system is used for businesses that have
minimal or uncomplicated transactions. This system records cash sales and business expenses that
are paid when incurred. This system is not traditionally used for businesses that have accounts
receivable, accounts payable or many capital transactions. The single-entry system consists of a
cash sales journal, a cash disbursements journal and your bank statements. An entry is made to the
sales journal when revenue is received, and an entry is made to the disbursement journal when an
expense is paid. Your journal entries should reconcile with your bank account transactions.

Double entry system: It is a method of recording each transaction in the books of accounts
in its two-fold aspects, i.e. two entries are made for each transaction, in the same set of books; one
being debit entry and the other a credit entry. It involves two parties—one for receiving the goods
or services and the other for giving them. Example:

a. Sale of paddy for Rs. 24,000.00.

Cash account and paddy account-two accounts

Cash a/c receiving account-the amount written on debit side of it

Paddy a/c giving account—the amount will be written on credit side of it.

Types of farm records:

Farm record system consists of three parts:

Physical farm records

Financial farm records

 Supplementary farm records

a. Physical farm records:

To implements the financial records and financial decisions, the physical data recording regarding
farms and its performance are essential. It helps to check performance of enterprises, for
controlling the business, to aid the analysis of past results, to detect the weakness and strengths to
guide future decisions and to provide planning data. As prices of input and output are subject to
continuous fluctuations, the physical data recording in many ways have greater importance than
financial information. The following physical records are to be maintained:

Farm map

Land utilisation records

Production and disposal record for crops, livestock, poultry and others

Labour records

Machinery records

Feed records

Stock and store register

b. Financial records: It is important for providing information regarding the profitability of the
whole farm business over a given period. It helps to carry out analysis to find out strength and
weakness of the farming system and also provide data for preparation of revised plan and budgets.
The information to be recorded are as follows:

Farm inventory

Farm cash or farm financial records

Classified farm cash account and annual business analysis

Capital assets and sale register

Cash sale register

Credit sale register

Purchase register

Wage register

Funds borrowed and repayment register

 Farm expenses paid in kind register

Non-farm income records

c. Supplementary records:

Sanction register

Auction register

Rainfall register

Hire register

Sanitary register

Farm inventory analysis:

Farm inventory is a list of all the physical properties/ materials of farm business along with their
value at a specific date. It is a complete list of farmer’s assets with their valuation at a point of
time. An inventory repeated at another point of time would account for the depreciation or
appreciation of assets and their sale or purchase during the period between the inventories. The
difference between two inventories reflects the profit or loss during that period, i.e. in an
agricultural year.

Assets: An asset is a physical property or intangible right owned by a business or an individual

that have a value. Assets are of three types:

A. Fixed assets: Fixed assets refer to those long term intangible assets which are not used
up in a production year, i.e. building, fence, land etc. and are depreciated over their
useful life with the exception of land which is appreciated over time.
B. Current assets: These are assets which can be easily converted into cash, i.e. cash on
hand, amount receivable, cash equivalent et. And are consumed or exhausted during
normal business operations.
C. Working assets: They are more liquid than fixed assets, such as machinery, equipments,
etc.

Methods of valuation of assets:

Cost minus depreciation

Cost or market price whichever is lower

Net selling price

Replacement cost minus depreciation

 Income capitalization method

a. Cost minus depreciation

It assumes that purchase price was an approximation of the value of the asset its value in
subsequent years can be determined by subtracting a depreciation allowance from its cost. It is
commonly used for working assets like machinery and breeding livestock.

b. Cost or market price: Valuation is estimated at the cost or the market prices whichever is lower
and is commonly used for valuing purchased supplies.

c. Valuation at net selling price: This means the price which could be obtained for the assets if
marketed less the cost of marketing.

Net selling price= market price - selling cost.

d. Valuation by replacement cost minus depreciation:

This method is to valuate the assets at what it would cost to reproduce them at present prices for
items ,e.g. buildings.

e. Valuation by income: This method is appropriate for the farm assts whose contribution to the
income of the farm business can be measured and which have a long life. The formula is follows:
𝐼
V= 𝑟

Where V= value in rupees, I= constant income over infinite number of years in future (net income
per year) r = rate of interest.

Depreciation: The deceleration in value of capital equipment due to wear and tear is called
depreciation. Whenever a machine is used for production, it efficiency reduces over time due to
wear and tear and after sometime ,it will be uneconomical to use further and need to be replaced
by a new one. So, so money must be set aside every year from the profit so that it can be replaced
in due time.

Methods of computation of depreciation:

The most common depreciation methods include:

Straight-line

Double declining balance

Units of production

Sum of years digits-digits method

 Compound interest method a. Sinking fund method, b. Annuity charging method

Insurance policy method

Machine hour basis method

1. Straight line method: It is a very common, and the simplest, method of calculating depreciation
expense. In straight-line depreciation, the expense amount is the same every year over the useful
life of the asset assuming same extent of use every year.

Annual depreciation= (Original cost - Junk Value)/(Expected life: No. of useful years of life)

(Junk value is also called scrap, salvage or residual value)

For, example, Depreciation Expense = (Rs.26,000 – Rs. 100) / 8 = Rs.3,125 / year

Years 1 2 3 4 5 6 7 8

Opening book value 25000 21875 18750 15625 12500 9375 6250 3125

Depreciation 3125 3125 3125 3125 3125 3125 3125 3125

Ending book value 21875 18750 15625 12500 9375 6250 3125 0.00

2. Annual revaluation method: This method estimates the market value of the asset in the beginning
and the end of the year and then taking the difference as depreciation and it is useful in case of
livestock in the early years of age.

3. Diminishing balance method: A fixed rate for depreciation for every year and applied to the
value of the asset at the beginning of the year. Here the original cost of the asset is divided by its
estimated life to reach a fixed percentage. This percentage is deducted every year from the
diminished balance till the asset reach the salvage value. Suppose a machine is purchased at
Rs.1000/ and its life is 10 years. At first year, the annual depreciation would be :
Original Cost Rs.1000
= = Rs.100 and it is 10% of Rs.1000/.
Expected life 10

So, every year 10 % of the value of the asset at the beginning is to be deducted to reach the value
of the asset at the next year as shown in the following table:

Years Value at the Amount to be Depreciated value

beginning depreciated (10% at the end of the
of the diminished year (Diminished
of the year value) (Rs.) balanced
1 (Rs)
1000.00 100.00 900.00
value)(Rs)
2 900.00 90.00 810.00
 3 810.00 81.00 729.00
4 729.00 72.90 656.10
5 656.10 65.61 590.49
6 590.49 59.05 531.44
7 531.44 53.14 478.30
8 478.30 47.83 430.47
9 430.47 43.05 387.42
10 387.42 38.74 348.68
4. Sum of the year-digits method: The annual depreciation is estimated by multiplying a fraction
times the amount to be depreciated (cost minus the salvage value). We can determine the fraction
for any year by the following method:

Years Value at Annual Remaining balance

the depreciation
1 beginning
92000 (92000- Rs.92000-Rs.15054.55
of the 10
9200)×55
year = Rs.76945.55
=Rs15054.55
2 76945.55 (92000- Rs.76945.55 -
9 Rs.15054.55
9200)×55=
Rs.13549.09 =Rs. 63396.46
3 63396.46 (92000- Rs. 63396.46 –
8 Rs.12043.64
9200)×55=
4 51352.82 (92000- =Rs.51532.82
Rs.51532.82 -
RS.12043.64
7 Rs.10538.18 =Rs.
9200)×55=
5 40814.64 (92000- Rs. 40814.64 – Rs.
40814.64
Rs.10538.18
6
9200)×55= Rs. 9032.73=Rs.31781.91
9032.73
6 31781.91 (92000- Rs.31781.91 –
5 Rs.7527.27=Rs.24254.63
9200)×55=
7 24254.64 (92000- Rs.24254.63 –
Rs.7527.27
4
9200)×55 = Rs.6021.82=Rs.18232.82
8 18232.82 (92000- Rs.18232.82 –
Rs.6021.82
3
9200)×55= Rs.4516.36=
9 13716.46 (92000- Rs.13716.46 – Rs.
Rs.4516.36
2 3010.90 =Rs.10705.56
9200)×55=
10 10705.56 (92000-
Rs.3010.90 Rs.10705.56 – Rs.
1 1505.45 =Rs.9200.11
9200)× =
55
Rs.1505.45
 The years of life remaining at the beginning of the accounting period
Fraction for any year = The sum of years of life of the assets

10
Fraction for1st year = =10/55
(1+2+3+4+5+67+8+9+10)

9 9
For 2nd year = = and so on.
(1+2+3+4+5+67+8+9+10 ) 55

The rate of depreciation = (Original cost - Junk value) × Fraction for the particular year Suppose
the value of a tractor is Rs. 92000/ and expected life is 10 tears and junk value is Rs.9200/

5. Compound interest method:

a. Sinking Fund method: In this method, a depreciation fund equal to the actual loss in the value
of the asset is estimated, taking into account, the interest on the so accumulated fund. The rate of
depreciation will be constant throughout the life of the asset.

Let, D= Rate of depreciation, R= Rate of interest on accumulated fund in fraction number,

C= Total cost of machine and N= No. of years of life of machine and S=Scrap value
R(C−S)
D= (1+R )N−1

b. Annuity Charging Method: In this method, interest is charged on the cost of machine or assets
every year on the book value, but the rate of depreciation is constant every year.

Let, Cost of machine, S= Scrap value, N= No. of interest in fractions and D= Rate of depreciation,

If the value of machine after 1 year becomes C1 , then

D= CR +C+C1 = C (1+R) – C1

After the value of the machine after 2nd year, D = C1R + C1 - C2 = C1 (1+R) – C2
⟨C (1+R)^N−S⟩ ⟨1−(1+R))
The standard formula will be : D = 1−(1+R)^N)

6. The Insurance policy Method: In this method, the machine is insured with the insurance
company and premiums are paid on the insurance policy. when the policy matures, the company
provides sufficient sum to replace the machine. Basically, the method covers the risk if the machine
becomes unserviceable before its estimated life.

7. Machine hour basis method: In this method, the rate of depreciation is calculated, considering
the total number of hours a machine runs in a year, and therefore, a work-hour chart for every
machine is maintained to know the total number of hours the machine operated in a year. Suppose,
a machine is costing Rs. 11000/ and expected to run for 10 years, the scrap value after the life is
Rs. 1000/ The machine is expected to run 2000 hours/year on an average. Now estimate the
depreciation charge per hour of the machine is given as follows:

Cost of the machine =Rs.11000/ and the scrap value is Rs.1000/

Depreciation fund = Rs. 11000/ - Rs.1000/ = Rs.10000/

Life of machine= 10 years=10 × 2000 =20000 hrs.

Depreciation charge per hour = 10000/20000 = Rs. 0.50 per hour.

Balance sheet analysis:

It is type of financial statement which provides information related to the financial strength and
stability of the organization at a particular point of time. Balance sheet is one of the three
fundamental financial statements and is key to both financial modeling and accounting. The
balance sheet displays the company’s total assets, and how these assets are financed, through either
debt or equity. It can also be referred to as a statement of net worth, or a statement of financial
position. The balance sheet is based on the fundamental equation:

Assets = Liabilities + Equity.

The balance sheet is divided into two sides (or sections). In general, the left side of the balance
sheet outlines all a company’s assets and on the right side, the balance sheet outlines the company’s
liabilities and shareholders’ equity. Sometimes it may be presented in revese order. Equity is the
sum of what would remain to the owner, if the business were sold and the all liabilities are paid.
Equity, also known as shareholders' equity, is that which remains after subtracting the liabilities
from the assets.

Liabilities are debts or amount of money owed by an individual, partnership or corporation which
is to be paid to others. This may be in the form of loan, promissory notes, materials bought on
credit. Current liabilities are those due within one year and include items such as accounts payable,
income tax deductions, pension plan contributions, medical plan payments, building and
equipment rents, etc. Long-term liabilities are any that are due after a one-year period. These may
include deferred tax liabilities, any long-term debt such as interest and principal on bonds, and any
pension fund liabilities.

The balance sheet is analysed mainly with the help of the three ratios:

A. Net capital ratio

B. Current ratio

C. Working ratio

A. Net capital ratio: It is measured to work out the degree of financial safety over a period of time.
 Total assets
Net capital ratio =Total liabilities

Higher the ratio, the safer is the business and less vulnerable to an unexpected fall in the value of
its assets or losses.

B. Working ratio: This measures the financial safety of the business over an intermediate period
of time.
Sum of working and current assets
C. Working Ratio = Sum of medium term liabilities and current liabilities

Current Ratio: It measures the degree of immediate liquidity. It measures a company’s ability to
pay its short-term obligations. The current ratio looks at current assets (those that can be converted
to cash in less than a year) and current liabilities (those that will have to be paid off in less than a
year).
Current assets
Current ratio = Current liabilities

The higher the ratio, the safer is the firm in the short-run, because the more likely it is to survive
unexpected demands from creditors.

Cash flow statement:

The Statement of Cash Flows (also referred to as the cash flow statement) is one of the three key
financial statements that report the cash generated and spent during a specific period of time (e.g.,
a month, quarter, or year). The statement of cash flows acts as a bridge between the income
statement and balance sheet by showing how money moved in and out of the business.

Three types of cash flows: 1. Operating Activities: The principal revenue-generating activities of
an organization and other activities that are not investing or financing; any cash flows from current
assets and current liabilities

Investing Activities: Any cash flows from the acquisition and disposal of long-term assets
and other investments not included in cash equivalents

Financing Activities: Any cash flows that result in changes in the size and composition of
the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends)

Cash Flow Definitions

Cash Flow: Inflows and outflows of cash and cash equivalents (learn more in CFI’s Ultimate Cash
Flow Guide)

Cash Balance: Cash on hand and demand deposits (cash balance on the balance sheet)
Cash Equivalents: Cash equivalents include cash held as bank deposits, short-term investments,
and any very easily cash-convertible assets – includes overdrafts and cash equivalents with short-
term maturities (less than three months).

1. Operating Cash Flow

Operating activities are the principal revenue-producing activities of the entity. Cash Flow from
operations typically includes the cash flows associated with sales, purchases, and other expenses.

2. Investing Cash Flow

Cash Flow from Investing Activities includes the acquisition and disposal of non-current assets
and other investments not included in cash equivalents. Investing cash flows typically include the
cash flows associated with buying or selling property, plant, and equipment (PP&E), other non-
current assets, and other financial assets. Cash spent on purchasing PP&E is called capital
expenditures (or CapEx for short).

3. Financing Cash Flow

Cash Flow from Financing Activities are activities that result in changes in the size and
composition of the equity capital or borrowings of the entity. Financing cash flows typically
include cash flows associated with borrowing and repaying bank loans, and issuing and buying
back shares. The payment of a dividend is also treated as a financing cash flow.

Method of calculating cash-flow:

Direct Cash Flow Method

The direct method adds up all the various types of cash payments and receipts, including cash paid
to suppliers, cash receipts from customers and cash paid out in salaries. These figures are
calculated by using the beginning and ending balances of a variety of business accounts and
examining the net decrease or increase in the accounts.

Indirect Cash Flow Method

With the indirect method, cash flow from operating activities is calculated by first taking the net
income off of a company's income statement. Because a company’s income statement is prepared
on an accrual basis, revenue is only recognized when it is earned and not when it is received. Net
income is not an accurate representation of net cash flow from operating activities, so it becomes
necessary to adjust earnings before interest and taxes (EBIT) for items that affect net income, even
though no actual cash has yet been received or paid against them. The indirect method also makes
adjustments to add back non-operating activities that do not affect a company's operating cash
flow.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the
total value of an asset that has previously been accounted for. That is why it is added back into net
sales for calculating cash flow.

Profit and loss account or Income statement

The profit and loss account shows what net profit and loss your business has made within an
accounting period after deducting all expenditure from the income. A net profit is earned if the
total expenditure is less than the sales and a net loss if it is greater.

The profit & loss statement is considered one of the most important documents for keeping an eye
on the financial health of a business. It is also sometimes referred to as the ‘income statement’.
The P&L statement is one of three financial statements every public company issues quarterly and
annually, along with the balance sheet and the cash flow statement. It is often the most popular
and common financial statement in a business plan as it quickly shows how much profit or loss
was generated by a business.

The income statement, like the cash flow statement, shows changes in accounts over a set period.
The balance sheet, on the other hand, is a snapshot, showing what the company owns and owes at
a single moment. It is important to compare the income statement with the cash flow statement
since under the accrual method of accounting, a company can log revenues and expenses before
cash changes hands.

The following items are shown in the credit side of the profit and loss account:-

Gross profit as per trading account

Cash discount received

Interest received from bank

Interest received from other sources

Profit on sale of fixed assets

Commission received

Rent received

Miscellaneous Incomes

Net loss transferred to capital account

Following items are shown in debit side of profit and loss account:-

Gross loss as per trading account

Salaries

Advertisement and publicity expenses

Bank charges

Bank Interest or interest on bank loans

Business promotion expenses

Books and periodicals expenses

Conveyance expenses

Cash discount allowed

Commission paid

Depreciation

Donations and charities

Electricity and water expenses

Interest paid on other loans

Interest on Capital of Partners

Miscellaneous expenses

Insurance expenses

Printing and stationery expenses

Postage and courier expenses

Rent paid

Audit fees

Legal and professional expenses

Staff welfare expenses

Telephone expenses

Traveling expenses

Vehicle maintenance expenses

 Loss on sale of fixed assets

Net profit transferred to capital account

After putting all the items in respected places the total of both columns of profit and loss account
is done. If the total of credit side is more than debit side then it will be net profit of the firm but if
the total of debit side is more than credit side then it will be the net loss of the firm. The net profit
or net loss is transferred to the capital account in case of proprietorship business or partnership
firm. The net profit of a limited company is transferred in reserve and surplus account after making
the provision for income tax and dividend etc.

Farm efficiency measures:

An important element in farm business management or decision making relates to the manner in
which the available resources are allocated. So, a measuring indicator is necessary to provide
guides and standard for appraising accuracy of decisions regarding the use of resources.

Efficiency can be related to:

The operation of farm business as a whole,

Any particular stage of the business, line of production or enterprise.

The use of various factors of production or resources,

To any single input.

Various efficiency measures, therefore, need to be developed to express technical efficiency in

various farm enterprises and to relate these to the financial success. The various farm efficiency
measures can be discussed as follows:

Physical efficiency (Technical efficiency),

Value efficiency (financial efficiency).

They can be further categorised into:

Aggregate or absolute measures

Ratio measures

1. Physical Efficiency measures:

a. Aggregate measures

i. Total area of the farm

ii. No. of livestock

iii. Total production

Ratio measures

Land use efficiency

• Yield per acre

• Production efficiency

• Crop yield index

• Cropping intensity

• Percentage of land under selected crop

Labour efficiency

• Crop acreage per man

• Productive man—Work-equivalent

Machinery efficiency

•Horse-power/ acre of land available and used

A brief description of some of the farm efficiency measures is given below:

Total Area of the Farm

The first measure of size is the acreage of the farm: either or total land or land under crops. This
is a fairly satisfactory measure for comparing a given type of land and a given type of farming.
Average area per farm varies from region to region and the combination of enterprises also varies
from good to poor soil and from humid to arid climates. One can consider number of standard
acres under such situations and compare the size of farms.

Land Use Efficiency

Some of the measures or indices measuring the rate of production are:

i. Yield per acre (production efficiency). The production efficiency of a farm with respect to any
particular crop enterprise can be expressed in terms of percentage as compared with average yield
of the locality.
An example: Wheat yield per acre of Farm ‘A’ = 13 qtls.

Average yield of the locality = 10 qtls.

Production efficiency of Farm ‘A’ = 13/10 x 100 = 130%

ii. Crop yield index: It is a measure of comparison of the yield of all crops on a given farm with
the average yields of these crops in the locality. The relationship is expressed in percentage terms.
This yield index is a convenient measure because it combines all the yields into a single figure.

Average yield (qtls) Acres of Crop yield on farm X Percentage

crop farm as a % of locality multiplied by
Crop Locality Farm ‘X’ ‘X’ (Col.(3)/Col.(2).X(100) acres

1 2 3 4 5 6

Cotton 3 qtls. 4 qtls. 3 133 399

Wheat 10 qtls. 12 qtls. 8 120 960

Maize 10 qtls. 9 qtls. 6 90 540

Total: -- -- 17 -- 1899

Crop yield index = 1899/17 × 100 = 111.7%

Intensity of cropping: It measures the extent of the use of land for cropping purposes during a
given year. It is expressed as a percentage.
Area cropped Gross cropped area
Cropping intensity =Total cultivated are𝑎 x 100 = x100
Net sown area

Labour efficiency measures:

i. Crop acreage per man equivalent :

The significance of this measure is influenced by the varying proportion of crops with high or low
labour requirements, such as potatoes compared with wheat. It is one of the simplest measures and
is computed by dividing the total acres in crops by man-equivalents.

ii. Productive man-work units per man-equivalent (PMWU) :

It is another good and accurate general measure of labour efficiency for all types of farms.
It is computed by dividing total productive man-work units by the number of man-equivalents on
the farm. A productive man work unit is the average amount of work accomplished by one man in
the usual eight –hour per day or 10-hourper day. The PMWU are obtained by multiplying the acres
of each crop and number of each kind of livestock by the average labour requirements per unit of
each enterprise in a region.

PMWU = acres of each crop × average labour requirements per unit of crop.

Financial efficiency measures—Aggregate and ratio measures

Aggregate measures:

i. Total capital managed

ii. Gross income
iii. Gross expense
iv. Gross profit
v. Net worth= Total assets – Total liabilities

Farm income and profit efficiency measures:

i. Net cash income=Total cash receipts – Total cash operating expenses

ii. Net farm income= Net cash income ± Change in inventory and depreciation
iii. Farm earnings= Net farm income+ Value of farm privileges
iv. Family labour earnings= Farm earnings – Interest charges on farm capital
v. Return to management= Family labour earnings – Imputed value of family labour
Farm earnings−Family labour value
vi. Percent return to capital = × 100
Average capital investment

Ratio measures:

i. Gross output per gross input

Fertilizers cost
ii. Fertilizer cost per crop acres= Crop acreage
Total cost of machinery
iii. Power and equipment cost per crop acre = Total crop acres
Total machinery investment
iv. Power and equipment/investment per acre= Total crop acres

Cost Ratios:
Operating expenses
• Operating cost ratio = Gross profit

Fixed expenses
• Fixed cost ratio = Gross profit

Total expenses
• Gross cost ratio = Gross income
 Total expenses
• Cost per acre = No.of acres

Capital ratios:
Total capital investment
• Capital per unit of gross profit = Gross income

• Capital per man

Income ratios
Gross income
• Rate of capital turnover = Total farm assets× 100

Gross income−Gross expenses

• Net income per acre = Net income per acre = No.of acres

Financial solvency Ratios:

• Net capital ratio

• Working ratio

• Current ratio

Cost ratios: Cost ratios are averages and their magnitudes reflect physical production efficiency,
selection of enterprises, prices received for commodities and the expense for the production
elements. These cost ratios are discussed below:

i. Operating cost ratio: The operating ratio is the percentage which operating expenses absorb out
of gross profit. It shows the proportion of total income used in (1) hiring labour (2) buying seeds,
fuel and other annual supplies and (3) in keeping equipment in operation, etc.
Total operating cost
Operating cost Ratio =
Total Profit

ii. Over-head charges (Fixed Ratio)

Fixed expenses continue in about the same amount regardless of the current operating policy. Their
relative importance in production can be expressed by a ratio determined by dividing the total fixed
costs by the gross profits.

The fixed costs generally include: (1) Land revenue (2) Water taxes, (3) Other taxes, (4)
Depreciation, (5) yearly insurance premium, (6) Interest on total investment, etc.
Operating Expenses
Overhead ratio =
Taxable net interest income + Operating income

Gross (Cost) Ratio

The gross (cost) ratio of total expenses to gross income is a combined measure of the profit making
ability of the farm and profit margin. While the net income expresses the amount by which income
exceeds expenses: the gross ratio expresses the percentage of gross income consumed by expenses
and is, therefore, independent of the absolute size of the business.

Example of measuring the farm income and profit efficiency

Item Farm ‘ A’ (Rs) Farm ‘B’(Rs)

i.Net cash income

•Sale of crops 3000 6000

• Sale of milk 1000 800

• Sale of eggs 500 300

• Miscellaneous sales 200 200

Sub -total 4700 7300

ii.Cash expenses

•Labour 600 800

•Seeds 200 200

•Fertilizer 400 550

•Purchase of feeds 300 200

•Misc. 100 250

Sub-total 1600 2000

iii.Change in inventory 300 900

iv.farm privilege 600 1000

v. Interest charges on av. Farm capital@10% 200 375

vi.Imputed value of family labour 450 800

• Net cash income (A)=(I -ii) 3100 5300

•Net farm income (B)=(A + iii) 3400 6200

 •Farm earning (C)= (B + iv) 4000 7200

•Family labour earnings(D)= (C - v) 3800 6825

•Returns to Mnagement (E)=(D - vi) 3350 6025

Cost concepts:

An amount that has to be paid or given up in order to get something, In business, cost is usually a
monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5)
risks incurred, and (6) opportunity forgone in production and delivery of a good or service.

Cost is ‘measurement in monetary terms of the amount of resources used for the purpose of
production of goods or rendering services.

Role of costs in farm management:

It helps in choosing from among varied alternative course of action,

It helps in pricing decisions,

It helps in determining the optimum level of operation inaccordance with the behavior of
cost in relation to scale of operation,

In deciding replacement of a capital equipment by a new one, cost information is

necessary,

In deciding whether to sell a product at one stage of processing or to further process it, cost
data are needed,

In deciding acquisition of fixed assets, cost is a relevant factor,

To decide whether an equipment is to be bought or hired cost data are essential,

Cost plays a vital role in performance evaluation and return analysis.

There are various costs concepts used in farm management study. They are:

Fixed and variable costs:

Nature Time Related Volume Related

Incurred Fixed costs are definite, they are Variable costs are incurred only when
when incurred whether the units are the units are produced.
produced or not.
 Unit Cost Fixed cost changes in unit, i.e. as the Variable cost remains same, per unit.
units produced increases, fixed cost
per unit decreases and vice versa, so
the fixed cost per unit is inversely
proportional to the number of output
produced.

Behavior It remains constant for a given period It changes with the change in the
of time. output level.

Combination Fixed Production Overhead, Fixed Direct Material, Direct Labor, Direct
of Administration Overhead and Fixed Expenses, Variable Production
Selling and Distribution Overhead. Overhead, Variable Selling and
Distribution Overhead.

Examples Depreciation, Rent, Salary, Insurance, Material Consumed, Wages,

Tax etc. Commission on Sales, Packing
Expenses, etc.

B. Out-of pocket cost and imputed cost

Out of pocket costs are those cash payments or cash transfers that are made for outsiders. These
costs involve both recurring or non¬recurring expenses. Material costs, hired labour cost and
interest on borrowed capital are e4xamples of out –of pocket costs. All the explicit costs, such as
wages, rent, interest, transport expenditure, and salaries, are out of pocket costs.

Imputed cost is otherwise called Notional Cost and Hypothetical Cost. It refers to assumed costs
or hypothetical costs. It includes the assumed costs of using owned resources for the business
carried on by the farm owner himself. Assumed interest of owned capital, assumed remuneration
for owner’s service or family labour is some typical example of imputed costs.

C. Opportunity cost and actual cost:

Opportunity refers to the value of benefits of a foregone next best alternative. Opportunity cost is
an economics term that refers to the value of what you have to give up in order to choose something
else. The opportunity cost of family labour is the amount of wages the farmer have sacrificed for
not selling out his own labour to others

Actual cost (real cost): Are those which are actually incurred by the firm in payment for labor,
material, plant, building, machinery, equipment ,etc.

Cost concepts used in estimation of cost of cultivation are as follows:

Cost A1 – It includes all actual expenses in cash and kind in production by the owner farmer given
below:

Value of hired human labour

Value of hired bullock labour

Value of machine labour, owned and hired

Value of owned bullock labour

Value of owned machinery

Value of hired machinery

Value of seed (a) farm produced & (b) purchased

Value of insecticides and pesticides

Value of manure (owned and purchased)

Value of fertilizers

Depreciation of implements and machinery

Irrigation charges

Land revenue

Interest on working capital

Misc. expenses (artisans etc.)

Cost A2: Cost A1 + rent paid for leased-in land.

Cost B: Cost A2 + Imputed rental value of owned land (net of land revenue) +interest on
owned fixed capital excluding land.

Cost C: Cost B + imputed value of family labour.

Cost concepts used by CACP (Commosssion for Agricultural Costs and Prices)

Cost A1 – includes all the items mentioned above

Cost A2 = Cost A1 + Rent Paid for leased in-land

Cost B1 = Cost A1 + Interest on value of owned fixed capital assets (excluding land)
 Cost B2 = Cost B1 + Rental value of owned land (net of land revenue) and rent paid for
leased-in land

Cost C1 = Cost B1 + imputed value of family labour

Cost C2 = Cost B2 + Imputed value of family labour

Cost C2* = Cost C2 + Additional value of human labour based on use of higher wage rate
in consideration of statutory minimum wage rate. (This is an intermediate concept).

Viii. Cost C3 = Cost C2* + 10 percent of cost C2* to account for managerial input of the farmer

Imputation procedures and guidelines to be followed while estimating the cost of cultivation of
crops:

Casual labours: Actual cash wages or kind wages and perquisites are to be imputed,
considering the ruling prices in the village at the time of operations.

Attached servants: The per day wage rate is to be arrived at, based ontotal wages
(cash+kind +perquisites) paid and the number of days.

Bullock labour: Actual charges paid are considered. In case of owned bullock labour—per
work day or per work hour cost of maintenance is to be taken into account.

Owned manures, seeds others are to be imputed at the prices prevailing in the village at the
time of their use.

Interest on working capital: Interest on entire cash costs are to be charged at the prevailing
bank rank rate for loan for half of the crop period for owned capital. Actual interest charges are to
be considered for borrowed capital.

Depreciation on fixed assets (other than the value of land)such as farm implements, farm
building, irrigation structures, work cattle, pump sets, are to be calculated following straight line
method.

Rental value of owned land : Prevailing rent for leased-in land or 30 % of the output (main
product + by product) is to be considered as rental value of owned land.

Family labour: Imputed value of family labour is to be charged as per the prevailing wages
in the villages for same operation.

Interest of owned fixed capital: It is to be charged at the baking rate of interest.

Rates of return over different cost concepts:

a. Gross farm income: Summation of income from selling of total output and by product
b. Farm business income = Gross income – Cost A1

c. Family labour income = Gross income - Cost B

d. Net income = Gross income - Cost C

e. Farm investment income = Farm business income - Wages of family labour.