. A farmer decides to stop growing crop A and instead use the land to grow crop B.

The amount
of potential profit lost by not growing crop A represents the farmer's:

A. opportunity costs.
B. variable costs.
C. marginal costs.

D.fixed costs

CHAPTER I: - INTRODUCTION TO FARM MANAGEMENT

Introduction
1.1 Definitions and Some Concepts of Farm Management
Farm management comprises two words: Farm and Management. Literally farm means a piece
of land where crops and livestock enterprises are taken up under a common management and
specific boundaries.
A) Farm

Farm is defined as:

A land devoted to agriculture to rare animals and grows plants by the farm owner.

The land where crop and livestock enterprises are taken up under the farmer/ farm family control

A productive unit specialized in converting resources or inputs in to agricultural products.

In general farm is a socio-economic unit to earn an income and a productive resource under
farmer's control.

B) Management:

Is concerned with meeting of goal and also the act or art of managing each activity

Is making use of available resource or allocating scarce resource in efficient manner.

Is a process which directs action in to some goals through planning, organizing, leading and
controlling of resources (financial and human resources).

Is making a decision to increase net return or profit

In a broader sense “Management is viewed as those activities relating to the organization and
operation of a firm for the attainment of specific ends.

1
Management responsibilities include: •What to produce (type of product), How much to
produce (amount of production) ,When to produce (time of production ) and How to produce or
(techniques production).

Functions of Management, Planning, Organizing, Leading and Controlling (PLOC)

Planning means defining goals and objectives, deciding the type of activities, determining the
resources needed to achieve goals and objectives.

Leading means attracting people to the organization, specifying job responsibilities, grouping
jobs into work units, allocation of resources and creating good working conditions

Organizing means the way of directing, motivating, communication with employees,

individually and in groups and conflict resolution.

Controlling means monitoring performance of people and units, provision of feedback or

information about progress, identification of performance problems and actions to correct
problems.

Therefore, Farm management is:

A decision making process whereby limited resources are allocated in to a number of production
units alternatively to attain some objectives.

Farm management is a decision-making science. It helps to decide about the basic course of
action of the farming business. The basic decisions of the farming business are:

(a) What to produce or what combination of different enterprises to follow?

(b) How much to produce and what is the most profitable level of production?
(c) What should be the size of an individual enterprise, which, in turn, will determine the best
overall size of the farm business?
(d) What methods of production (production practices or what type of quality of inputs and their
combination) should be used?
(e) What and where to market?
Definition of farm management explained by different authors in different ways:
➢ Farm management is concerned with how can the individual farmer organize the factors
of production land, labor, and capital on his farm, so adapt practice to his particular
environment and so dispose of his product, as to yield him the target net return while still
maintaining the integrity of the land and equipment (Butter field, 1910).

2
 ➢ Farm management is the subdivision of economics which considers the allocation of
limited resources with the individual farm. It is a science of choice and decision making
(heady and Jensen, 1954).
➢ Farm management can be thought of as being a decision making process. It is a
continuous process. The decisions are concerned with allocating the limited resources of
land, labor and capital among alternative and competing uses. This allocation process
forces the manager to identify goals to guide and direct the decision making (Kay and
Edwards, 1994).

In simple words, farm management can be defined as a science which deals with judicious
decisions on the use of scarce farm resources, having alternative uses to obtain the maximum
output and profit

What are Productive resources? Resources are inputs which are used for further production.
These are also known as factors of production. These are basically,

❖ Land ,labor, capital, management and technology and marketing/ demand

1). Land: refers to all natural resources that can be used as inputs for production such as
minerals, water, air, forests, oil and even such intangibles as rainfall, temperature, and soil
quality. The key distinction between lands consists of natural resources or conditions improved
by labor or capital expenditure. In short, land is the short hand extension for natural resources.
The payment to land is called rent.

2) Labor – is the physical and intellectual exertion of human beings in the production process. It
embraces a wide variety of skills in specialized trades and occupations, and abilities of
organization and management that are crucial in the productive process. It is clear that some
labor is valued (paid) more than other labor. This is because labor, like land, can be much more
valuable. This occurs when individuals devote money and time to increasing their labor skills.
We refer to this development of labor skills as investment in human capital- the accumulation of
labor enhancing abilities, including health that increases labor’s productivity.

Wages are the resource payments that entrepreneurs make for the use of labor.

3
3) Capital- refers to all man-made aids (past human efforts) to production, the tools and
production factors, warehouses, stocks of inventories, etc. The term is, however, used in a
number of ways. Capital in its economic definition is the machinery; the tangible equipment that
used to produce other capital can purchase or rented. The payment to capital is called interest.

4) Management/Entrepreneur:

 it is the major and last component of factor of production

 describes the task of making decision and implement these decisions
 It is mental /soft ware energy of human being used in production to organize, lead, direct
and take risk and bear responsibility. Its reward is profit.
Some Preliminary Concepts
Farm: A farm is the smallest unit of agriculture which may consist of one or more plots
cultivated by one farmer or group of farmers in common for raising crop and livestock
enterprise. It is both a producing unit as well as a consuming unit.
Family farm: A family holding (farm) may be defined briefly as being equivalent, according to
the local conditions and under the existing conditions to technique, either to a plough unit or to a
work unit for a family of average size.
Agriculture: The sum total of the practices of crop production and livestock rising on individual
farms is called agriculture. Hence, the agricultural production of country is the sum of
contributions of the individual farm units, and the development of agriculture means the sum of
developments of millions of farm units. Hence it is the macro-economic approach that considers
agriculture as a unit.
Farm Firm: The farm is a firm because production is organized for profit maximization.
Hence, it is a business unit of control over factors of production. On the other hand, it is a
household unit demanding maximum satisfaction of the farm family. The manager of the farm
comes to understand the twin objectives by linking one with the other.
Synonyms
Factors of production, resources and inputs are synonyms.
Farm and farm holding are synonyms.
Factor-product relationship, input-output relationship, and input (say, fertilizer) response are
synonyms.

4
Stock and flow inputs- Stock inputs are resources which are consumed during the production
period, like seeds, fertilizers, pesticides and the like. They can be stored, if not used currently, for
future use. As against this, flow inputs like labor and management, if not used, cannot be stored
for the next season.
Fixed resources: Level of some resources fixed over a production-planning period irrespective
of the level of enterprises taken up. These are called fixed farm resources, E.g. Land, building,
machineries, etc. The quantum of fixed resources does not change with the level of production.
Some of the resources, which are fixed during a short period, may become variable during a long
term.
Variable resources: Some resources like seed, fertilizer, labour, etc vary with the level of
output. These are variable resources.
Production: It is a process of transformation of resources or inputs like labour, seed, fertilizer;
water, etc. into products like paddy, wheat etc
1.2 Importance of farm management
• Farm management investigations give thrust and direction to farm business improvement
by providing useful information to planners, farmers and extension workers. Better
understanding of the sequential flow of new technology is provided by farm management
research that contributes to more realistic projection of production potential. Again, basic
information provided by farm management studies on specific farm projects, such as land
reclamation, settlement, irrigation and drainage, serves as an aid to formulating national
policies.
• In the context of socio-economic changes that are likely to occur as the wheels of
economy of developing countries move to the closing years of the present century, there
is likelihood of the emergency of awe-inspiring problems of population explosion and
scarcity of resources. But farm management has an inherent capacity of developing
strategic approaches to making the best use of scarce resources and, as such, can view the
threats and problems that lie ahead as veiled opportunities for showing its potential as one
of the nation’s saviors. Hence, there is bound to be far greater awareness and
understanding of the role of farm management in the nation’s economy.

5
Why study farm management?
 The main aim of farm management is to help in realization of the maximum net profit
from the various enterprises on a farm. A typical farm is a combination of two or more
enterprises and the chief aim of the farm manager would be to get the whole unit give the
maximum total returns. It is not the return from anyone enterprise that determines the
financial success of a farm, but it is the total return from all enterprises that counts its
success or failure. A proper understanding of farm management principle helps in
selection, combination and execution of enterprises, which are consistent to a sound
agricultural policy. The management study is undertaken: A farm manager must not only
understand different methods of agricultural production, but also he must be concerned
with their costs and returns. He must know how to allocate scarce productive resources
on the farm business to meet his goals and at the same time react to economic forces that
arise from both within and outside the farm.

✓ To study the input-output relationship in agriculture and determine the relative

efficiency of various factor combination.
✓ To determine the most the profitable crop production and livestock raising methods.
✓ To study the cost per hectare and per quintal or per kg and to evaluate the farm resource
and land use.
✓ To study the comparative economics of different enterprises.
✓ To determine the relation of size of farm to land utilisation, cropping pattern, capital
investment and labour employment.
✓ To study the impact of technical 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 is to help in realization of the maximum profit from the various
enterprises on a farm
✓ To find out ways and means for increasing the efficiency of farm business
✓ Farm labor and equipment are utilized more efficiently.
✓ It provides twin objectives, viz., and maximization of farm profit and improvement of
standard of living of their families.
✓ IT provide appropriate decisions at appropriate time for farmer

6
 Why do some farm businesses grow and expand, while others struggle to maintain their size?
Why the farm is difference each other? Usually this is due to the Management. Observation and
analysis often had the same conclusion. The differences due to management can be shown in
three main areas;

1. Production differences; includes choice of agricultural commodities to be produced and how

they are produced.

2. Marketing differences (includes)

When, where, and how of purchasing inputs and selling commodities (prices differences)
3. Financing covers not only borrowing money and related questions of when, where and how
much, but also the entire area of how to acquire the resources necessary to produce agricultural
commodities.
The risks have to be considered in all the three areas – i.e. how a farm manager adapt to and
handle the risks can have a major impact on profit.

In every association or system, management is the key ingredient. The manager makes or breaks
the business. In agriculture, management takes a different dimension especially with uses of
many technological innovations, and mechanisation.

1.3 Objectives and Scope of Farm Management

1.3.1 Objectives of Farm Management
Looking at the farm structure as a whole, it is apparent that the objective of farm management
are those that have to do with the two aspects of the same farm as a producing unit and as a
consuming unit along with the harmonization of their behavior and goals.
Broadly speaking the objectives of farm management are:
❖ To study the existing resources - land, labor, capital and management - and the
production pattern on the farm.
❖ To perform the strategic task of finding out the deviation of the resources from their
optimum utilization.
❖ To explain the means and the procedure of moving from the existing combination of
resources to their optimum use for profit maximization.

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 ❖ To outline conditions that would simultaneously obtain its objectives of profit
maximization and maximization of family satisfaction through optimum use of resources
and judicious income distribution.
❖ To work out costs and returns on individual enterprises and on the farm as a whole.
1.3.2 Scope of Farm management
Farm management is generally considered to fall in the field of micro-economics. That means, in
a way concerned with the problems of resource allocation in the agricultural sector and even the
economy as a whole, the primary concern of farm management is the farm as a unit. It deals with
the allocation of resources at the level of an individual farm.
It covers the whole aspects of individual farm business which have bearing on the economic
efficiency of the farm. These include
❖ The types of enterprises to be combined/enterprise relationships
❖ The kinds of livestock, crops and varieties to be grown/choice of input-output
combinations
❖ The dosage of fertilizer to be applied and the implements to be used
❖ The way the farm functions are to be performed
❖ Investment decisions and appraisal of farm resources
❖ Farm planning and budgeting and farm prices, credit and profits
❖ Risk and uncertainty and planning the marketing of farm produce
All the above aspects of farm business, which fall within the purview of the subject of farm
management, are so interlinked and drawn together that systematic study of all of them is
required to understand the business of farms within the circle of scarcity and choice.
The subject of farm management includes:
Farm management research – solution of economic problems faced by the farmer is greatly
facilitated through recording of data related to the farm. And these data have to be analyzed with
a view to identify causes of inefficient functioning of the farm.
Farm management extension- once the results of a study are known, they are to be made
available to the farmers. The farmers also have to be educated and trained in the application or
adoption of these results.
Farm management teaching – training in farm management science is essential for agricultural
graduates to understand farmers’ response to varying economic pressures and stimuli. It also help

8
the farmers to take the right decisions as to what to grow, how much to grow, how to grow and
where to sell and buy.
Research, training and extension together thus seek improving the ability of the farmers to
introduce desirable changes in the utilization of scarce resources at the farm with a view to
increase incomes and improve standards of living of the farmers.
1.4 Nature and Characteristics of Farm Management Science
Farm Management is basically both an applied and pure science.
• It is a pure science because it deals with the collection, analysis and explanation of
factors and the discovery of principles (theory).
• It is an applied science because the ascertainments and solutions of farm management
problems (technology) are within its scope. Farm management science has the following
distinguishing characteristics from other fields of agricultural sciences.
1. Practical science: It is a practical science, because while dealing with the factors of other
physical and biological sciences, it aims at testing the applicability of those facts and findings
and showing how to put these results to use on a given farm situations. A farmer has to select a
method which is more practicable and economical to his particular farm situation taking in to
consideration the volume of work and financial implications.
2. Profitability oriented: Farm management alone is interested in profitability. Biological fields
such as agronomy and plant breeding concern themselves with distaining the maximum yield per
unit irrespective of the profitability of inputs used. But the farm management specialist always
considers the costs involved in producing each unit of output in relation to returns, and decides
optimum level of production. He has to consider all relevant factors such as financial
implications, transpirations, storage facilities and costs.
Profitability is the major criterion in the decision making process/adoption of a new technology
of farming practice. Farm management is interested in optimum results/yields which may not
necessarily coincide with the maximum production point. In brief, when other sciences deal with
physical efficiency, farm management concerns with economic efficiency.
3. Integrating science or interdisciplinary science: The facts and findings of other sciences are
coordinated for the solution of various problems of individual farmers with the view to achieving
desired goals. It involves different disciplines to decision making. It considers the findings of

9
other sciences in reaching its own conclusions. Principles of farm management integrate results
thrown out by physical sciences under specific set of conditions.
4. Broader field: It uses more than one discipline to make decisions. It gathers knowledge from
many other sciences for making decision and farm management specialists have to know the
broad principles of all other concerned sciences in addition to specialization in the business
principles of farm management.
5. Micro-approach: In farm management, every farm unit is considered as unique in terms of
available resources, problems and potentialities. It recognizes that no two farms are exactly
identical with respect to soil, other production resources, farmers’ managerial ability, etc.
Each farm unit has to be, therefore, studied, guided or planned individually.
6. Farm unit as a whole: In farm management analysis, a farm as a whole is considered to be
the unit for making decisions because the objective is to maximize the returns from the whole
farm instead of only improving the returns from a particular enterprise or practice. Farm
management considers all possible aspects of crop and livestock enterprises of a given farm.
The principles of farm management, thus, help to get the optimum enterprise mix that would
yield the highest income to the farmer from the total farm organization.
1.5 Basic Farm Management Decisions
As indicated before, Farm management is concerned with the allocation of limited resources
among a number of alternative uses which requires a manager to make decisions.
A manager, first, must consider the resources available for attaining goals which have been set.
Limits are placed on goal attainment because most managers are faced with a limited amount of
resources.
In a farm business, goal attainment is confined within some limits set by the amount of land,
labor and capital available. These resources may change overtime, but they are never available in
infinite amounts. The level of management skill available or the expertise of the manager may be
another limiting resource. If the limited resources could only be used one way to produce one
agricultural product, the manager’s job would be much easier. The usual situation allows the
limited resources to be used in several different ways to produce each of a number of different
products. In this case, the manager may be faced with a number of alternative uses of the limited
resources and must make decisions on how to allocate them among the alternatives to maximize
profit from the total business. This is one of the reasons why decision making is mentioned in the

10
definition of farm management. Without decision nothing would happen. Even allowing things
to continue as they are implies a decision, perhaps not a good decision but a passive decision
nevertheless.
The process of making a decision can be formalized into a logical and orderly series of steps.
Important steps in farm decision making process are:
1. Identifying and defining the problem
2. Collecting relevant data, facts and information
3. Identifying and analyzing alternative solutions
4. Making the decision – selecting the best alternative
5. Implementing the decision
6. Observing the results and bearing responsibility of the outcomes
Following these steps will not ensure a perfect decision. It will, however, ensure that the decision
is made in a logical and organized manner.
1. Identify and define the problem: A manager must constantly be on the alert to identify
problems and to identify them as quickly as possible. Most problems will not go away by
themselves and represent an opportunity to increase the profitability of the business through wise
decision making. Once identified, the problem should be concisely confined. Good problem
definition will minimize the time required to complete the remainder of the decision making
steps.
2. Collecting relevant data and information: Once a problem has been identified, the next step
should be to gather data, information and facts, and to make observations which pertain to the
specific problem.
3. Identifying and analyzing alternatives: Once the relevant information is available, the
manager can begin listing alternatives which are potential solutions to the problem. Several may
become apparent during the process of collecting data (unorganized collection of facts and
numbers obtained from various sources) and transforming data into information (final product
obtained from analyzing data in such a way that useful conclusions and results are obtained).
Each alternative should be analyzed in a logical and organized manner to ensure accuracy and to
prevent something from being overlooked.
4. Making decision: Choosing the best solution to a problem is not always easy, nor is the best
solution always obvious. Sometimes the best solution is to do nothing or to go back, redefine the

11
problem and go through the decision-making steps again. These are legitimate decisions, but
they should not be used as a way to avoid making a decision when a promising alternative is
available. After all the pros and cons of each alternative are weighed, one may not appear to be
definitely better than any other. The one showing the greatest increase in expected profit would
normally be selected. Uncertainty and risks should be considered if several alternatives have
nearly the same potential effect on profit.
5. Implementing decision: Selecting the best alternative will not give the desired results unless
the decision is correctly and promptly implemented. Resources may need to be acquired and
organized. This requires some physical actions to be taken.

Classifying decision: Decision made by farm manager can be classified in a number of ways.
One way of classification system may be to consider decisions as.
Organizational decisions are those in the general areas of developing plans for the business,
acquiring the necessary resources and implementing the overall plan. Some of such decisions
include;
❖ Decisions regarding selection of the best size of the farm
❖ What scale should be the farm operation
❖ Decisions regarding
• How much land to purchase or lease
• How much capital to borrow
• The level of mechanization and
• Construction of buildings and irrigation facilities, etc.
Therefore, Organizational decisions are related to planning and organization of the farm that
tend to be long run decisions which gives shape to the overall organization of the farm and are
not modified or reevaluated more than once a year. Compared to operational decisions,
organizational decisions require heavy investment and have long lasting effect.
Operational decisions are made more frequently than the organizational decisions and relate to
the many details made on a daily, weekly or monthly basis and are repeated more often than the
organizational decisions as they follow the routines and cycles of agricultural production.
Operational decisions are frequent which involve relatively lower investment and their effect is
short lived. Some of such decisions include:

12
 • Selecting fertilizer and seeding rates for a given field and year
• Making changes in livestock feed ration
• Selecting planting and harvesting dates
• Marketing decisions and daily work schedules
• What to produce (selection of enterprises)
• How much to produce (enterprise mix and production process)
• How to produce( selection of least cost method)
• When to produce (timing of production)
Farm Management decisions are not only classified as organizational and operational decisions
but there are also other ways.

Decisions can have a number of characteristics, which provide another classification system.
These include;
✓ Importance Frequency
✓ Imminence Revocability and
✓ Number of alternatives available
Importance: Given the many decisions made by a farm manager, some will be more important
than others. Importance can be measured in several ways, but the most common would be in
terms of the amount of birr involved in the decision or the size of the potential gain or loss.
Decisions involving a few birr might be made routinely, with little time spent gathering data and
processing through the steps in the decision-making process. Decisions involving a large amount
of capital and potential profit or loss need to be analyzed carefully.
They can easily justify more time spent on gathering data and analyzing possible alternatives.
Frequency: Some decisions may be made only once in a life time, for example, the decision to
choose farming as a vocation. Other decisions must be made almost daily, for example, livestock
feeding times, milking times and the amount of feed to be fed each day.
Imminence: A manager is often faced with making some decisions before a certain deadline or
very quickly to avoid a potential loss. But sometimes decisions to be made may have no
deadline, and there may be little or no penalty for delaying the decision until more information is
obtained and more time spent analyzing the alternatives.

13
Revocability: Some decisions can be easily reversed or changed if observation indicates the first
decision was not correct. An example would be a livestock feed ration, which could be changed
rather quickly and easily as long as the change was not so abrupt as to upset the livestock. Other
decisions may not be reversible or can be changed only at a very high cost.
Examples would be decision to dig a new irrigation well or to construct a new building. Once the
decision is made to go ahead with these projects, the choice is either to use them or abandon
them. It may be very difficult or impossible to recover the money invested.
Availability of alternatives: Some decisions have only two possible alternatives. They are of the
yes or no and buy or not buy type. The manager may find these decisions easier and less time
consuming than the others which have a large number of alternative solutions or courses of
action. Where a large number of alternatives exist, the manager may be forced to spend
considerable time identifying the alternatives and analyzing each one.
Farm business decisions: These include the following:
Production and organization problem decisions (Strategic decisions)
These decisions involve heavy investment and have long lasting effect. These include decisions
on,
✓ Size of the farm
✓ Machinery and livestock program
✓ Construction of buildings
✓ Reclamation programs
Administrative problem decisions
These decisions involve financing the farm business. These are,
❖ optimum utilization of funds
❖ acquisition of funds- proper agency and time
❖ supervision of work
❖ accounting and bookkeeping
Marketing problem decisions
These include decisions on:
➢ Buying decision: such as what, when, from whom and how to buy,
➢ Selling decision: such as what, when, where, and how to sell.

14
 ➢ Factors Influencing Farm Management Decisions: Farm management decisions
continuously undergo change overtime because of the changing environment around the
farm, farmer and his family. The factors which influence the decision making process
are:
Economic factors like prices of factors and products.
b) Biological characteristics of plants and animals.
c) Technological factors like technological advancements in the field of agriculture and
suitability of different varieties and farm practices to varied agro - climatic conditions.
d) Institutional factors like availability of infrastructural facilities which include storage,
processing, grading, transport, marketing of inputs and outputs, etc, government policies
on farm practices, input subsides, taxes, export and import, marketing, procurement of
produces and so on.
e) Personal factors like customs, attitude, awareness, personal capabilities and so on
1.6 Some Farm Management Problems under Ethiopian condition
1. Small size of farm business

In Ethiopia:

 80- 90% of labor force engaged in agricultural sector

 Agriculture has about 0
 32% contribution to GDP
 Agricultural sector also covers 90% of export earning
 Average land holding size 0.75ha and fragmented, difficult to manage or prepare farm
plan
 High family size
 High dependency ratio
 less application of - intensive farming ,Technology ,double cropping
But in developed countries:

 3-4% of labor force engaged in agricultural sector

 industrial sector contributes more to GDP
 main export earning is industrial sector
2. Farm as a house hold:

 Work habits of the farmers are closely related to food intake, sanitation and living
condition as a whole
 Use of similar farming system

15
  Less application of specialization and diversification principles
 Subsistence farming, not promoting commercial farming
3. Inadequate capital: farmers do not have enough capital. On top of this, lack of availability of
credit at required time, amount and need of collateral also other problem to farmers. Due to this
farmers use less of modern technologies like;

o fertilizer, improved seed

o Different farm implements (water harvesting technologies, motor pumps etc.
o irrigation technologies
4. under employment: it means that farm family seems to be employed but not fully employed
due to:

▪ Small size of the farm

▪ Large family labor supply
▪ Seasonal nature of agricultural production
▪ Lack of subsidizing or supporting industries
▪ Lack of off-farm employment activities like petty trade,
This condition creates:

▪ Economic frustration
▪ Social tension
▪ Laziness/idleness
This in turn also reduces efficiency and productivity of rural farm.

5. Slow adoption of innovation: low income farmers are usually conservative and most time
skeptical to adopt the technology easily. This is due to risk aversion. There are farmers who
prefer risk and there are also farmers who prefer averse.

Risk preference: a person who wants to take a risk and maximize profit.

Risk averse: a person who does not want to take risk and wants to get a usual profit.

6. Inadequate supplies of inputs: farmers face problems, in getting improved technologies, at

required time, quantity, place and reasonable price.

7. Lack of managerial skill:

• the problem of solving economic problems

 managers are scarce

16
  illiteracy of farmers
 farmers wants to produce as usual
8. Lack of infrastructure

 lack of transportation facilities to transport the products

 Lack of price information about input/out put
 Lack of communication facilities etc.
1.7. Characteristics of Farming as a Business
Farming as a business has many distinguishing features from most other industries in its
management methods and practices.
The major differences between farming & other industries are:
1. Primary forces of production: Agriculture is primarily biological in nature. A slight
change in the environment may cause serious difficulties. One day of cold, for example,
may destroy the whole of a standing crop. Unforeseen changes in the environment such
as plant or animal diseases and storm can cause a considerable damage. Most of the other
industries are less likely to be affected by such circumstances.
2. Size of the production unit: Farming is a small- sized business as it gives little scope
for division of labor. In this business the farmer is both the laborer and the capitalist.
3. Heavy dependence upon climatic factors: Weather changes may involve
readjustments. As a result of dependence on climatic factors, management practices in
farming must be much more flexible than in other industries.
4. Frequency and speed of decisions: Farming requires many and speedy decisions on
the part of the farmer and the farm workers.
5. Changes in prices: Agricultural prices and production usually move in opposite
directions. Because of the effects of climate and biological factors, a relatively large
volume of production of a given farm commodity is usually followed by a decrease in
price, and a smaller volume results in increase in prices.
6. Fixed and variable costs: Of the total costs, portion of fixed costs is more in
agriculture than in other industries. This high proportion of fixed costs tends to make the
adjustments in production more difficult.

17
 7. Inelastic demand for farm products: Agriculture deals with production of food &
raw materials. As standard of living improve and income increases, the demand for
agricultural products will increase less rapidly than that for industrial products. On the
one hand, if increased production comes from the decreased marginal returns phase, costs
will go high. Higher production may reduce prices so low that total returns might not
increase or even may decrease.
8. Perishable and bulky nature of agricultural commodities cause storage, processing
and transportation problems.

CHAPTER TWO: -PRODUCTION RELATIONSHIPS

Introduction
Production is the transformation of natural and human made resources (inputs) into commodities
(or outputs). For example, when we get wheat on a plot of land with the help of inputs like labor,
fertilizer, capital and seeds, it is termed as production of wheat. Similarly, when, in a cloth mill,
inputs like labor, capital and threads are transformed into cloth, it is called production of cloth.
Generally production is the process of changing inputs to outputs.
Input production output= Theory of production

Factors Affecting Production

1. Technology: A firm’s production behavior is fundamentally determined by the state of

technology.

2. Inputs: Inputs are economic resources that can be used in the production of goods and services.

All inputs used in production are broadly classified into four categories: land, labour, capital and
entrepreneurship

The inputs can also be divided into two main groups

18
1. Fixed inputs: is the one whose quantity cannot be varied during the period under
consideration. A fixed input is one whose quantity cannot be varied during the period under
consideration. Ex. Equipment, machine tools and buildings.

2. Variable inputs: are inputs whose quantity can be changed during the period under
consideration. An input whose quantity can be changed during the period under consideration is
known as a variable input. Ex, raw material, labor, power, transportation etc.

3 . Other natural factor affects production like weather condition

Economists classify production period in two categories:

Production period: It is the time period required for the transformation of resources or inputs into
products. These can be;

1.Short-Run: Short-run refers to the period of time over which the amount of some inputs,
called the ‘fixed inputs’, cannot be changed . For example, the amount of plant and equipment,
etc., is fixed in the short-run. This implies that an increase in output in the short-run can be
brought about by increasing those inputs that can be varied, known as ‘ variable inputs’. For
example, if a producer wishes to increase output in the short-run, she/he can do so by using more
of variable factors like labour and raw material.

2. Long-Run: Long-run is defined as the time period during which all factors of production can
be varied. A firm can install a new plant or raise a new factory building. Long-run is the period
during which the size of the plant can be changed. Thus, all the factors are variable in the long-
run.

It may be noted that the distinction between the short-run and the long-run does not correspond
to a specific calendar period, such as a month or a year. It is rather based on the possibility of
input adjustments.

2.1 Production Function

Production function shows the physical and mathematical relationship between factor inputs and
output.

19
It describes the amount of output expected from different combination of input usage. It also
describes the manner and extent to which a particular product depends upon the quantities of
input, or services of inputs, used at a given level of technology and in a given period of time.
A production function reflects the best technology available for a given level of output in the
production process.
The production function expresses a functional relationship between quantities of inputs and
outputs. It shows how and to what extent, output changes with variations in inputs during a
specified period of time.

Uses of Production Function

Production function enables us to derive how national product is produced from the various
resources. Production function expresses the relationship between national product and the
available resources used in producing it.
Production function is also used to assess inter-regional or international trade balances.
Coefficient is used in the interregional and international trade to apportion goods to various
countries. The coefficients derived from the production function serve as the base for
determining optimum patterns of intra-state, inter-state, inter-regional and international trade.
Production function is equally useful in the allocation of total output or national income. In other
words production function is a useful tool in the marginal production theory of distribution. d)
Production function served as a useful tool in the maximization of profit of a farm.
It show the of point maximum output and input relationships , the point of economic optimum
and the quantity of resources to use in producing a given maximum either physical or economic
maximum.

The production function is written mathematically as:

Y = f (X1, X2, X3 … Xn) , where x1 , x2 , x3 , ....., xn are different inputs and Q is amount of
output.
Suppose a firm uses labor (L) and capital (K) to produce a given level of output. And let A and B
are two different combinations of factor inputs:
A B
Labor(L) 5 4

20
 4 4
Capital(K)

Both A and B use the same quantity of capital but A uses more labor than B. Then, input
combination A will not be represented on the production function. Only methods that use the
fewest inputs would be captured by the production function.
Production function can also be described as a technical and mathematical relationship
describing the manner and extent to which a particular product depends upon the quantities of
inputs and service of inputs used. That level of output of a particular commodity depends upon
the quantities of inputs used for its production. This relation between inputs and outputs can be
characterized as a production function or simply production function can be defined as the
relationship between physical inputs and physical output of a farm firm.
The following mathematical equations can present different forms of production functions.
a) Production functions involving one variable input
Y = f (X1/X2, X3 … Xn)
Fitting the function - the procedure followed in calculating the constants in production function
is known as fitting the function.
The letter f stands for the phrase functions of.
The vertical bar (/) is used for separating the variable inputs from the fixed inputs. The inputs to
the left of the vertical bar are variable inputs where as those to the right of the bar are fixed
inputs.
Y- denotes output per unit of time and X1, X2 ... Xn are different inputs of time.
The equation denotes that the output Y depends on or 'determined by' or 'related to' or is the
'function of ' inputs (s) used. Function is a causal process, where as formula is a relationship
giving one algebraic number in terms of other algebraic number and/or arithmetic number (s).
For example: Y = P (1+r/100)
b) Production function involving two variables inputs
Y=f (X1, X2/X3, X4 ... Xn)
The equation says the output Y depends jointly upon the inputs X1 and X2 when other inputs to
the right of the vertical bar are held constant.
c) Production function involving all the variable inputs

21
Y= f (X1, X2, X3, Xn)
The equation says the output Y depends upon the variable inputs X1 to Xn.
The production function is generally written in the form of equation:

Y= f (X1, X2, X3, -----------, Xn)

To be specific the production function can be expressed in terms of:

 Tabular form
 A graph
 An equation/ algebraic
• Assumptions of production function
• It is always related to a specified period of time
• Technical knowledge is assumed to be constant
• The firm in question will use the best and the most efficient technique available
• The factors of production are divisible into invariable units
Types of Production Functions
Several types of production functions used in agriculture are as follows:
1. Linear Production Function: Also known as first degree polynomial. It’s algebraic form is
given by Y= a0+ bx where a0 is the intercept and b is the slope of the function. It is not
commonly used in research because it violates the basic assumptions of characteristic functional
analysis.
2. Quadratic PF: Also known as second degree polynomial. This type of PF allows both
declining & negative marginal productivity thus embracing the second and third stage of
production simultaneously. Y= b0+b x1+ b x22 where b0, b1, & b2, are the parameters. Such
PFs are quite common in fertilizer response studies.
3. Cobb-Douglas PF: It is also known as power production function. It is most widely used PF. It
accounts for only our stage of production at a time & cannot represent constant, increasing or
decreasing marginal productivity simultaneously. Y = Y = b0x1b1 where b0 is efficiency
parameters & b1 is elasticity of production.
4. Translog PF
4. Constant elasticity of substitution (CES) function … etc
2.1.1 Types of Production Function based on input measurement

22
Production function is of two types Continuous Function and Discontinuous or Discrete
Function
1. Continuous production function: It can be explained by response of yield to fertilizer or
seeds where the doses or levels of inputs can be split into small units. Fertilizer can be applied to
a hectare of land in quantities ranging from a fraction of a kilogram up to hundreds of kilograms.
Labor is also quite divisible in terms of hour. Tractor can be also divisible in terms of tractor
hour not as an input tractor.
2. Discontinuous or Discrete Function: Such functions are obtained for input factors or work
units that are used or done in whole number such as one plunging or a number of plunging. In
discrete functions, the alternative decision points get limited otherwise same method of analysis
is followed in both continuous and discrete production functions.
The difference between discrete data and continuous data is, thus, in the divisibility of the inputs
or outputs. An example of a discrete input is a cow.
2.2. Types of production relationships
There are numerous relationships between the resources and farm products, both simple and
complex. The major production relationships fall under three categories;

1. Factor –product relationships or input-output relationship-production function: this

relationship is concerned with resource allocation to optimum production.

2. Factor-factor or input –input relationship or input combination: this relationship is concerned

with minimizing cost at a given level of output.

3. product-product relationship or output- output relationship or enterprise combinations: this

relationship is concerned with optimum combination of out puts for a given input level.

1. Input-Output Combination/ Factor –product relationships

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. This relationship is concerned with resource allocation to optimum production. In this
case, a choice indicator is used as a criterion for finding out which of the many alternatives is
optimum. The choice indicator can be a price ratio, a substitution ratio, or a consumer
preference. It is a measuring rod that brings physical data into the realm of economics in respect

23
of resource allocation to optimize input-output or factor-product relationships is important. In
this process, first it is essential to study the physical or technical relationship and then for the
purpose of decision making, application of economic choice indicators such as price ratio can be
utilized. Further questions such as, how much fertilizer to be applied per acre? how much
irrigation to be given? and so on are all within the scope of factor – product relationship

Many times resources or capacities of technical units, such as hectare of land, or a cow, are fixed
and a choice is to vary the input of only one factor, such as fertilizer, labor or feed.
Fertilizer application to a hectare of land, feed to a dairy cow, for example, be varied, while other
inputs such as fixed capital, buildings, implements, and technical know-how remain the same.
Under such a situation pertinent questions would be: how much fertilizer to apply?
How much feed to be given to a cow? Such situation can be explained through single factor
single product relationships. It is also known as single variable production functions.

There can be three types of input-output relationships in producing a commodity where one input
is varied and the quantities of other inputs are fixed. The nature of relationships between a
single input and a single output can either be of the one or a combination of types given below.
2.2.1. Laws of Production (Returns)
The nature of relationship between a single input and a single output can be either of the one or a
combination of the types given below:
1. Constant marginal rate of returns (constant productivity)
2. Increasing marginal rate of returns (increasing productivity)
3. Decreasing marginal rate of returns (decreasing productivity)
1. Constant Marginal Rate of Returns (The Law of Constant Returns)
In constant returns or linear relationships, each additional unit of the variable input when applied
to the fixed factor (s) produces an equal amount of additional product. The amount of the product
increases by the same magnitude for each additional unit of input. For example, addition or
employment of an additional tractor plus driver will do the same amount of work as a previous
tractor and driver did.
Table 2.2 Constant relationship of fertilizer response function (hypothetical data)

24
 Doses of fertilizer Marginal Total product of Marginal yield Marginal rate of
Kg ( X) dose(∆X) wheat (Y) kg (∆Y) returns ∆Y/∆X

0 1300

10 10 1350 50 50/10= 5

20 10 1400 50 50/10= 5

30 10 1450 50 50/10= 5

40 10 1500 50 50/10= 5

The relationship in the above table shows that with every increase in input there is equal or
constant increase in the level of output. This is known as constant marginal returns function. It
can also be illustrated using graph.
Mathematically, the relationship can be expressed as:

Y1 Y2 Yn

= ..... =
X 1 X 2 X n
The function is a straight line having the same slope throughout its entire range. In specific
production function form, the constant returns production function can be expressed as:
Y = a+ bx
Y = 1300 + 5x
This shows that 1300kg of wheat is produced without applying fertilizer and wheat output (Y)
increase by 5kg for every increases of one kg for fertilizer.
Linear production function does not exist when input per ha or per animal is intensified. Such a
relationship only exists where the initial doses applied per ha or per animal are very small (only
for a small range). Agronomists and soil scientists sometimes make recommendations as if the
production functions were linear, which of course, is never true in real practice. Before making
any recommendation, one should therefore, carefully consider the nature of returns and economic
criterion.
2. Increasing Marginal Returns Function (the Law of Increasing Returns)
In this case every additional or marginal use of input adds more to the total product than the
previous unit, i.e. addition to total product is at an increasing rate. In actual practice the cases of

25
purely increasing returns is rarely available except, again in a very limited range. The
relationship is possible when the fixed resources or factors are in excess capacity and addition of
small units of a variable resource makes more and more efficient use of fixed resource.
Wheat seed marginal dose Total production Marginal Marginal Rate
rate X ∆X of wheat Y production ∆Y ∆Y/∆X

10 1000

15 5 1025 25 25/5 = 5

20 5 1075 50 50/5 = 10

25 5 1150 75 75/5 = 15

30 5 1250 100 100/5 = 20

35 5 1375 125 125/5 = 25

The table above shows that every time 5 units of fertilizer is added, marginal addition to the total
output goes on increasing. This represents a case of increasing marginal returns function.
Mathematically, the relationship can be expressed as:
Y1 Y2 Yn
 ..... 
X 1 X 2 X n
3.Decreasing Marginal Returns Function (The Law of Decreasing Returns)
In this type of function each additional unit of input adds less to the total product than the
previous unit did. For example, if the first input adds 20 units to the total output, while the
second adds 15 units, the third adds 10 units, and soon. Such production relationship exists in
almost every practical situation in agriculture. Responses to fertilizers, insecticide, seeds,
irrigation, etc, all show decreasing returns. A production function of a single variable nature
showing diminishing returns throughout is given in table below.
Table 2.4 Application of fertilizers and output of wheat
Fertilizer input Marginal dose Total wheat Marginal Marginal rate of
(X) (∆X) production. (Y) production change ∆Y/∆X
(∆Y)

0 - 500 - -

26
 10 10 1400 900 900/10 = 90

20 10 2100 700 700/10 = 70

30 10 2600 500 500/10 = 50

40 10 3000 400 400/10 = 40

50 10 3300 300 300/10 = 30

60 10 3500 200 200/10 = 20

The table shows that every time 10 units of fertilizers are added, the marginal addition to the
total output goes on decreasing. The curve as in function is concave to the origin. The
relationship can also be indicated algebraically

Y1 Y2 Yn

 ..... 
X 1 X 2 X n
Since ΔX1 = ΔX2 =..... = Δ X n, ΔY/ΔX goes on decreasing as higher and higher input level is
adopted. This is the law of biological responses and is applicable in almost all practical situations
of agricultural production under varied farm situations. Before taking any decisions however,
one needs to have an understanding of Total Physical Product (TPP), Average Physical Product
(APP) and Marginal Physical Product (MPP) and their relationships and as well Factor - Product
Price Ratio.
The Relationship between Total, Average and Marginal Product
One of the problems that a producer faced in the short-run is that how much of the variable
inputs to employ, given the limit set by the fixed inputs of the firm. This problem can be
understood and analyzed only after we understand the concepts of total, average, and marginal
products. In general, as input level increases, output increases. But it is the rate at which the
output increases that is used to explain the different laws of production.
Given the production function which transforms a set of inputs into output, the technical
relationship between inputs and output could further be analyzed by deriving marginal and
average product curves. The behavior of total product curve (schedule) has an interesting
implication to the marginal and average product curves (schedules).

27
Total product
Total product (TP) is the total amount that is produced during a given period of time. It is simply
the total output that the farm produces over a given period of time when the units of the variable
factors are changed.
Table 2.5 Total Product, Average Product and Marginal Product
Qty of capital Qty of Labor Total product Average product Marginal product
(K) (L) (TP) (AP) (MP)
5 0 0 - -

5 1 15 15 15

5 2 34 17 19

5 3 48 16 14

5 4 60 15 12

5 5 62 12.4 2

5 6 60 10 -2 (Show LDMR)

Suppose capital is fixed at 5 units. By applying varying quantity of labor, the firm can produce
different levels of output. Capital being held fixed at 5 units, as the quantity of labor increases,
the level of output (TP) increases. Average product (AP) increases at first and then declines. The same is
the true of marginal product.
Average Product
Average product (AP) is the total product divided by the number of units of the variable factor used to
produce it. Or it represents the output per unit of the input. It is measured by dividing the total output by
the units of labor used. It is the average output per unit of input. It refers to all the units of inputs used.
TP
AP = Where: X is the amount of the variable input used in the production process.
X
If we let the number of units of labor be denoted by L, the average product can be written as:
TP
AP =
L

In Table 2.5 above, as more of the variable factor (labor) is used, AP first rises and then falls.

28
The level of output at which AP reaches maximum is called the point of diminishing average
productivity. Up to that point, average productivity is increasing; beyond that point, average productivity
is decreasing.
Marginal Product
Marginal Product (MP) is the change in total product resulting from the use of one unit more of a variable
factor. In Table 2.5 above, as the first unit of labor are employed total product increases by 15 units. This
increase in TP is the marginal product of the first unit of labor. The second unit of labor adds 19 more
units of output to TP; therefore, its MP is 19 units. The fifth unit of labor’s MP is just 2 units of output,
while the last unit of labor’s contribution to output is negative. The additional output from each
successive unit of input is called the marginal product. It is the extra output obtained from the
employment of additional unit of the variable input.
TPPn−TPPn−1
MPP = 𝑋𝑛−𝑋𝑛−1
=∆TPP/∆X

Where: ΔY = Change in output (Y),

ΔX = Change input (X)
MPP is the rate at which the output increases that is used to explain the different laws of production,
popularly known as laws of returns. If the MPP remains constant, it is called the law of constant returns.
If the marginal product goes on increasing, it is called the laws of increasing returns. Likewise, when the
marginal product declines, it is called the law of diminishing returns. Or marginal product is simply the
additional output from each successive unit of input. Or it is the extra output obtained from the
employment of additional unit of the variable input.
TPn−TPn−1
MP = = ∆TP/∆X
𝑋𝑛−𝑋𝑛−1
Where: ΔTP = Change in output (TP)

ΔX = Change input (X)

MP = ∆TP/∆L
Where: ΔTP is the change in TP, and
ΔL is the change in L.
MP = dTP/dL
Where: dTP is the change in TP, and
dL is the change in L.

Relationship between TPP & MPP

1. Since MPP is a measure of rate of change, therefore

29
 (i) when TPP is increasing, MPP will be +ve,
(ii) when TPP is constant MPP will be zero
(iii) When TPP decreases, MPP will be –ve.
2. So long MPP moves upward,
TPP increases at an increasing rate.
3. When MPP remains constant,
TPP increases at a constant rate.
4. When MPP starts declining, TPP increases at a decreasing rate.
5. When MPP is zero, TPP will be at maximum.
B. Relationship between MPP & APP
1. When MPP is increasing,
APP is also increasing.
So long as MPP is above APP, the APP keeps increasing.
2. When MPP curve goes below APP curve,
APP starts declining, that is, when AP is decreasing the MP is always less than APP.
3. When MP = AP, AP will be at maximum.
4. MP curve must intersect AP curve from above at its highest point.
At initial stages, MP increases as additional variable factors (labor) are employed. Then reaches
maximum and declines. After certain range, it becomes negative with employment of additional
variable factors. The level of output at which, marginal product reaches its maximum level is
called point of diminishing marginal productivity.
Which show the law of Diminishing Marginal Returns (LDMR): The law states that as more
and more of one factor input is employed, assuming all other input quantities held constant, a
point will eventually be reached where additional quantities of the varying input will yield
diminishing marginal contributions to total product.
The Relationship between MP and AP: Algebraic Approach
Given a production function Q = −cL + bL2 − aL3 ,

dQ Q
MP = = −c + 2bL − 3aL2 , and AP = = −c + bL − aL2
dL L

The maximum point of MP occurs where its slope is zero.

30
 b
2b − 6aL = 0 L=
3a

The maximum point of AP, on the other hand, occurs where its slope is zero.

b b b
b − 2aL = 0 L= . Since  , the maximum point of MP lies to the
2a 3a 2a
left of the maximum point of AP.

Let’s now try to show that MP cuts AP at its maximum point. If this is true, the point of
intersection of MP and AP must coincide with the maximum point of AP. At the point of
intersection, MP = AP

Example

The production function that a firm faces is given as follow by assuming capital (K) is constant:
2
Q = f ( L) K = 8L2 − L3
3
This production function shows the maximum output that can be produced from various levels of
labor employment. Therefore, it represents TP. The AP is, then, derived as:
2
8L2 − L3
TP 3 = 8L − 2 L2
AP = =
L L 3
Given the AP function, the point of diminishing average productivity occurs where the slope
AP is zero.
dAP 4
The slope of AP= =8− L = 0
dL 3 by using derivation Ap respective of labor
4
L=8 L=6 There for the maximum point of AP occurs at L =6
3

At this point of intersection of AP and MP become equal, but if AP less than 6 AP becomes less
than MP and also if AP greater than 6 AP greater than MP

Similarly, MP is derived as

31
 2
d (8L2 − L3 )
dTP 3
MP = = = 16L − 2 L2
dL dL by using derivation MP respective of labor
Given the MP function, the point of diminishing marginal productivity occurs where the slope of
MP is zero.
dMP
The slope of MP = = 16 − 4 L = 0 4L = 16 L = 4.
dL

The Relationship between AP and MP graphic approach

In figure 2.3 below, the maximum point of the AP is attained at L2 level of employment, while the
maximum point of the MP occurs at a lower level of employment L1. The MP curve cuts the AP at its
maximum point. As long as MP is above AP, AP will continue to rise. If the contribution of an additional
unit of labor is greater than the AP of the previous units of labor, the new AP will be higher than the
previous one. On the contrary, if the additional output due to employment of one more unit of labor is less
than the AP of the previous units of labor, the new AP will be less than the previous one.

Figure 2.3: The Relationship between AP and MP

In figure 2.3, for employment level between 0 and L1 units, TP increases at an increasing rate (slope of
the TP becomes steeper and steeper). This means that MP and AP are also increasing. At L1, MP reaches
its maximum. Between L1 and L2 units of labor, TP increases at a decreasing rate and MP declines, but is
above AP. As a result, AP increases. At L2, AP reaches maximum and is cut by MP. Between L2 and L3,
TP still increases at a decreasing rate, but MP is below AP. This pulls the AP down and AP falls. At L3,
MP is zero and TP reaches maximum. Beyond L3, MP is negative, therefore, TP declines.

32
2.3.1 The Stages of Production

A typical production function such as the type illustrated in Figure 2.4 can be divided into three
distinct stages. Figure 2. 4 showing TPP, APP and MPP curves can be reproduced to show the
three stages in production process.

Characteristic Features of Stage 1

• Stage 1 ends with the extensive margin where APP equals MPP
• TPP first increases at an increasing rate and then from the point of inflection begins to
increase at a decreasing rate.
• MPP increases and reaches a peak and begins to decline.
• APP also continues to increase and reaches its peak where stage 1 terminates. At this
stage MPP is greater than APP

33
 • The average rate at which input X is being converted to output is still increasing
• In this stage, it is advisable for farmers to continue to add more variable input.
• It is an irrational stage of production
• All the input resources are increasing.
• The technical efficiency of variable input decreases as indicated by the decrease in APP.
• The technical efficiency of fixed inputs increases as indicated by increase in TPP.

Characteristic Features of Stage 2

• Stage 2 of production starts where APP is equal to MPP.

• After this point APP is greater than MPP
• At the end of stage 2 MPP is equal to zero
• In stage 2, MPP is equal to or less than APP but equal to or greater than zero.
• This stage represents the region of rational production where profit could be
maximized.
• Elasticity of production is less than one, but equal to zero at the end of the stage.
• This is the minimum amount of variable input that will be used & it occurs when the
efficiency of variable input is at its maximum

Characteristic Features of Stage 3

• Stage 3 of production starts where MPP is equal to zero

• In stage 3, MPP becomes negative
• Both TPP and APP continue to decrease
• Elasticity of production is less than zero
• Variable resource is in excess relative to fixed resources.
• The technical efficiency of variable resource and fixed resources declines
• Stage 3 is therefore irrational stage of production

Formally, the efficient stage of production is defined by the condition:

MPL  2Q
= 2 < 0  the slope of MP should be negative
L L

Q
MPL =  0 MP of labor should be positive.
L

Elasticity of production
The elasticity of production refers to percentage change in output in response to the percentage
change input in. The elasticity measures the responsiveness of production to change in factor of
production. It can be denoted by the symbol Єp and computed as:

34
 Percentagechangein outpot
p =
Percentagechangein input

 Y 
p =  Y  100 =  Y   X  = MP
 X   X   Y  AP
  
 X
Y X
Or p =
X Y

Ep > 1 in Stage I, 0<Ep<1 stage II , Ep is negative .

The elasticity of production may be greater than one, less than one, zero or less than zero (or
negative). The following are essential points to remember about elasticity of production:
A production function with an elastically of one indicates constant returns to scale. This means a
one percent increase in input is always accompanied by exactly one percent increase in output. In
this case, marginal and average products are equal.
Elasticity of production is more than one only up to the point of maximum average product
(AP>MP) . This shows an increasing return to scale. That means a one percent increase in input
is accompanied by a more than one percent increase in output.
The elasticity of production is less than one but positive between the point of maximum average
product (AP=MP) and the maximum total product (MP=0). This indicates a decreasing return to
scale. The implication is that a one percent increase in input will result in a less than one percent
increase in output.
When elasticity of production becomes less than zero, total product declines.
If elasticity of production is known, we can calculate MP, or where MP is given, elasticity of
production can be worked out. The availability of this information has a great significance; it is
directly applicable to the analysis of the Cobb-Douglas production function. The knowledge of
the coefficients of elasticity of production is also helpful in distinguishing the states of
production function and is helping in locating the rational zone where in one could make
decision on the optimum use of resources.
Short summary for the Relationship between Total Product, Marginal Product, and
Average Product (see figure 2.4)
1. The relationship between MP and AP:
• When MP > AP, this means that AP is rising,

35
• When MP = AP, this means that AP is maximum,
• When MP < AP, this means that AP is falling.
• So long as the MP curve lies above the AP curve, the AP curve is a positively sloping curve,
AP rises
• When the MP curve intersects the AP curve, AP is at maximum,
• When the MP curve lies below the AP curve, the AP curve slopes downward, i.e., AP declines.
2 .The relationship between TP and MP:
• When TP increases at an increasing rate, marginal product increases,
• While TP increases at a diminishing rate, MP declines,
• When total product reaches its maximum, marginal product becomes zero,
• When TP begins to decline, MP becomes negative
So when MP > AP = AP↑ ,MP < AP =AP↓ ,MP = AP AP is at maximum
2. Factor-Factor Relationships (the question of input substitution)
The particular concern of this section is with the possibilities of substituting one factor (X1) for
another factor (X2) as product level (Y or TP or Q) is held constant. Thus, the objectives of this
analysis of factor-factor relationships are two points.
• Minimization of cost at a given level of output, and
• Optimization of output to the fixed factors through alternative combinations of resource
use that produce a unique amount of output.
Iso-quants
The word Isoquant is derived from two Latin words: Iso and Quant. Iso means equal while quant
means quantity. Therefore the literary meaning of isoquant is equal quantity
Iso-quant can be described as a curve which shows the combinations of two variable inputs X1
and X2 required to produce a given quantity of a particular product.

Isoquants are lines joining all combinations of factors of production which yield equal products.
This definition of Isoquant assumes that it is possible to obtain the same output using various
combinations of variable factors. The aim of farmer here will then be to look for a particular
combination of the factor that will require the least cost.

This relationship between two variable inputs to produce the same output can be expressed in
algebraic form as well as tabular and graphical forms.

36
Algebraic form can be expressed as: Q = ƒ(X1, X2)

Where Q = constant output and X1 and X2 = inputs In a tabular form Isoquant can also be
illustrated as follows:

Table 2.6: Combinations of X1 and X2 producing 100 units of output

Variable input (X1) Variable input (X2) Total Output (Q)

1 37 100 units
2 28 100 units
3 21 100 units
4 15 100 units
5 10 100 units
Characteristics of iso-quants:

• They have negative slope. In the economic region, the iso-quants have negative slope that
indicates substitution between inputs to produce a fixed level of output. Substitutability
reduces the use of one input and increases that of the other.
• They are convex to the origin and convexity indicates diminishing marginal rate of
technical substitution (MRTS). MRTS is the rate at which marginal unit of an input can
be substituted for the marginal unit of the other so that the level of output remains the
same.
• Iso-quants cannot intersect each other or be tangent each other. Tangency or intersection
of iso-quants implies that a single input combination can give two different output levels.
• Iso-quants for higher level of output will normally lie above and to the right of iso-quants
for lower level of output. It normally requires more of either one or both resources to
produce more output
• Iso-quant may have various shapes depending on the degree of substitutability of factors.
That means the shape of the iso-quants will depend upon the manner in which the
variable inputs are combined to produce a particular level of output. There can be three
categories of such a combination of inputs.

37
1. Fixed proportion combination of inputs: there are certain enterprises or products which can
only be produced if inputs are added or combined in fixed combinations at all levels of
production. In this case, there is no problem in decision because the inputs are combined in fixed
proportions. The iso-quants are ‘L’ shaped (Leontief iso-quants) and factors are perfect
complements (zero substitutability). Though, operation anywhere on the vertical as well as the
horizontal segments is possible, however, it involves larger quantity of one of the factors and not
less of the other to produce the same level of output. This implies, therefore, irrational behavior.
Example, one tractor and one man who drive tractor.

Iso-quant

0 L

Figure 2.5: L- shaped iso-quant curve

2. Constant rate of substitution: Such substitution take place when resources that substitute at
constant rate and the resulting curve is known as Linear (straight line) Iso-quant curve. In this
case, inputs are perfect substitutes and the slope of the iso-quant curve is constant. Consider the
following example; different combinations of two inputs (X1 and X2) Producing 100 units of
output

Table 2.7. Constant rate of substitution

X2 X1 ΔX1 ΔX2 MRS

(Women labor) (Men labour) (ΔX2/ΔX1)

10 1

8 2 1 2 2

38
 6 3 1 2 2

4 4 1 2 2

2 5 1 2 2

If we plot the data of Table 2.7 on a graph, we gat an iso-quant curve, which is straight line

X1

Iso-quant

0 X2

Figure 2.6. Linear iso-quant

3. Varying rate of substitution - there can be either an increasing or decreasing rate of

substitution. In this case MRS varies over the iso-product curve. The amount of one input X1
required to substitute for one unit of another X2 at a given level of production increases or
decreases as the amount of X1 used increases. Substitution at an increasing rate is not commonly
available but substituting at a decreasing rate is more common case in agriculture and the
resulting iso-quant curve is convex.

Concepts of Factor Substitutions

In order to understand the basic concepts of factor substitution, we will confine our selves to
only two inputs/factors and one output and the relationship can be given as: Y = f (X1, X2/X3,
X4 ...Xn) Here output (Y) is a function of X1 and X2 while other inputs are held constant. This
expression shows that the amount of output (Y) depends in a unique way upon X1 and X2. Let
us now turn to the discussion of substitutability between two factors. It was mentioned that along
a convex iso-quant curve, a firm has to increase the quantity of one factor of production (L) for
any fall in the quantity of the other factor (K) in order to produce the same level of output.

The slope of an iso-quant − Δ K / Δ L could be defined to show the degree of substitutability of

factors of production. It declines in absolute value as we move from left to right along an iso-

39
quant. The slope of an iso-quant is called Marginal Rate of Technical Substitution of labor for
capital (MRTSL,K).

MRTSL,K=− Δ K / Δ L= dK/dL= MPL/APK

Iso-Cost Lines

Just as an iso-quant can be constructed to indicate all possible combinations of inputs which will
produce a given quantity of output, an iso cost line can be drawn to indicate all possible
combinations of two inputs which can be purchased with a given outlay of funds. Each
combination of two inputs has some total cost which includes the costs of two inputs (X1 and
X2) combined. Since total outlay is a function of the amount of X1 and X2 used, it can be
graphed in a manner similar with the production surface. Just as a production surfaces are
characterized by isoquant, similarly total outlay surfaces can be described by iso-cost lines.

Suppose for example, a farmer has Birr 36 to spend on two variable inputs X1 and X2. The cost
per unit of X2 is 4 birr and that of X1 is 3 birr. He may either purchase 12 units of X1 or 9 units
of X2. These two points can be located on the graph as shown below .When the two lines are
connected by a straight line, the result is iso-cost line for total outlay. On this line, he can trace
any number of combinations of the two inputs which will cost the same.

X1

12

9 X2

Figure 2.10 Iso-cost line

Mathematical equation of the iso-cost line can be obtained by

Y = PX1X1 + PX 2 X2 for X1 as an explicit function of X2

X1=Y/PX1- (PX2/PX1 )X2

Characteristics of iso-cost lines

40
Under constant price situation each possible total outlay has a different iso-cost line. As total
outlay increases, the iso-cost line moves higher and higher, further away from the origin. But the
slope will be similar.

Change in input price will change the slope of the iso-cost lines. When prices of input decreases,
more inputs of it can be purchased with the same total outlay and conversely when input prices
increase lesser units can be purchased. This changes the slope of the iso-cost line.

Here the problem is to find out a combination of inputs which should cost the least; a cost
minimizing problem. There are three methods to find the solution to cost minimization problems.

1. Simple arithmetic calculations 2. Algebraic method 3. Graphic Method

Let see algebraic method

Procedures for finding the least cost combination is

Find the MRTS X1X2 (Δ X2/ Δ X1) Compute the price ratio (PX1/PX2) equate the above two

Δ X2/ Δ X1=p1x1/px2.Therefore, the least cost criterion is that MRS of X2 for X1 should be
equal to Px1 Δ.x1. Δ X1 = Px2. Δ X2

If at any point on the iso-quant, if Px1. Δ X1 >Px2. Δ X2 the cost of producing the output can be
reduced by increasing the use X2 and decreasing the use ofX1, because the cost of added unit of
X2 is less than the cost of the replaced units of x1. On the other hand, if at any point on the iso-
quant, Px1. Δ X1 more of X1. This equality criterion signifies that any change in the input
combination from this point would increase cost of producing the output.

3 .Product-Product Relationships

In this section instead of considering the allocation of inputs to an enterprise or among

enterprises, we will discuss enterprise combinations involving product-product relationships. The
producer must decide how to allocate the resources he owns, rented or borrowed to the
alternative products which can be produced. The choice involves whether to concentrate on the
production of one, two or a combination of many enterprises as there is a choice to be made
between specialized or diversified system of farming.

41
The economic principle of choosing what to produce is the principle of comparative advantage
which states simply that each unit of resource should be used where it will earn the greatest
return.
Some resources are limited in supply. So, enterprises will compete with each other for some of
these fixed resources. Therefore, expansion of one enterprise will be accompanied by a reduction
in the other. Algebraically, this relationship can be written as:
Y1 = f (Y2) one product is dependent on the other
Y1= f (Y2, Y3, Y4, Y5…) one product is dependent on others
Y1=f(X1, X2…) one product is explained by some inputs
Y2=f(X1, X2…) another product too is explained by the same inputs
Suppose a farmer has 10 hectares of land and he wants to grow wheat along with other
competitive crops like barely, sugarcane, sorghum etc. In this case, hectare under wheat will be a
function of hectare under barely, sorghum etc.
Production Possibility Curves (PPC) and Iso revenue curve
Production possibility curve represents a locus of all possible combinations of two products
which can be produced from a given amount of input. For example, the level of outputs of two
enterprises Y1 and Y2 for a given level of input of 100 of capital are given in Table 2.10. If we
plot the data on a graph, we will get a curve known as production possibility curve (Fig 2.12).

Unit of
Input Unit of output (Y2)
Output (Y1)

100 30 0

100 25 25

100 15 45

100 0 52.5

42
Types of Production possibility curve
The shape of the production possibility curve depends on the type of product relationship
involved or substitutability of two outputs. These are:
i. Straight line production possibility curve
The curve is straight line when a unit change in one product is accompanied by same unit but
opposite change in the other product. Suppose a farmer can produce 30 quintal wheat yield per
hectare and 40 quintal barley per hectare and there is no yield effect of growing any combination
of the two crops. If each hectare of land shifted from wheat to barley would reduce 30 quintal of
wheat and increase 40 quintal of barley, the resulting production possibility curve is straight line.
In this case the slope (MRPS) of the curve is constant. To maximize profit only one of them
should be produced (specialization).

43
Figure 2.13. Straight line production possibility curve
ii. Concave production possibility curve
The curve is concave when each unit increase in the level of one product is accompanied by
larger and larger decrease in the level of the other. In this case two products substitute at an
increasing rate and the slope (MRPS) of the curve increases when we move from the top to
bottom. Fig. 2.12 above represents for a concave production possibility curve and on that figure
the slope at point ‘e’ is larger than that of point ‘f’.
When two products substitute at an increasing rate, profit will be maximized when the marginal
rate of product substitution (MRPS) between two products is equal to their inverse price ratio.
iii. Convex production possibility curve
The curve is convex when each unit increase in the level of one product is accompanied by
smaller and smaller decrease in the level of the other. In this case two products substitute at a
decreasing rate and the slope (MRPS) of the curve decreases when we move from the top to
bottom, i.e. in fig 2.14, the slop at point ‘a’ is larger than point‘d’. It will be economical to
produce only one of the products because successive increase in one product requires sacrifice of
smaller quantities of the other.

44
Figure 2.14 Convex production possibility curves
Basic production (enterprise) Relationships
We have four basic enterprise relationships: These are
i) Joint products: Joint products are products which are results from the same production
process and production of one product without the other is impossible.
For example: cotton lint and cotton seed, beef and hides, wheat and straw, mutton and wool and
cattle and manure, etc. quantity of one product produced decides the quantity of the other
product.

ii) Complementary products:

Complementary relationship among enterprises exists when with a change in the level of one
product, the other also changes in the same direction. That is these enterprises help each other
and do not compete for the same resource. The base for such relationship could be that one
enterprise produces an input that enhances the output level of the other enterprise. Crop

45
production and livestock rising can be an example of complementary enterprises as crop
production supplies grain and straw that can be used as an input in livestock production activity
and livestock farming also supplies manure that can be used as an input in crop production.
Complimentary enterprises become competitive at some level of output. That means, increasing
the level of complimentary enterprises requires increasing amount of resources and at some
point, when all resources are exhausted, they start compete for the same resource. In this range
the MRPS of the production possibility curve has positive slope. In addition, the profit
maximizing combination of complimentary enterprises is found in the competitive range.

The figure shows that along the segment ‘de’ and ‘fc’ of production possibility curve the slope of
the curve is positive. i.e. Y1 and Y2 are complimentary because when output Y1 increases from
‘o’ to ‘b’, output Y2 also increase from‘d’ to ‘g’ and when output Y2 increases from ‘o’ to ‘a’,
output Y1 also increase from ‘c’ to ‘h’. However, on the segment ‘ef’ of the production
possibility curve, the two outputs become competitive and so the slope of the curve is negative.

iii) Supplementary products: Two enterprises have supplementary relationship when increase
or decrease in the production of one product doesn’t affect the production level of the other
product. That is these enterprises do not compete for the same resource. The base for such
relationship is that the supplementary enterprise make use of otherwise unused resources.

For example, small poultry and beekeeping enterprise that utilize family labour and managerial
skill that would otherwise be unutilized can be supplementary enterprise on small farms. The
utilization of labour and machinery on many farms is another example of supplementary

46
relationships. Using machinery on crop 1 for a certain amount of time may increase income from
Y1 but may not reduce income from an alternative crop Y2. Supplementary relationships
increase profit by improving resource use. That is enterprises are able to share the services of
resources with cost remaining fixed and thereby increasing the profit margin.
It should be noted that within supplementary range of the production possibility curve, the
MRPS between the two enterprises is zero, i.e. no substitution. In addition, all supplementary
enterprises become competitive at some point. That means, increasing the level of supplementary
enterprise requires increasing amount of the previously unused resources. Therefore, when the
supply of the unused resources is exhausted, the enterprises must compete for additional unit of
the resource. In the competitive range of the production possibility curve, MRPS is negative.

The shows that along the segment ‘de’ and ‘fc’ of production possibility curve the slope of the
curve is zero. i.e. Y1 and Y2 are supplementary because when output Y1 increases from ‘o’ to ‘b’
output Y2 do not change and when output Y2 increases from ‘o’ to ‘a’, output Y1 do not change.
However, on the segment ‘ef’ of the production possibility curve, the two outputs become
competitive and so the slope of the curve is negative.

IV Competitive product: Two enterprises are competitive when an increase in the output of one
enterprise results in a decrease in the output of the other enterprise and vice versa. The two
enterprises compete for the same resources at the same time. Therefore, when two products are
competitive, some of one product must be given up to increase the level of the other product and,

47
therefore, the MRPS of the production possibility curve is negative. When two enterprises are
competitive, they may substitute at a constant rate or at an increasing rate or at a decreasing rate.
(See fig. 2.13, 2.12, and 2.14).
Determination of optimum product combination
Arithmetic calculation
Example: assume there are only 10 units of inputs given. The price of maize is birr
7 per quintal and that of wheat is birr 10 per quintal. What is the profit maximizing combination?
(Price of input is 40 Birr per unit).
Table 2.11 Product-Product relationship

Yield of Yield of Return Return

Total return Total cost Profit
Maize (Y1) wheat (Y2) from maize from maize

0 78 0 780 780 400 380

10 76 70 760 830 400 430

20 72 140 720 860 400 460

30 67 210 670 880 400 480

40 60 280 600 880 400 480

50 48 350 480 830 400 430

60 28 420 280 700 400 300

70 0 490 0 490 400 90

Table 2.11 above shows that profit maximizing combination is 40 units of maize and 60 units of
wheat with a maximum profit of 480 birr.
Graphically
Since the slope of the iso-revenue line indicates the ratio of product prices and slope of the
production possibility curve represents the marginal rate of product substitution, maximum profit
for a given level of input will be indicated by the tangency of the two curves.
Slope of production possibility curve = slope of iso-revenue line

48
Given the production possibility curve is concave; the optimum combination of outputs will be at
the point where the iso-revenue line is tangent to the production possibility curve. The graph
illustrated as shown below.

Figure 2.18 Optimum output combination

For profit maximization, marginal value product per unit of a variable input (resource) should be
equal in each enterprise.
Specialization and diversification
Specialization means a situation where farmers specialize in one enterprise at a time whereas
diversification means adopting more than one enterprise at a time.
There are many physical, economic and social conditions which influence the choice of these
patterns of production.
When there is supplementary or complementarily relationship exists between enterprises,
diversification will be the choice. However, when products have competitive relationship, the
choice depends on the MRPS. Risk and uncertainty are also the factors that dictate specialization
or not. If any is there, diversification is recommended. Length of sowing season also affects
specialization. If sowing period is short, diversification is favourable otherwise specialization
will be select.

49
CHAPTER THREE: THRORY OF COST
3.1 Basic concepts of costs
The term cost of production refers to the total amount of fund used for purchase of different
fixed and /or variable inputs employed in the production process.
Cost of production exists because the supplies of productive resources are scarce and has market
value. The costs of production usually calculated in relation to a particular amount of product
(per unit of output) in a particular time period because the cost of production in any particular
period include the value of the resource/services transformed into a product in that single period
rather than the value of the resource itself.
3.1.1Explicity and implicit cost
Explicit Cost: The term explicit cost refers to those expenses that are actually paid by the
producers for purchase of different inputs in the production process. In other words, any expense
or payments made to those outsiders who are supplier of labour services, raw materials, fuel,
transportation services, power etc. to the firm are called explicit cost. It is also called cash cost.
The value of purchased inputs (explicit costs) is usually determined by market price (accounting
price) of that particular input. Such costs usually appear in the accounting records of the firm.
Implicit Cost: The term implicit cost refers to the earning of those employed resources, which
belong to the owner him/herself in the production process. The value of self owned inputs
(implicit costs) should be inputted or estimated from what they could earn in their alternative use
which is called opportunity cost of that input.
Examples of these costs are:
The salary of owner manager,
✓ Depreciation cost of a building that belongs to the owner of the farm,
✓ Depreciation cost of a tractor or other fixed farm equipments, which belongs to the
owner of the farm,
✓ Interest forgone when the owner uses his capital in his farm, etc.
✓ The total cost of production is the sum of explicit cost and implicit cost.
3.1.2 Economic/opportunity cost

50
Economic (opportunity) cost
Opportunity cost is the economist’s concept of costs of production that are based on the fact that
recourses are scarce and have alternative value. That means, when resources are used for certain
production activity other alternative products must be forgone. Therefore, production of one
product entails giving up so much of the opportunity to produce something else because
recourses are used for production of the first product.
Opportunity cost, therefore, means the value forgone because the resource was used for another
purpose. In other words, it is the return which must be given up in the next best alternative use.
Suppose, for example, by using 3 quintal of fertilizer , a farmer can add birr 300 to the total
revenue from wheat production and birr 250 total revenue from maize production. If that farmer
fertilizes his maize, his opportunity cost is birr 300, which he has forgone by not fertilizing his
wheat. On the contrary, if that farmer fertilizes his wheat, his opportunity cost will be birr 250,
which he forgone by not fertilizing his maize.
Or Opportunity cost is the benefit lost when choosing one option precludes receiving the benefits from
the alternative option.
Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant in
current decision making.

3.2 Production cost in the short-run

As it has been briefly indicated, we have two major categories of costs in the short-run: fixed costs
and variable costs.
Total Fixed Cost (TFC)
Fixed costs are costs associated with owing fixed inputs. These are costs, which are not changed in
magnitude as the amount of output of production changes and incurred even when production is not
undertaken.
Fixed costs are costs of the investment goods used by the firm on the idea that these reflect a long-
term commitment that can be recovered only by wearing them out in the production of goods and
services for sale. They consist of both cash and non cash fixed costs. Fixed cash cost includes: land
tax, interest on borrowed capital, insurance premium, annually hired labour wage, rent for building or
machinery etc. Fixed non cash cost includes: depreciation cost of buildings, machineries and other
fixed equipments, interest on own capital investments etc.
Total Variable Cost (TVC)

51
Variable costs are costs that are incurred in using variable inputs. Therefore, these costs increase with
the increase in the level of output of the firm. This means, the variable costs of production are
incurred by a firm only when there is an output. Cost items such as wages paid to labourers,
payments made to the raw material suppliers (like feed, fertilizer, seed, chemicals etc.) payments
made to the fuel suppliers and transportation agencies etc. are examples of variable costs. TVCS are
computed by multiplying the amount of variable inputs used by the price per unit of input.
TVC = Px * X
Where: Px is the price of input
X is the level of input
Total cost (TC)
The total cost of production is a sum of total fixed cost and total variable cost. In the short run, it will
increase only as TVC increases, as TFC is a constant value.

Figure 3.2.Total, fixed and variable cost curves

Figure 3.2 shows the shapes of TFC, TVC and TC curves. The fixed cost curve starts at some
point above the origin and it is horizontal. The TVC curve starts from the origin and it slopes
positively upwards. It indicates that the variable cost is zero when the level of output of a firm is
zero and these costs increase with the increase in the level of output. Since it is the sum of
TFC and TVC, the TC curve has the same shape as the TVC curve. However, it is always higher
by a vertical distance to TFC.
Average (Per unit) Cost
Costs may be more meaningful if they are expressed on a per-unit basis, as averages cost per unit
of output (Q). The average costs are:

52
 ✓ Average fixed cost (AFC),
✓ Average variable cost (AVC), and
✓ Average total cost (ATC).
Average fixed costs (AFCs): are costs obtained by dividing the total fixed costs (TFCs) by the
level of output.
TFC
AFC =
Q
Table 3.2 shows the AFC column is computed by dividing the AFC column by the different
quantities of output (Q). As the rate of output (Q) increases, TFC remain the same, and the
AFC becomes smaller and smaller. The corresponding AFC curve, as shown in fig.3.3, is also
down ward slopping to the right throughout its entire length.
As the quantity of output increases, the AFC curve approaches but never touches the output axis.
This indicates, a farm can reduce substantially its cost per unit by producing larger quantities of
output (Q). Therefore, for every small level of output, AFC is high and for larger output it is low.
Average Variable Costs (AVCs): are obtained by dividing the total variable cost by the
respective level of output (Q).
TVC
AVC =
Q
In the Table 3.2 the AVC column is computed by dividing the TVC column by the different
quantities of output (Q) using the above formula.
The AVC may be either increasing or decreasing depending upon the underlying production
function or average productivity of inputs. For a given production function, AVC will initially
decrease as output is increased and then will increase beginning at the point where average
physical product (AP) start to decline.
As shown in fig. 3.5., the AVC cost curve is inversely related to average physical product
(AP), i.e., when AP is increasing, AVC is decreasing. When AP is at its maximum, AVC attains
its minimum. And when AP is decreasing, AVC is increasing.

53
As AP measures the efficiency of the variable inputs, AVC provides the same measure for cost
function. Therefore, when AVC is decreasing, the efficiency of the variable inputs is increasing.
It is at its maximum when AVC is at its minimum; and it is decreasing when AVC is increasing.
Output
TFC TVC TC AFC AVC ATC MC TR MR Profit
(Q)

0 20 0 20 - - - - 0 - -20

2 20 5 25 10.00 2.50 12.50 2.50 6 3 -19

5 20 10 30 4.00 2.00 6.00 1.67 15 3 -15

9 20 15 35 2.22 1.67 3.89 1.25 27 3 -8

14 20 20 40 1.43 1.43 2.86 1.00 42 3 2

19 20 25 45 1.05 1.32 2.37 1.00 57 3 12

23 20 30 50 0.87 1.30 2.17 1.25 69 3 19

26 20 35 55 0.77 1.35 2.12 1.67 78 3 23

28 20 40 60 0.71 1.43 2.14 2.50 84 3 24

29 20 45 65 0.69 1.55 2.24 5.00 87 3 22

54
 29 20 50 70 0.69 1.72 2.41 0.00 87 3 17

28 20 55 75 0.71 1.96 2.68 0.00 84 3 9

Average cost (AC) or (ATC): It is simply total cost (TC) divided by quantities of output (Y) or
it is the sum of AVC and AFC.

The shape of AC curve is usually thought to be a U shape curve. This U shape depends upon the
efficiency of both fixed and variable input used. At the initial stage (fig.3.3), the ATC decreases
because AFC is decreasing rapidly and AVC is also decreasing. However, at larger output level,
AFC will be decreasing less rapidly and AVC will eventually increase and be increasing at faster
rate than the rate of decrease in AFC. The combined effect of this leads ATC curve to increase
and have U shape.
The minimum point of the ATC curve must be to the right of the minimum point of the AVC
curve. That means, as shown in Fig. 3.4, the minimum point of the AVC curve lies at a lower
output level than does the minimum point of the AC curve.

55
Marginal Cost (MC): is the extra cost of producing an additional unit of output
(Q). It can also be defined as the change in total cost resulting from one unit change in output.
the change in total costm TC
m arg nal cost = or MC =
the change in output Q

The above figure indicates that MC and MP are inversely related. At low level of output a farm
benefits from increasing marginal returns to the variable inputs (that is increasing MP),
MC will be declining. MC reaches its minimum at the level of output at which MP is at its
maximum. When the farm encounters diminishing marginal returns, so that MP is falling and
MC begins to rise. Whenever there is a fixed factor, so that the law of diminishing returns comes
into operation, the MC curve eventually starts to rise. If we plot the MC curve on a graph against
output, we can see that it is a U shaped curve (see fig.3.4).
TVC
MC =
Q
Since a change in total cost (ΔTC) is caused only by a change in total variable cost (ΔTVC),
marginal Cost (MC) depends on no way upon TFC. So that, we can say that MC is depends on
the change in TVC.
TC = TFC + TVC
ΔTC = Δ (TFC + TVC)
ΔTC = ΔTFC 0 + ΔTVC

56
 TVC TC
ΔTC = ΔTVC therefore, MC = or MC =
Q Q
3.3 Cost function
A mathematical formula used to predict the cost associated with a certain action or a certain level
of output. Businesses use cost functions to forecast the expenses associated with production, in
order to determine what pricing strategies to use in order to achieve desired profit margins..
3.4 Nature and Relations among ATC, AVC, AFC and MC:
Nature and Relations among ATC, AVC, AFC and MC

1. AFC approaches both axes asymptotically.

2. All AVC, ATC, and MC curve first decline, reach at minimum point, and then rise up.
3. The minimum points of these curves are not the same (Usually, output at minimum point
of MC less than output at minimum point of AVC which is less than output at minimum
point of ATC).
4. As AFC approaches asymptotically close to the horizontal axis, AVC approaches ATC
asymptotically.
5. MC equal to both AVC and ATC when these curves attain their minimum values;
6. MC lies below both AVC and ATC curves over the range in which these curves decline;
and it lies above these curves when the curves are rising.
3.5 Production cost in the Long-Run
Over a long period, all resources are variable and there will be no total and average fixed costs.
In other words, in the long run, a business can vary all of its inputs, and can change the whole
scale of production. Therefore, a farm-firm can change its size of operation and it can do so if its
situation seems to require it. Thus, the farm would choose the size/scale of operation at which it
can maximize its profits, or where it can produce at the minimum cost.
When the farm-firm plans to expand the scale of its operation, we may expect to have a different
set of cost curves associated with each operation. In other words, we can think of the long run as
a series of alternative to short run situations into any one of which the farm-firm can move. We
will now think a bit about the long run, using the concept of average cost and marginal cost.

Long-run Average Cost (LAC)

57
Suppose you were planning to build a new plant, perhaps to set up a whole new farm and you
know about how much output you will be producing. Then, you want to establish the farm so as
to produce that amount at the lowest possible average cost.
To make it a little simple, suppose that you have to pick just one of three farm sizes: small,
medium, and large, which have the short run average cost curves AC1, AC2 and AC3,
respectively.
➢ If you produce 1000 units, the small farm size gives the lowest cost.
➢ If you produce 3000 units, the medium farm size gives the lowest cost.
➢ If you produce 4000 units, the large farm size gives you the lowest cost.

Here the curve LAC (log run average costs) represents the lowest average costs that can be
reached if a firm requires producing most efficiently at each of the various plant size/scale of
operation or output levels measured on the horizontal axis.
As shown in fig. 3.7, the output level 100 is the most efficient size of the first farm that can
produce the amount of output at minimum average cost of 100. The output level 300 is the most
efficient size of the second farm which can produce its product more cheaply; its minimum
average cost will be 50. The third farm steel produce larger output 400 will be less economical
than the second farm, and it’s per unit cost cannot be less than 75.
Therefore, the long run average cost (LAC) - the lowest average cost for each output range - is
described by the "lower envelope curve," shown by the longest curve that follows the lowest of
the three short run curves in each range. The LAC curve envelopes a number of short-run
average cost curves and hence it is also called an envelope curve.
Long-run Marginal Cost (LMC)

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The long-run marginal cost (LMC) is derived from the short-run marginal cost curves (SMC),
but it does not ‘envelope’ them. It is formed from points of intersection of the short-run marginal
cost curves with vertical lines (to the x-axis) drawn from the point of tangency of the
corresponding short-run average cost (SAC) curves and LAC curve. The LMC curve crosses the
LAC curve when the later attains its minimum value.

Figure 3.8 Long-run Marginal Cost Curve

Find the minimum point of the average cost function AC = 25q−1 + 0.1q2
dAC/dq= 25-2 + 0.2q = 25q−2 q3 = 125 ,q = 5

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CHAPTER THREE; Economic Principle Applied in Farm management
4.1 The Principle of Variable Proportion
The principle of variable proportion is also known as the principle of diminishing returns. This
law describes the relationship between an output and a variable input when other inputs are held
constant. The low states that ‘if increasing amount of one or more variable inputs are added to a
production process while all other inputs are held constant, the amount of output added per unit
of variable input will eventually decline’. The fact that one or more of the resources involved in
production are fixed in quantity is essential to this principle.
This principle helps in making decisions, such as:
• The level to which yield per hectare, milk per cow, etc., should be pushed to secure
maximum profit.
• The size of the farm one should operate with the given resources of capital, labor and
management.
• The amount of variable inputs such as fertilizer or labor one should use to maximize
profit.
Table 3.1. Application of fertilizer and output of wheat
Fertiliz Estimate Additio Additional MP TC MC TR MR Profit
e r d Yield nal l l output ΔY/ (π)
use/ha /ha (Y) Input (ΔY) ΔX
(X (Δ X)
0 2 - 2 0 - 100 100
1 6 1 4 4 30 30 300 200 270
2 9 1 3 3 60 30 450 150 390
3 10.5 1 1.5 1.5 90 30 525 75 435
4 11.5 1 1 1 120 30 575 50 455
5 12 1 0.5 0.5 150 30 600 25 450
6 11.5 1 -0.5 -0.5 180 30 575 -25 395

For example, a farmer might want to know how much fertilizer should be added to one hectare
of wheat to maximize his profit, the price of wheat being birr 50 per quintal and price of fertilizer
birr 30 per quintal and the physical input-output data on wheat yield in response to fertilizer is

60
given in Table 3.1. Based on the principle of variable proportion, the farmer can determine the
most profitable level of fertilizer use (or on the other hand he can also decide simultaneously the
economic amount of output) by equating the marginal product to the input-output price ratio
( Δ Y/ Δ x = P X / P Y ) or by equating the marginal revenue to marginal cost (MR = MC).
As is shown in Table 3.1, the optimum level of fertilizer to be used in this case is 4 units. If the
farmer uses more than this, the marginal value derived will be birr 25 and the marginal cost
fertilizer will be birr 30. Thus, the farmer has to incur loss to the extent of birr 5 and further
extension of fertilizer will bring less and less marginal returns than the factor cost. Therefore, for
this particular input-output relationship, the farmer should cease from applying more than 4 units
of fertilizer. However, he can go on applying fertilizer up to 4 units, as it adds more value than
the factor cost.
Decision rule of principle of variable proportion
1. If the marginal unit of variable input (in our case fertilizer) yields less than its price; the
use of that input can be reduced.
2. If the application of further units of variable input yields more value than the cost of that
input; its use can be increased
3. Its use can be stopped when the value of additional product equals to the added cost of
that variable input (MC=MR).
4.3 The Principle of Comparative Advantage
You know that certain crops can be grown in only limited areas because of specific soil and
climatic requirements. This means, even those crops and livestock which can be raised over a
broad geographical area often have production concentrated in one region.
There are two types of advantages in raising the farm products on the bases of maximum net
revenue per hectare. These are: Absolute advantage and Comparative (relative) advantage
Consider two regions of equal size, Region1 and Region 2, both of which produce and consume
two agricultural products, maize and wheat. A region said to have an absolute advantage in the
production of a commodity or a group of commodities if it can produce them more efficiently
than the other region. This means, the other region has an absolute disadvantage in production of
these products.

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However, if there are differences in relative efficiencies of producing the different goods in the
two regions, we can always be sure that even the disadvantageous region can have a comparative
advantage in those commodities for which it is relatively most efficient.
The principle of comparative advantage states that individuals or regions will tend to specialize
in the production of those commodities for which their resources give them a relative or
comparative advantage. . While livestock and some crops can be raised over a broad
geographical area, the yields, production costs, and profit may be different in each area. Thus, it
is relative yields, costs, and profits which are important for this principle. An illustration of this
principle using yields is shown below. Region 1 has an absolute advantage in the production of
both crops because of the higher yields. However, Region 1 must give up 2½ quintals of maize
for every quintal of wheat it grows while region 2 has to give up only 2 quintals of maize to get a
quintal of wheat. Region 2 has an absolute disadvantage in the production of both crops but
relative or comparative advantage in the production of wheat, since it gives up less maize for a
quintal of wheat than Region 1.
Region 1 Region 2
Maize 100 60
Wheat 40 30
Wheat farmers in Region 2 would be willing to give up 0.5 quintal of wheat to get a quintal of
maize, and maize farmers in Region 1 would be willing to take 0.4 quintal or more of wheat for a
quintal of maize. Assume region 1 specializes in maize production and region 2 in wheat
production. Farmers in both regions would be willing to trade if 0.4 to 0.5 quintal of wheat could
be exchanged for a quintal of maize. Farmers in each region could obtain the product from the
other region at less cost than raising it themselves. Therefore they will tend to specialize in
producing the product for which they have comparative advantage. Specialization can also make
the combined regions better off. Assume that there is 100 hectare in each region and each plants
one-half maize and one-half wheat. Total production is 8,000 (5000 in region 1 and 3000 in
region 2) quintals of maize and 3,500 (2000 in region 1 and 1500 in region 2) quintal of wheat. If
Region 1 specializes in maize and Region 2 in wheat, total production is 10,000 quintals of
maize and 3,000 quintal of wheat. As long as the income from an additional 2000 quintal of
maize is more than the income lost from 500 quintal less wheat, specialization increases the total
value of the crops produced.

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The trade between the regions allows each to obtain the final desired combination of the two
products. Thus the low of comparative advantage directs a farmer in selection of those crop and
livestock enterprises, in the production of which available resources have the greatest relative,
but not absolute, advantage. That is why we can find fruit and vegetable farming near the
cities/towns, sugarcane farming around the sugar factories and sheep farming in the highland
areas. All these are the result of the operation of this principle.

4.4 The Principle of Equi - Marginal Return

When resources are limited, expansion of one enterprise generally requires an equivalent
contraction in another enterprise. The question here is which enterprise or combination of
enterprises will give the greatest income? Such an optimum choice of enterprises is made based
on the principle of eqi-marginal returns or the principle of opportunity cost. The eqi-marginal
principle provides the guideline and the rules to ensure that the allocation is done in such a way
that profit is maximized from the use of any limited input.
The principle of eqi-marginal return states that profit from the available limited resources can be
maximized by using the recourses in such a way that the marginal return (marginal value
product) of the last unit used on each enterprise is equal. If the marginal returns in different uses
are in fact unequal, it will clearly pay to transfer some of the resource from the use where its
marginal return is lowest to the use where is highest. This process continues until marginal
returns are equal in all alternative uses. For an illustration of this principle, suppose a farmer has
birr 5000, which can be invested to grow crops (wheat), raise dairy, or poultry. The farmer’s
problem is to determine the amount of capital that he should invest on each enterprise to get the
highest profit. The problem is illustrated in Table 3.3.
Table 3.3, Marginal Value Production of capital on three enterprises
Capital MVP1000
invested Wheat Barley poultry Dairy
1000 1400 1150 1300 1450
2000 1300 1100 1200 1300
3000 1200 1000 1100 1100
4000 1200 900 900 1000
5000 1100 850 800 900

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Total return from birr 5000 6200 5000 5300 5750
Net profit 1200 0 300 750
Average return 1.24 1 1.06 1.15

If the farmer follows the low of average returns, he will invest the whole capital for production
of wheat to gets a gross return of birr 6200 and a net profit of 1200. However, if he follows the
low of equi-marginal returns where the marginal return in each direction of his investment on the
three crops are equalized, he can get a gross return of birr 6750 or a net profit of 1750. Therefore,
the farmer should allocate birr 2000 for wheat production, birr 2000 for dairy production and birr
1000 for poultry production, which results the maximum net profit of birr 1750. Any other
alternative schedule different from the principle will not result increased income. The allocation
would be as indicated in Table 3.4
below. This principle dictates that the resource should be used no where they bring the highest
average returns, but where they yield the highest marginal returns. The best combination of
enterprises is attained not when we select profitable enterprise but when we select the most
profitable combination of enterprises.
Table 3.4, Investment Allocation on the three Enterprises
Allocation Selected enterprise Added Return
The 1st birr 1000 Dairy 1450
The 2nd birr 1000 Wheat 1400
The 3rd ,4th & 5th birr Wheat, Poultry & Dairy 1300 each
1000
Total return from birr 5000 6750
Net Profit 1750

The equi-marginal return principle is sometimes referred to as the opportunity cost principle. The
opportunity cost indicates the return that can be achieved for the use of a resource in its most profitable
alternative use. In the event, a resource is allocated in sub optimal manner; the opportunity cost will
exceed the return achieved. For example, in the above Table 3.3, if the farmer allocates the available
limited capital as 2000 to wheat production, 2000 for dairy production and 1000 for barley production,

64
the opportunity cost of the last 1000 is 1300 that could be obtained from using the money for poultry
production. Thus, an allocation based of the equi-marginal return principle has an opportunity cost
concept.
Time comparison principle
Farmers normally do not think of time as an input to the production process, but time can be
thought of as an input. In such situations the principle of time comparison is applied. Such time
adjustments relate to taking account of: 1) Time element in the calculation of present value of
future income. 2) The risks and uncertainties involved in farm operations over time.
• A dollar earned a year from now is not the same thing as a dollar earned today. A dollar spent
today is not the same thing as a dollar spent a year from now.
A dollar earned a year from now is not the same thing as a dollar earned today. A dollar spent
today is not the same thing as a dollar spent a year from now. There are two reasons for this. •
First, a dollar earned today could have been placed in the bank and interest would have accrued.
That interest is foregone if the dollar is earned a year from now. • Moreover, the opportunity cost
of a dollar spent today is the interest that could have been earned if the dollar had not been spent
today. • Government policy at the federal level over time plays a significant role in determining
the profitability of agriculture over time.
Inflation or deflation in asset values clearly affects agricultural investments, particularly those in
land, over time. • Because of inflation, a dollar earned a year from now is less valuable than a
dollar earned today. • A dollar borrowed today can be paid back with cheaper dollars earned a
year from now.

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CHAPTER FOURE: FARM PLANNING AND BUDGETING

5.1.1. Definition of planning and Farm planning

Planning mean taking decisions in advance. It stimulates thinking, broadens understanding &
challenges the farmer to move forward. It is a forward-looking approach.

Farm planning is a process to allocate the scarce resources of the farm and to organize the farm
production in such a way that to increase the resource use efficiency, the production and the
income of the farmer.

Farm planning is a decision making process in the farm business, which involves organization
and management of limited resources to realize the specified goals continuously.

Farm planning is a basic but complex management function combining financial, physical and
technical aspects of the farm for selecting and developing the best of the alternative way of
achieving the stated objectives.
Farm planning is an integrated coordinated and advance program of actions, which seek to
present an opportunity to cultivators to improve his level of income. Farm planning a basic
management function that involves selecting a particular strategy or course of action among
alternative courses of action with the objective of obtaining the greatest satisfaction of the firm’s
goals.

5.1.2 Objectives of Farm Planning

The ultimate objective of farm planning is the improvement in the standard of living of the
farmer and immediate goal is to maximize the net incomes of the farmer through improved
resource use planning. In short, the main objective is to maximize the annual net income
sustained over a long period of time. The farm planning helps the cultivator in the following
ways:

a) It helps him examine carefully his existing resource situation and past experiences as a basis
for deciding which of the new alternative enterprises and methods fit his situation in the best
way.

66
b) It helps him identify the various supply needs for the existing and improved plans.

c) It helps him find out the credit needs, if any, of the new plan.

d) It gives an idea of the expected income after repayment of loans, meeting out the expenditure
on production, marketing, consumption, etc.

e) A properly thought of a farm plan might provide cash incomes at points of time when they
may be most needed at the farm. A farm plan is a programme of total farm activities of a farmer
drawn out in advance. An optimum farm plan will satisfy all the resource constraints at the farm
level and yield the maximum profit.

5.1.3 Why farm planning

Without planning, farm business decision would become random, ad hoc choices. The following
concrete reasons explain the paramount importance of farm planning.

i. Income improvement

Farm planning primarily concerned with making choices and decisions: selecting the most
profitable alternative from all possible alternatives, and seek to present an opportunity to
cultivators his level of income. It is this opportunity of income maximization that induces
farmers to adopt desirable changes. Such income maximization could be achieved from a given
bundle of resources by re-organizing present type of production as well as introducing changes in
technology.

ii. Focuses attention on the farm organization’s goals

Farm planning helps the manager to focus attention on the organization’s goals and activities.
This makes it easier to apply and coordinate the resources of the farm more effectively. The
whole organization is forced to embrace identical goals and participate in achieving them. It also
enables the farm manager to outline in advance an orderly sequence of steps for the realization of
organizations goals and to avoid a needless overlapping of activities.

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iii. Educational process

Farm planning is an educational tool to bring about a change in the outlook of the cultivators and
the extension workers. Knowledge of the latest technological advances in agriculture is a pre-
requisite for better farm planning; so farmers or farm managers keep their information up-to-date
through this forced action situation of farm planning process. This act is used as a self-educating
tool for the farmers. The farmers or farm managers can closely study their own business and see
more clearly their opportunities and limitations, thus, improving their managerial ability.

iv. Desirable organizational change

Planning helps to introduce desirable change in farm organizations and operations. In its broad
sense, it may mean any contemplated change in the method or practices followed on the farm.
The advantage of farm planning lies in its treating the farm as an operational unit and tailoring
the recommendation to fit into the individual farmers' opportunities, limitations, problems and
resource position.

v. Minimizes risk and uncertainty

By providing a more rational and fact based procedure for making decision; farm planning
allows managers and organizations to minimize risk and uncertainty.

vi. Facilitates control

In planning, the farm manager gets goal and develops plans to accomplish these goals. These
goals and plans then become standards or benchmarks against which performance can be
measured. The function of control is to ensure that the activities confirm to the plans. Thus,
control can be exercised only if there are plans.
Characteristics of a Good Farm Plan
A good farm plan generally should have the following characteristics:
a.An element of flexibility in a farm plan is essential to account for changes in the environment
around the farm.
b .Farm plan should maximize the resource use efficiency at the farm.
c) It should provide for the attainment of the objectives of profit maximization through optimum
resource use and balanced combination of farm enterprises.
d) Risk and uncertainty can be accounted for in a good farm plan.

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e) The plan helps in timely acquisition and repayment of farm credit
5.1.4 Who is to make farm plan
Planning technique can be applied to large commercial and small individual farms. On large
commercial farms usually highly trained manager will be employed and he/she may have the
assistance of technical and economic advisors in drawing up plans. However, in small individual
farms, it is the farmer who is expected to keep records and account to prepare his own plan; at
least to the extent of making some rough estimates on paper, otherwise they need to get
assistance from individual specialist for the purpose.

Individual farmers have many objectives. They want low risks, low investment, a certain amount
of leisure time, security, high net income this year and in future years etc. It is usually not
possible to maximize all these objectives at once. Maximum net income for 5 to 10 years from
now may be achievable only by sacrificing some net income in current and in the next few years.
High income usually involves greater risk than low one and will usually require heavier
investments. More leisure will usually be at the cost of lower earnings, etc. Different farmers put
different values on each of these. Therefore, if the plan is prepared by an outsider, he/she cannot
develop a suitable plan for a farmer without knowing how he wants to compromise his
objectives. Thus, one has to plan a farm with the farmer. Hence, the decision making should also
rest with the farmer because it is he who will gain or lose by implementing the decisions.
Moreover, the farmer would be more willing in implementing the decision made by himself than
when it is made by someone else for him.

5.1.5 The Steps of Farm planning

There are six steps in farm planning

1. Define the business opportunity/change

2. Swot analysis
3. Setting up objectives
4. Developing functional plans and budgeting
5. Implementation
6. Monitoring and adjusting.

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1. Define the business opportunity

This is mainly a process to acquire information relevant to the farm business. Technical and business
information is essential, Such as new technology of cropping and Livestock rearing, price trends, market
demands and potential capital resources. There has been much conjecture about why one person
recognizes an opportunity or problem and another does not. Basic findings suggest a preparedness or
frame of mind able to recognize and define new conditions or problems.

Several factors have been identified as being associated with competence in opportunity / problem
recognition Included are:

(a) Experience (growing up on a farm or having farming experience) ,

(b) Level of schooling (exposure to a broad range of ideas and approaches to problem solving),

c) Motivation by accomplishing a goal, and (d) willingness to take risk

2/ The Swot Analysis

SWOT analysis is concerned with the identification of specific views, feelings and information that is
directly collected from different sources such as customers, managers, labours, competitors, etc. Issues to
be identified include the strength or achievements, the weakness or constraints, the opportunities for
improvement and the threats which are considered as external negative forces which increase the risks of
failure. SWOT is therefore the abbreviation formed by the first letters of the words. Strengths ( s) ,
weaknesses (w) , opportunities ( o) and Threats ( T) . The SWOT analysis is to identify the internal and
external factors of a farm.

SWOT is a tool to help a manager /farmer to identify the advantages and disadvantages of a farm
undertaking by analyzing the internal forces (strengths and weaknesses) and the external forces
(opportunities and threats) that affect the development process/ production process

3 Setting up objectives

In would make little sense to start out on a trip without a pretty of idea where you are going.

The objective answer the question'' what are we trying to accomplish'' It gives purpose and direction to
decisions and actions. For planning purposes it is necessary that a farm's objectives specifically indicate
the direction in which the resources of the organization should be pointed.

70
They must be defined so as to serve as a measure of success or failure therefore, the importance of
objectives is ( a) set direction, (b) provide performance targets, and (c) constrain decisions. Objectives
should answer a number of fundamental questions about the farm’s future growth and development.

For example:

A/ what is the economic mission of the farm?

B/ what kind of business should be the farm be in?

C/ what goods and services should be sold?

D/ what markets should be served?

E/ what share of the market is desired?

F/ what are the profit objectives?

G/ The rate of growth are required in sales, profits, assets, and values of equity capital
investment.

Objectives, therefore establish a direction in which the management of the farm wishes to be heading. The
attainment of the objectives should be measurable in some way and ideally people should be motivated by
them.

4/ developing functional plans and budgeting

Functional plans include market, production, people and finance plan. To develop the functional plans we
have to follow the following steps:

a/ Resource inventory

b/ Identifying enterprises and resource requirements

c/ Budgeting

d/ Developing plan

5/ implementing the plan: select a plan and put it into operation. Once the planning process is completed
the best alternative must be selected and action taken to place the plan in to operation. The selected plan
should be implemented with all the efforts to meet the expected objective. It is important to recognize that

71
preparation and completion of the document itself is not the end of successful planning. This requires the
acquisition and organization of the necessary land, labour, machinery, livestock, and annual operating
inputs.

The contents and intent of the plan should be understood and accepted by all employees on the farm.
Clear responsibility and indexes should be assigned to specific person. The objective of the plan should
be closely related with the benefits of each department and individual. An important part of the
implementation function is the financing of the necessary resources. Since implementation can take time,
it must begin early enough that all required resources are available at the proper time. Information
system, including statistics system, technical testing system and accounting system, should be set up to
collect all necessary information for the farm management.

6/ Monitoring and adjusting

The operation plan is dynamic. It means the implementation of farm plan can be affected by the changes
in natural, social and economic conditions, which may not have envisaged in your original plan. The plan
should be monitored and adjusted constantly. It is important to recognize that preparation and completion
of the document itself and then implementing of the plan is not the end of successful business planning.
You now have the initial task of undertaking follow-up exercise and making adjustment if there is any
deviation from the original plan.

5.1.6 Techniques of farm planning

we are going to see the different techniques or tools used in farm planning. There are many
techniques or tools or models and aids available to a farm planner for generating answer to
multifarious farm management problems either separately or simultaneously. The various tools
and aids to farm planning

Production and organization planning tools

A. Perfect knowledge and certainty situation

1. Production function model 2 Farm budgeting technique

3. Linear programming 4. Non-linear programming
5. Dynamic programming 6. Integer programming

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B. Imperfect knowledge and risk situations

1. Modified programming Models 2. Diversification models

3. Probabilistic models 4. Game theory models

Administrative planning tools and aids

1. Farm technological coefficients (Input-output data) 2. Electronic accounting and data

processing facilities

3. Interdisciplinary research facilities 4. Metrological forecasting services

5. Management consulting agency 6. Commercial servicing

7. Contractual farming or operations

Marketing planning tools and aids

1. Demand and supply projection analysis 2. Future trading analysis

3. Marketing management research 4. Improved credit facilities

5. Price policies

5.2 Farm budgeting

A farm budget is a statement giving an estimate of all the farm receipts and expenses to be incurred for
the agricultural year. In other words, it is the expression of a farm plan in monetary terms by estimation of
receipts, expenses and net income of a farm or a particular enterprise is called budgeting.

Budgeting is a very simple and straight forward exercise, which can be used to select the most
profitable plan among a number of alternatives and used to test the profitability of any proposed
change in a plan. It is a way ‘try it out paper’ before a plan or a proposed change in a plan is
implemented. Therefore, farm planning and budgeting go side by side.

There are different types of budgeting, each of which is adapted to a particular size, purpose and
type of planning problems. Basically the following types of budgets are known to exist:

1. Partial budget,
2. Enterprise budget,
3. Whole farm (complete) budget.

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5.4.1. Enterprise Budget
An enterprises budget is a listing of all estimated income and expenses associated with a specific
enterprise to provide an estimate of its profitability. Therefore, one can develop an enterprise’s
budget for each actual and potential enterprise in a farm plan such as cotton, wheat, maize, beef
cows, dairy cows, and so forth.

The primary purpose of an enterprise budgeting is to aid in selection of inputs and enterprises
consistent with the resources available. In addition, it also aid to select combination (s) of
enterprises that will increase income from the farm business so that it can be included in the
whole farm plan because a whole farm plan often consists of several enterprises.

Although construction of an enterprise budget requires a large amount of data, once completed, it
could be used as a source of data for other types of budgeting. Several kinds of data are
necessary for budgeting, which includes:

• Physical input data (variable and fixed inputs) involved for production of a particular
enterprise,
• Field output data (yield per hectare at different level of input use),
• Price data for all inputs and outputs of that enterprise.
Table7. An example of enterprise budgets estimate for wheat production (1 hectare).

No. Item Unit Quantity Unit pice Value/ha

1 Revenue
Main product (wheat output) Qt. 50 250.00 12500
By product (straw) “ 30 60.00 1800
Total Revenue Birr 14300
2 Variable Cost
Seed Qt. 5 260.00 1300
Manure & fertilizer
Manure Qt. 50 20.00 1000
Inorganic fertilizer “ 4 260.00 1040
Chemical
Pesticide Kg 10 80.00 800
Fungicide “ 10 70.00 700
Machinery expense
Fuel Lt 50 4.00 200
Oil Kg 5 35.00 175
Lubricant “ 1 50.00 50
Machinery repair Birr 500.00 500

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 Labour
Normal Hr. 57 2.00 114
Peak season ” - - -
Contractual “ 30 3.00 90
Operating interest (@ 10% for 6 months) Birr 596.9
Total Variable Cost “ 6565.9
3 Gross Margin (1-2) 7734.10
4 Fixed Cost
Depreciation Birr 200.00 200
Interest on investment (10%) “ 20.00 20
Tax and insurance “ 100.00 100
Land charge “ 300.00 300
Total Fixed Cost “ 620
5 Total Cost (2+4) “ 7185.9
6 Estimated Profit (1-5) “ 7114.1

5.4.2. Complete Budgeting

The whole farm plan discussed earlier does not provide full and details information on sources
and amounts of income, types and amount of expenses, and the total expected profit for the farm
business using the plan. A whole farm budget is needed to provide additional details and the final
estimate of farm profit. Therefore, a whole farm budget is a summary of the expected income,
expenses, and profit for a given farm plan. It considers the cost and returns of all the crop and
livestock enterprises in order to drive the net return of the whole farm.

Table8. Example of whole farm budget showing projected income, expenses, and profit

No. Description
1 Income
Cotton 54000
Milo 43000
Wheat 13500
Stocker steers 40000
Total income 150000
2 Variable expenses
Fertilizer 11900
Seed 3600
Chemical 7900
Fuel, oil, Greases 4050
Machinery repair 2650
Feed purchase 1600
Feeder livestock purchase 29000
Custom machine hire 10250

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 Operating interest 7340
Miscellaneous 2450
Total variable expenses 80740
Gross margin (1-2) 69760
3 Fixed expenses
Property taxes 2600
Interest on debt 22000
Insurances 1250
Machinery depreciation 7200
Building depreciation 3200
Other fixed costs 3000
Total fixed expenses 39250
4 Total expense (2+3) 119990
5 Net farm income (1-4) 30510

5.4.3. Partial budgeting

Improvement in agricultural production technology is necessary for agricultural development.
Agricultural scientists usually develop new production technologies to improve farmers’ welfare.
Farm managers adopt new production technology that is economically superior to the existing
one(s). However, before changing from one production method to another, the farm managers
consider many factors, such as agro-ecological requirements, availability of required additional
production resources (labor, credit, skill, farmland, equipment etc.), additional costs, and
additional income resulting from the change. Particularly, farmers want to know the implication
of the proposed change on costs and incomes, or whether the extra incomes earned by changing
to the new technology justify the extra cost, etc. One of the tools in economics used to compare
the economic benefits of such a change is partial budget analysis.

Partial budgeting is the method of making a comparative study of costs and returns analysis resulting
from a small change or possible adjustment in the part of farm business plan.

Partial budgets do not calculate the total income and expenses for each of the two plans. Rather it
considers only those income and expenses which are affected by the proposed adjustment in the
plan.

A partial budget usually prepared to ascertain the effect on the net benefit of the farm due to a
small change in the farm plan such as:

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 ➢ Substituting one enterprise for another without any change in the entire farmland area, for
example, substituting 1 ha of soybean for 1 ha of maize.
➢ Changing to different levels of a single technology, for example, estimating the effect of
changing one level of N-fertilizer application to another in maize production on net
benefit
➢ Changing to different technologies, for example, changing from hand weeding to
herbicide use for weed control
The format used for computing a partial budget is:

Gain Cost

a) Additional income d) Reduced income

Expected additional returns that would accrue Returns that will no longer be received after the
from the change under consideration. change has been made.

b) Reduced expenses e) Additional expenses

The savings in cost which will no longer be Additional direct costs that would occur in
incurred if the changes are made. year’s business as a result of the change.

c) Total gain f) Total cost

Additional income (a) plus reduced cost (b). Reduced income (d) plus additional expenses
(e).

Net change (change in net income)

The difference between total gain (c) and total cost (f) is net farm income. A positive difference
indicates that the proposed change plan has higher expected net income than the base plan and
vice versa.

The example below illustrates how a partial budget can be used to analyze the decision to
substitute wheat for maize production. The farmer has observed that the expected wheat price for
the coming year appears to be somewhat more favorable than the projected maize price. Based
on this information, that farmer is considering decreasing his maize production by 40 hectare and

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increases his wheat production by the same amount. The available additional information used to
determine the profitability of the two alternative plans are:

▪ The farmer can produce 14 quintal of wheat and 18 quintal of maize per hectare.
▪ The farmer needs to use 3 quintal of wheat and 5 quintal of maize seed per hectare.
▪ The farmer needs to hire 41 and 47 hour of labour per hectare for wheat and maize
production, respectively.
▪ The farmer can earn an income of birr 170 and 140 per quintal from the sell of wheat and
maize products, respectively.
▪ The farmer costs birr 182.2 and 146.8 to purchase a quintal of wheat and maize seed,
respectively. In addition, the farmer requires to pay birr 4.25 for an hour of labour used
for wheat or maize production.
The question is to determine the profitability of the proposed plan.

Solution

Gain Cost

a) Additional income d) Reduced income

Increased wheat income Loss of maize income

14 qt. wheat output per ha.* birr 170 per qt.* 18 qt of maize output per ha.* birr 140 per qt. *
40 ha = 95200 40 ha = 100800

b) Reduced expense e) Increased expense

Reduced maize cost Additional wheat cost

5 qt. maize seed per ha.* birr 146.8 per qt.* 40 5 qt. wheat seed per ha.* birr 182.2 per qt.* 40
ha. = 29360 ha. = 21864

47 hr of labour per ha* birr 4.25 per hr * 40 ha 41 hr of labour per ha* birr 4.25 per hr * 40 ha
= 7990 = 6970

Total Reduced Expense = 37350 Total Additional Expense = 27834

c) Total Gain (a + b) = 132550 f) Total Cost (d + e) = 129634

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Net Gain = 132550 - 129634 = 2916

Conclusion: This analysis shows that the farmers could increase their returns from wheat
production by birr 2916 by substituting the available 40 hectare of maize land to wheat
production.

Thus, partial budget deals with such changes in the farm organization which can increase farm
income without changing the total farm organization. These minor changes (improvements) can
be affected in the total farm organization as and when necessary. The farmer would know the
total net benefit from the change, the details of what he should do at what cost and what he is not
to do after the change and come out with higher profits.

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CHAPTER SIX: FARM RECORDS AND ANALYSIS
6.1. Farm Record and Account

Records are statements of fact or data concerning a specific subject which may be specified in physical,
monetary, mathematical or statistical terms.

Farm records pertain to information recorded on the day-to-day operation of a particular farm.

Farm records can be defined as systematic documentation of all activities taking place in a farm enterprise
over a given period of time. It is an act of writing down every activity engaged in on the farm in every
production season and at different stages of the production process up to the final disposal of the goods
and services to the ultimate consumer.

Farm record keeping is more than just keeping track of what crop was planted in what field, it is a
concept applicable to the entire farm operation.

A complete farm record will include all daily activities and transactions and with a proper accounting
system it should be possible to have a complete estimate of the profit or loss statement at the end of the
year.

6.2 Purpose of farm records

The use of timely and accurate records can provide useful information and indications on the past, current
and future performance of the business. Without a proper understanding of record keeping and its current
and future implications, the farm operator will not make it very far in today’s business environment.
When used properly, good records can help a farmer to improve his performance, even though it may
already be of a high standard.

Specifically Records should be used to:

Evaluate past performance of the operation,

Provide a financial picture of the present situation, and
Serve as a planning guide for future decisions.

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 6.3. Types of farm records
Farm records system consists of two main (2) parts.

1. Physical Farm Records: - Non-monetary

- Essential to implement the financial records and financial decisions

a) Farm map

b) Land utilization records

c) Production and disposal record for crops livestock, poultry and others.

d) Labour records

Paid labour- hired - full- time

- Part-time

* Market wage rate is taken

Unpaid labour- operator (family) labour

* Opportunity cost is calculated

NB labour days used on crops and livestock enterprises can be recorded separately on monthly basis.

e) Machinery use records

f)Livestock and feed records

g) Stock (goods ready to sale) and store register

2. Financial Farm Records- expressed in monetary terms

✓ -Important to provide information regarding the profitability of the whole farm business over a
given period.
✓ All the cash incomes from the operation and expenditures to the operation are recorded
✓ Year day and mouth should be included
✓ Include the following

a. Farm inventory

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 - All kinds of goods purchased and consumed during the operation are recorded

- The es (increases) and es (decreases) in inventory also recorded

b. Farm cash or farm financial record

c. Classified farm cash accounts and annual business analysis (credit and debt accounts)

d. Capital asset and sale register e. Cash sale register

f. Credit sale register g. Wage register

h. Funds borrowed and repayment registers i. Purchase register

j. Farm expenses paid in kind register k. Non-farm income record.

Financial records track operating expenses, equipment, feed and seed purchases, fertility expense,
wages and salaries, depreciation expense and interest and loan payments.

Farm entrepreneurs need both sets of records to make good decisions about the health and future of the
enterprise. Financial Farm Records

• Income Statement:

• Balance Sheet

• Statement of Owner Equity

Income Statement

• This is a summary of revenues and expenses for a given accounting period.

• The difference between the revenues and expenses is called net farm income.

• A positive difference indicates a profit and a negative value indicates a loss.

• If accrual accounting is used, the necessary adjustments to reflect beginning and ending
accounting period differences, such as variations in inventories, accounts payables and
receivables, accrued expenses, etc, are included in the net farm income evaluation.

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• Producers who report net farm income on a cash basis should also compute their net income by
the accrual method in order to determine the true income of their farm business operation for each
year.

Balance Sheet

• It shows the status of the farm business assets, liabilities and owners’ equity at a specific time.

• It is a snapshot, and must be analyzed with reference to comparative prior balance sheets.

• • In summary, it shows what is OWNED (assets) and what is OWED (liabilities), and the
difference between them, which is called NET WORTH.

• The term “balance” comes from the requirement that the ledger be in balance through the basic
accounting equation of:

• Assets = liabilities + owner equity

• Asset is anything the firm owns that has value because can sell it and/or use it to produce sellable
goods

• Liquid assets: easy to sell, ready market for them (grain, livestock)

• Illiquid assets: hard to sell quickly at full value (machinery, land)

• Current Assets

• Cash, bank accounts, marketable funds, accounts receivable (money owed to you), inventories of
liquid assets: grain, feed, supplies, livestock

• Non-Current Assets

• Everything else: machinery, equipment, buildings, land

• Obligations or debts owed; any outside claims against one or more of your assets

• Current Liabilities

• Financial obligations due within 1 year

• Interest & principle on operating loans

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 • Accrued expenses: property and income taxes

• Non-Current Liabilities

• Everything else not due in the next 1 year

• Remaining balance on long-term debts

• It Measuring the financial position of a business at a point in time is done primarily through the
use of two concepts:

• Solvency: measures the liabilities of the business relative to the amount of owners’ equity
invested in the business.

• It also provides an indication of the ability to pay off all financial obligations if all assets were
sold.

• 2. Liquidity: measures the ability to meet financial obligations as they come due without
disrupting the normal operations of the farm business.

• There are three main ratios to analyze solvency:

1. Debt to Assets = Total liabilities/ Total assets

• This ratio measures what part of total assets is owed to lenders.

• This ratio should have values less than one and even smaller values are preferred.

2. Equity to Assets = Total equity /Total assets

• This ratio measures what part of total assets is financed by the owners’ equity.

• Here, higher values are preferred, but this ratio cannot exceed 1.0.

• Debt to Equity= Total liabilities /Total equity

• This ratio measures what part of the financing is provided by lenders in relation to what is
provided by the business owner.

• Smaller values are preferred and this ratio will approach zero as liabilities approach zero.

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 Two computations are used to analyze liquidity:

1. Current Ratio = Current assets /Current liabilities

• Ratio values larger than 1.0 are preferred.

• A value close to 1 indicates that although there are enough assets to cover current liabilities.

• Therefore, the higher the ratio value, the better.

2. Working Capital = Current assets – Current liabilities

• Working capital is not a ratio, it measures the dollars that would remain after selling and paying
all current liabilities.
• Negative working capital values, or values close to zero, generally indicate some sort of financial
distress.

• In any case, it is important to relate the amount of working capital to the size of the business.

Statement of Owner Equity

• The balance sheet shows the amount of owner equity at a point in time, but not what caused the
changes in this value over time.

• The statement of owner equity shows the sources of changes and the amount that came from
each source.

6.4 Methods of computing depreciation

Depreciation refers to the financial estimate of the annual loss of value of capital equipment due
to wear and tear over its useful life. The original cost of the asset is a prepaid expense. However,
if the asset is used in more than one accounting period, this cost will be allocated to those

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accounting periods that correspond to the productive life of the asset. Depreciation cost of an
asset can be computed using different methods. Some of these are:

1. The straight line method,

2. The reducing balance method,
3. Sum-of-the year digit method.
Straight line method

It is the easiest, simplest and usually very satisfactory for most purposes. This method assumes
that assets are used more or less to the same extent every year. Therefore, equal amount of costs
on account of their use can be charged over its useful life. Based on this method the annual
depreciation of the asset can be computed as:

Original cost − Salvage value

Annual depreciation =
Useful life of the asset

Where:

Original cost is the purchased price of the asset,

Salvage (scrap/junk) value is the value of the asset at the end of its useful life. It is zero if the
asset is completely worn out at the end of its useful life.

Useful life is the expected number of years that item will be used in the business.

Example: A fixed equipment costs birr 1000 and is expected to last for 5 years. The salvage
value of the asset after 5 year is birr 50. The annual depreciation cost using straight line method
is computed as:

1000− 50 950
Annual depreciation = = = 190
5 5

Throughout its useful life the asset depreciate by birr 190.

Reducing balance method:

It is a method that uses a fixed rate of depreciation each year and it applies the rate to the value
of the asset at the beginning of the year (book value). This means, a fixed percentage is deducted

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every year from the diminished balance till the asset reaches the salvage value. Here no further
depreciation is possible. Using the previous example of an asset costing birr 1000 and taking an
annual depreciation rate of 40 percent, the depreciation cost of the asset is given by Table 10.
The formula is: Annual depreciation = (Book value)×Fixed rate
Table10 Annual depreciation at 40% on reducing balance
Year Book value Depreciation Value
1st 1000.00 400.00 600.00
at the year end
2nd 600.00 240.00 360.00
3rd 360.00 144.00 216.00
4th 216 86.4 129.6
5th 129.6 51.84 77.76
The amount of depreciation is different at different stages and gradually diminishes with the life.
In this particular example the depreciation cost diminishes from 400 to 51.84 within 5 year of
useful life.
Sum-of-the year digit: In this method the annual depreciation is found out by multiplying a
fraction by the amount to be depreciated (cost minus salvage value). The formula is:
RL
Annual Depreciation = * (Originalcost − Salvagevalue)
SOYD
Where:
RL is remaining useful life
SOYD is the sum-of-the year digits’, which is simply the sum of the numbers 1 through the
estimated useful life. For example, for 5 year useful life, the SOYD is 15
SOYD for 5 year = 1+2+3+4+5 = 15

Table 11 shows the annual depreciation cost of an asset, costing birr 1000 with an estimated life
of 5 year and a scrap value of birr 50, computed using the sum-of-the year digit method.

Table11 Annual depreciation using sum-of-the year digit method

Year RL SOYD Depreciable Depreciation

1 5 15 950.00 316.67
2 4 15 Value
950.00 Cost
253.33
3 3 15 950.00 190.00
4 2 15 950.00 126.67

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 5 1 15 950.00 63.33

Definition risk and uncertainty

Risk - defined as a situation where all possible outcomes are known for a given management decision and
the probability associated with each possible outcome are also known. Probabilities are often assigned to
other events such as the probability of rain in a weather forecast or the outcome of a sporting event -
However they are subjective probabilities based on the judgement and experience of an individual. In any
situations the true or actual probabilities can't be determined subjective probabilities are the only ones
available, and they may vary from individual to individual.

Uncertainty- Defined as imperfect knowledge. We do not know when it occurs. Exist when one or both
of two situations exist for a management decision. Neither all possible outcomes nor the probabilities of
the outcomes are known. It is lack of knowledge about the state of the world at some future time. World
represents both economic and natural events. There is less uncertainty about tomorrow than is about a
year; hence less about a year than about ten years Long term farm-system planning is far more hazardous
than seasonal or annual planning.

With distinction b/n risk and uncertainty, most agricultural decisions would be classified by risk and
uncertainty. Given it all possible outcomes can seldom be accurately determined. The best that can be
done is to assign subjective probabilities. These are the decision maker's best estimate of the true
probabilities based on the limited information available and past experience is the same or similar events
and decisions.

7.1. Sources of risk (kinds of risk)

- Many but the most common sources are summarized as follows.

1. Production risk:- Some types of manufacturing firms know that the use of a certain collection of
inputs will always result in a fixed and known quantity of output. This is not the case in most agricultural
production processes, because we are highly dependent on nature.

E.g. crop and livestock yields are not known with certainty before harvest or final use. Some of the
factors, which yield production risk or which cannot be accurately predicted are:

➢ Weather condition ( rain fall, lack or excess)

➢ Crop disease, insects, weeds and infertile breeding livestock

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Even if the same quantity and quality of inputs are used every year, these and other factors will cause
yield variations which can't be predicated at the time most input decisions must be made. These yield
variations are an example of production risk.

2. Technical risk: - A risk due to a change in from old to new production technology.

o Will the new technology perform as expected?

o Will it actually reduce costs and/or increase yield?
These and other questions must be answered before adopting a new technology.

3. Price or marketing risk: - risk due to variability of input and output prices. A major source of risk in
agriculture is the variability of output prices. While farmers may feel they have some influences on yields
through their decision, prices are often beyond their control except possible through some type of
cooperative effort or government action.

Also includes a number of other factors as:-

▪ The level of future interest rates

▪ A lender's willingness to continue lending at the levels needed now and in the future.
▪ Market values of loan collateral, and
▪ The ability of the business to generate the cash flows necessary for debt repayment.
4. Institutional risk:- risk due a change in government policy. Like fiscal policy, monetary policy, land
reform policy, etc.

5. Others like Theft, fire, family illness

7.2. Strategies to reduce risk

There are about 3 general reasons why risk- adverse manager would be interested in taking steps to
reduce risk

1. To reduce the variability of income over time

2. To ensure some minimum income level to meet family living expenses and other fixed
expenses.
3. To survive the business/ to increase farmers capacity to bear the consequences of risk/
Possible strategies to reduce risk;

A. strategies to be adopted at farm level

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B. strategies to be adopted at government level

A. Farm level strategies

a) Selection of less risk enterprise b) Contract farming (to reduce price risk)

c) Share cropping d) Diversification (in crop-livestock, with in season)

e) Use of stable enterprise g) Maintaining flexibility over time and in durable asset

h) Keeping reserve food supplied, seed and fodder

i) Use of inter cropping, ex. maize and sorghum, because of that crops have different characteristics

j) Use of multiple cropping, double cropping

k) Use of soil conservation practices, use of irrigation, use of water harvesting technologies etc.

B. Government level strategies

a) Insurance (livestock, machine, crop etc.) b) Support pricing for output/ produce

c) Subsidy pricing of inputs- to boost production and productivity d) Institutional credit facilities
(micro financing)

e) Institutional market facilities and storage facilities (market information, spread sales over time,
seek better opportunities, arrange alternative out lets (channels)

f) Development of irrigation strategies

g) Promote agricultural research and extension ( to release short maturity period varieties, etc.)

C. Other Financial Risk Management Strategies

a) Maintain high equity ratio

b) Maintain credit worthiness

c) Maintain a cash reserve

d) Maintain current assets (assets that will easily change into cash)

E) Maintain social network (is deferent organization)

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f) Off-farm employment.

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