Principles of Agricultural Economics (AEC 201) - Lecture 3

Lecturer: Dr (Mrs.) C. S. Onyenekwe

TOPIC
Decision Making Units: The Firm
 Outline
• Introduction
• Definition
• Goals of Firm
• Factors of production
• Long run and shortun
• Production function
• Total physical product
• Average physical product
• Marginal physical product
 Definition of a firm
What is a Firm?
A firm is a business enterprise or organization that makes use of productive resources
to produce goods and services that are offered at the marketplace for the purpose of
making profit.
 Note that not every organization is a firm. The distinguishing factor is the goal of the
organization. Once the goal is profit maximization through the selling of goods and
services at the market, then it is a firm.
The ultimate role of every firm is value addition; transforming productive resources
(land, labour, capital, and entrepreneurship) into goods and services.
There are 3 fundamental decisions every firm needs to make:
 what product or combination of products to produce
 how to produce which involves the decision of the combination of inputs to use; and
 how much to produce which involves decisions on the volume of output
 Goals of a firm
The goals of a firm are those underlining objectives for which the firm is
established.
Traditionally, the most fundamental goal of every firm in neo-classical
economic theory is profit maximization.
Other goals are:
long term survival,
sales maximization,
maximization of the balanced rate of growth and
satisfying behaviour.
A firm can have more than one goal at a time. These goals are not
mutually exclusive.
 a firm’s behaviour will be influenced by what its objectives are
 Factors of Production
A factor of production is a productive resource. They are inputs in the
productive process used in manufacturing goods and services.
 In traditional neo-classical economic theory, there are four factors of
production namely;
land,
capital,
labour, and
entrepreneurship.
Land
The “gifts of nature” that we use to produce goods and services are land.
All the things we find on, in and under the land e.g. soil, water, natural gas, oil,
fish, trees etc.
The reward for land is rent.
 Factors of Production
Labour
Labour is the human resource that is an embodiment of the physical, intellectual capacities
and skills of the workforce.
The reward for labour is wage.
Capital
Man-made resources used for producing goods and services.
 They include buildings, fund, tools, machinery, vehicles, etc.
The reward for capital is interest.
Entrepreneurship
The human resource that organizes land, labor, and capital is entrepreneurship.
An entrepreneur is any person who takes the risk by employing other resources to produce
goods and services.
For example, a businessman, head of the shop, head of the factory etc.
It is also referred to as a specialized form of labour, and its reward is profit.
Time Periods in Production Process: Long run and short run
Before we look at this it is important to define what a fixed and variable
inputs are.
A fixed input is an input whose quantity is fixed for a period of time and
cannot be varied.
A variable input is an input whose quantity the firm can vary at any time
The long run is the time period in which all inputs can be varied.
The short run is the time period in which at least one input is fixed.
 For example, if a coffee bar became more successful it could serve more customers
per day in its existing shops, if there was space, increase the quantity of milk and
coffee beans it purchase, hire more staff, depending on conditions in the local labour
market, and purchase additional coffee machines if there was space to install them.
However, in the short run it could not extend its existing shops or have new ones
built. This would take more time.
 The Long run and short run
 The long run is a time period long enough for all inputs to be varied. Given enough
time, a firm can build additional factories and install new plant and equipment; a
coffee shop can have new shops built.

The actual length of the short run will differ from firm to firm and industry to industry.
It is not a fixed period of time.
 Production Function

Production function is the mathematical relationship between the quantity

of inputs a firm uses and the quantity of output it produces.
This can be represented as:
Y = f(X1, X2, X3.....,Xn)
where Y = quantity of output, X1....Xn are the quantities of different inputs
used in the production
Every production function refers to a definite period and depends on the
state of technology; every change in technology changes the production
function of a firm.
Three important concepts are illustrated by a production function: namely,
total physical product (TPP),
average physical product (APP) and
marginal physical product (MPP).
 Total physical product (TPP)
TPP is the total amount of output produced during a given period of time by all factors
of production.

Output, Y, is often termed total physical product (TPP), which is the same thing as total
product (TP)

Note that the emphasis here is on measurement in physical units such as kg, tonnes,
bushels and not monetary units.

Example: The first two columns of Table 6.1 and the top diagram in Figure 6.1 show how
total wheat output per year varies as extra workers are employed on a fixed amount of
land
Tabular and Graphical representation of Total physical product (TPP)
 Average physical product (APP)
This is total output per unit of the variable input used i.e.
TPP(Y)/X where TPP or Y is output and X is variable input
It is a form of measure of how technically efficient the variable inputs used
are.
 Marginal physical product (APP)
This is the extra output (∆TPP) produced by employing one more unit of the
variable input
i.e MPP= ∆TPP (Y)/∆X
where ∆TPP (Y) is change in output, ∆X is change in input
MPP represents the slope on the TPP curve
The law of diminishing marginal returns states that when increasing amounts
of a variable factor are used with a given amount of a fixed factor, there will
come a point when each extra unit of the variable factor will produce less extra
output than the previous unit.
Tabular and graphical representation of Average and Marginal
physical product (APP & MPP)
 Stages of Production
Stage 1: Increasing Returns
Here output is growing at an increasing rate. Every extra units of variable input
will produce additional output. The average product reaches its highest point
and is equal to the marginal product at point c when 4 workers were
employed.

A rational, price-taking firm will always operate beyond stage 1 because the
production per unit of the variable input is improving.

This means that it will pay the producer to keep adding more variable inputs in
order to maximize output.

the marginal product is greater than average product (MP> AP)

 Stages of Production
Stage 2: decreasing Returns
This is the most essential stage of production.
This stage begins at the intersection of the average product and the marginal
product; where the MP cuts the AP from above.
Here, output is increasing at a decreasing rate, and both average and marginal
product curves falling. Stage 2 starts from point c, where the marginal and
average curves meet and continue to point d, where the marginal product
becomes zero.
Stage 2 exhibits the optimum input/output combination for the price-taking
firm
 For a rational price-taking firm, this is the most profitable stage to operate
 In stage 2, the marginal product is lower than average product (MP < AP)
 Stages of Production
Stage 3: Negative Marginal Returns
In Stage 3, output is decreasing at a decreasing rate.
This stage begins where the MP curve is at zero; This point also corresponds
to the highest point of TP (where TP is maximum).
Here, total product starts declining and marginal product is negative.
This signifies that much more variable input is being used in the production
process compared to fixed inputs. Hence, variable units are being over-utilized
Stages of Production
 Conclusion to be drawn from the curves
The MPP between two points is equal to the slope of the TPP curve
between those two points.
 MPP rises at first: the slope of the TPP curve gets steeper.
 MPP reaches a maximum at point b. At that point the slope of the TPP
curve is at its steepest.
After point b, diminishing returns set in. MPP falls. TPP becomes less steep
As long as MPP is greater than zero, TPP will go on rising: new workers add
to total output.
At point d, TPP is at a maximum (its slope is zero). An additional worker will
add nothing to output: MPP is zero.
Beyond point d, TPP falls; MPP is negative