Chapter-3

Economic Principles Applied in

Farm Management Decisions

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• Basically farm management is the application of
agricultural sciences & economic principles to the
organization & operation of a farm business.

• The following are some of the basic principles applied in

making rational farm management decisions:

i. The principle of variable proportions

ii. The principle of cost
iii. The principle of equi-marginal return
iv. The principle of comparative advantage

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 1. Law of variable proportion (law of diminishing
returns)
• This law was developed by early economists to
describe the r/ship b/n output & a variable input
when other inputs are held constant in amount.

• The law states that

“as equal amount of one input is added to a
production process while all other inputs are held
constant, the amount of output added per unit of
variable input will eventually decrease”.

• The law suggests that there is some right amount

of variable input to use in combination with fixed
inputs. 3
 Cont…

• The producer should neither use too much nor too

little quantity of variable inputs.

• This law requires that method of production does not

change as changes are made in the amount of variable
input.

• It does not apply when all inputs are varied.

• This law can be explained with the help of the

following hypothetical data:
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 Cont…
Units of input Units of ΔX ΔY MP AP MVP M FC
(X) output (Y) (ΔY/ΔX) (Y/X) (MP.PY) (Px)

5 10 - - - 2 - 10
10 25 5 15 3 2.5 15 10
15 45 5 20 4 3 20 10
20 60 5 15 3 3 15 10
25 70 5 10 2 2.8 10 10
30 75 5 5 1 2.5 5 10
35 73 5 -2 -0.4 2.09 -2 10
40 69 5 -4 -0.8 1.725 -4 10

• If price per unit of input & output are birr 10 & 5

respectively, determine the optimum level of input use. 5
 Decision rule
• The optimum level of input use can be determined by using the
following criteria:

A. Marginal product = Price of factor i.e. ΔY = PX

Price of product ΔX PY

B. Value of added product = Value of added cost

ΔYPY = ΔXPX
– If ΔYPY > ΔXPX, more quantity of inputs can be used
– If ΔYPY < ΔXPX, quantity of variable input needs to be reduced
– If ΔYPY = ΔXPX, optimum level of input use is attained.
C. Marginal value product equals marginal factor cost
i.e. MVP = MFC or MP.PY = PX
• Therefore, the optimum input utilization level for the above
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 2. The principle of cost
• Cost of production refers to the total amount of fund used
for purchase of different inputs used in the production
process.

• Cost of production exists because the supplies of

productive resources are scarce & have market value.

• The costs of production usually calculated in relation to a

particular amount of product in a particular time period.

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 Cost categories
1. Explicit cost –those expenses that are actually paid by
the producers for purchase of different inputs in the
production process.
• It is the payments made to those outsiders who will
supply labor services, raw materials, transportation
services, etc. to the farm.

2. Implicit cost: it is the value of non-purchased inputs

owned & used by a farm in its own production activity.
• Eg: the salary of owner manager (farmer) of the farm;
depreciation cost of a building, interest foregone when
the owner uses his capital in his farm, etc. 8
 Cont…
• The value of implicit cost is estimated based on
opportunity cost of that input.
• Opportunity cost- is the value of the product which must
be given up in the next best alternative use of the
resources.
• Eg: suppose that, by using 1quintal of fertilizer, a farmer
can add birr 500 to the total revenue from wheat
production & birr 400 to the total revenue from maize
production.
– If that farmer fertilizes his maize, his opportunity cost is birr
500, which he has foregone by not fertilizing his wheat.
– On the contrary, if that farmer fertilizes his wheat, his
opportunity cost will be birr 400, which he has foregone by not
fertilizing his maize.
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 Accounting periods
• Based on the length of period of producing a product, planning/
accounting period can be divided into short run & long run.

Short-run is the period of time over which the amount of at least one
input cannot be changed.

• That means we have two major categories of inputs in this period:

fixed inputs and variable inputs.

• Consequently costs are of two types: fixed costs and variable costs.

Long-run is the period of time over w/c all factors of production can
be varied.

i.e. in the long-run, all inputs are variable and hence all costs are also
variable. 10
 Production Costs in the Short-run
A. Total Fixed Cost (TFC)-is cost associated with
using/owing fixed inputs.

• It is not affected by the level of output & can exist even

when there is no production.

• The fixed cost curve starts at some point above the

origin & it is horizontal.

• Eg: rent for land, rent for building or machinery, interest

on borrowed/own capital, etc.

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 Cont…

B. Total Variable Cost (TVC)-associated with the use of

variable input.
• It varies with the level of output.
• The TVC curve starts from the origin & it slopes
positively upwards.
Eg: costs for raw materials, transportation services, cost of
casual labor.
• TVC = Px. X

C. Total Cost (TC)- is the sum of TFC & TVC.

• The TC & TVC curves are parallel.
• The distance b/n the two curves is the amount of TFC.
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Cont…

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 Cont…

D. Average Costs
• are unit costs.
• In cost theory, there are 3 averages: AFC, AVC & ATC.

i. Average Fixed Cost (AFC)

TFC
AFC 
Q

• AFC will become smaller & smaller as the level of output

increases.

• AFC is down ward slopping throughout its entire length.

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 Cont…

ii. Average Variable Cost (AVC)

TVC
AVC 
Q
• For a given production function, AVC will initially
decrease, reaches a minimum & then increase as output
increases.
• The AVC curve is U-shaped.
iii. Average Total Cost (ATC)
ATC 
TC  AVC  AFC
Q
• ATC has also a U-shape curve.
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 Cont…
E. Marginal Cost (MC)-is an extra cost incurred by a firm while
producing an extra unit of output.

• It is the change in total cost as a result of the change in output by

one unit.
TC dTC
MC  
Q dQ
• MC depends on no way upon TFC.

• It depends on the change of TVC.

TC (TFC  TVC ) TFC TVC TVC

MC     Q  Q
Q Q Q

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 Cont…

• MC can be given by the slope of TVC or the slope of TC curves at

a given output level.

• MC also has U-shape.

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 The Relationship b/n Product & Cost Curves
• Suppose that we have one variable input of X & price of X
is Px. Hence, TVC=XPx.

increases, reaches a maximum & then declines, AVC first

declines, reaches a minimum & then rises.

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 Cont…
• Similarly, TVC PxX  X
MC    Px
Q Q Q
 1  Px
 MC  Px 
 MPx  MPx

• This implies that MC & MP are inversely related.

• As MP first increases, reaches a maximum & then

declines, MC first decreases, reaches a minimum &
then increases.

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• The MP curve lies above the AP curve in the region where the MC
lies below AVC.

• The MP curve lies below AP curve in the region where the MC

curve lies above the AVC curve.

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 The Economic Optimum

• If we use TC-TR approach, the economic optimum of

production is reached when the d/ce b/n TC & TR is
maximum.
• i.e. MC = MR.
• Profits are at maximum when output is at a level where
MC=MR.

• production of an additional unit is always profitable as

long as MC is less than MR because less is added to TC
than is added to TR.

21
 Cont…

• Production of an additional unit is always unprofitable

if MC > MR, since more is added to the TC than is
added to the TR.

• Therefore, there is a need to decrease production to the

point where MR=MC.

• Example: Based on the following table, determine the

profit maximizing output and the maximum profit if the
cost per unit of input(X) is birr 5 and the price per unit
of output(Y) is birr 3.

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 Cont…

• The economic optimum occurs at an output level of about 28 units, where

MC=MR =PY
• At this level, the total profit become birr 24.

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 Three rules used for making production decision in the short
run:
1. When selling price (P1) is greater than ATC profit can be
made and is maximized by producing where MR=MC.
2. When selling price (P2) is less than minimum ATC but is
greater than minimum AVC the income/revenue will not
be sufficient to cover total cost.
 It covers all variable costs with some left over to pay part of
fixed costs.
 The loss can not be avoided and will be somewhere between
zero and TFC.
 Production will continue and the loss is minimized by
producing where MC=MR.
 The point where selling price is equal to the minimum ATC
is called break-even point (B). 24
 Cont…

3. When selling price (P3) is less than minimum AVC the

income will not even cover the variable costs.
 The loss is minimized by shutting down.

 This would minimize the loss at an amount to

TFC.

 When selling price is equal to minimum AVC, the

loss is equal to TFC and the point is called as shut
down point (S).
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Cont…

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 The Law of Equi-marginal Returns
• 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 equi-marginal returns.
• The principle of equi-marginal returns states that profit
from the available limited resources can be maximized by
using the resources in such a way that the marginal
return (the marginal value product) of the last unit of
the resource used on each enterprise is equal.
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 Cont…

• Example: Suppose a farmer has birr 5000, which can be

invested to grow crops (wheat & barley) and raise dairy
& poultry. The farmer`s problem is to determine the
amount of capital that he should invest on each
enterprise to get the highest profit.

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• If the farmer follows the law of average returns, he will
invest the whole capital for production of wheat to get a
gross return of birr 6200 and a maximum profit of birr
1200.
• However, if the farmer follows the law of equi-marginal
returns, where the marginal return in each direction of
his investment are equal, he can get a gross return of birr
6750 and a maximum profit of birr 1750.

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 Cont…
• Therefore, the farmer should allocate birr 2000 for wheat
production, birr 1000 for dairy and birr 2000 for poultry
production, which results the maximum profit of birr
1750.

• The Table below shows investment allocation on the

three enterprises.

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 Cont…

• An allocation based on the equi-marginal return principle

has an opportunity cost concept.

• For example, in the above table, if the farmer allocates

the available limited capital as 2000 to wheat production,
birr 2000 for poultry production and 1000 for barley
production, the opportunity cost of the last 1000 is birr
1300 that could be obtained from using the money for
dairy production.

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 4. The Principle of Comparative Advantage
• Consider two regions of equal size: Region 1 & Region
2, both of which produce & consume two agricultural
products: maize & wheat.

• A region is 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 the production of these products.

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 Cont…
• 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 more efficient.

• Therefore, regional specialization in the production of

agricultural commodities and other products is explained
by the principle of comparative advantage.

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 Cont…
• 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
profits may be different in each region.
• Thus, it is relative yields, costs & profits which are
important for this principle.
• An illustration of this principle using yields is shown
below.
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 Cont…

 Region 1 has an absolute advantage in the production of both

crops because of the higher yields.

• However, Region 1 must give up 2.5 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 relative or comparative advantage in the production
of wheat, since it gives up less maize for a quintal of wheat than
Region 1.
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 Cont…
• Assume Region 1 specializes in maize production and
Region 2 in wheat production.

• Therefore, they will tend to specialize in producing the

product for which they have comparative advantage.

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• END OF THIRD CHAPTER

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