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Farm Management
Chapter 7Economic Principles
Choosing Production Levels
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Chapter Outline
• Marginalism
• The Production Function
• How Much Input to Use
• How Much Output to Produce
• Applying the Marginal Principles
• Equal Marginal Principle
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Chapter Objectives1. To explain the concept of marginalism2. To show the relation between a variable input and
an output by use of a production function3. To describe the calculation of average and marginal
physical products4. To illustrate the law of diminishing returns5. To find the profit-maximizing point using the
concepts of marginal value product and marginal input cost
6. To find the profit-maximizing point using the concepts of marginal revenue and marginal cost
7. To explain the use of the equal marginal principal
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Marginalism
The term marginal refers to incrementalchanges, either increases or decreases,that occur at the edge or at the “margin.”
It may help to mentally substitute “extra”or “additional” whenever the word marginallyis used. But keep in mind that the “extra”can be negative.
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The Production Function
The production function is a systematicway of showing the relation between different amounts of a resource orinput that can be used to produce aproduct and the corresponding output.
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Table 7-1 Production Function in Tabular Form
Total Average Marginalphysical physical physical
Input product product productlevel (TPP) (APP) (MPP)
0 01 12 12.0 12.02 30 15.0 18.03 44 14.7 14.04 54 13.5 10.05 62 12.4 8.06 68 11.3 6.07 72 10.3 4.08 74 9.3 2.09 72 8.0 -2.0
10 68 6.8 -4.0
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Total Physical Product
Total physical product (TPP) is theamount of production expected from using each input level. Output oryield is often called total physical product.
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Average Physical Product
Average physical product (APP) is the average amount of output produced per unit of input used.
APP = TPP
input level
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Marginal Physical Product
Marginal physical product (MPP) is the additional TPP produced by using an additional unit of input.
MPP = TPP
input level
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Figure 7-1 Graphical illustration of a production function
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Stages of Production
• Stage I: APP increasing, MPP>APP, TPP increasing
• Stage II: APP decreasing, MPP<APP, TPP increasing
• Stage III: TPP decreasing, MPP<0
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Law of Diminishing Marginal Returns
As additional units of a variable inputare used in combination with one ormore fixed inputs, marginal physicalproduct will eventually begin to decline.
Diminishing returns may start with thefirst unit of input used, or may startlater after a period of increasing returns.
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How Much Input to Use
• Do not produce in Stage III, because more output can be produced with less input.
• Do not normally produce in Stage I because the average productivity of the inputs continues to rise in this stage.
• Stage II is the “rational stage” of production.
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Marginal Value Product
MVP = total value product
input level
TVP = TPP × product selling price
If output price is constant:
MVP = MPP × product selling price
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Marginal Input Cost
MIC = total input cost
input level
TIC = amount of input × input price
If input price is constant:
MIC = input selling price
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Table 7-2 Marginal Value Product, Marginal Input Cost
and the Optimum Input Level
input price = $12; output price = $2
Total Marginal Total Marginal Marginalphysical physical value value input
Input product product product product costlevel (TPP) (MPP) (TVP) $ (MVP) $ (MIC) $
0 0 01 12 12.0 24 24 122 30 18.0 60 36 123 44 14.0 88 28 124 54 10.0 108 20 125 62 8.0 124 16 126 68 6.0 136 12 127 72 4.0 144 8 128 74 2.0 148 4 129 72 -2.0 144 -4 12
10 68 -4.0 136 -8 12
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The Decision Rule
MVP = MIC
If MVP > MIC, additional profitcan be made by using more input.If MIC > MVP, less input shouldbe used.
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How Much Output to Produce
An alternative way to find the profit-maximizing point is to find directly the amount ofoutput that maximizes profit.
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Marginal Revenue
MR = total revenue
total physical product
Total revenue = Total value product
If output price is constant:
MR = output selling price
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Marginal Cost
MC = total input cost
total physical product
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The Decision Rule
MR=MC
The decision rule, MR=MC, leads tothe same point as the decision ruleMVP=MIC.
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Table 7-3 Marginal Revenue, Marginal Cost and the
Optimum Output Level
Total Marginal Total physical physical Total input Marginal Marginal
Input product product revenue cost revenue costlevel (TPP) (MPP) (TR) $ (TIC) $ (MR) $ (MC) $
0 0 0 01 12 12.0 24 12 2.00 12 30 18.0 60 24 2.00 0.673 44 14.0 88 36 2.00 0.864 54 10.0 108 48 2.00 1.205 62 8.0 124 60 2.00 1.506 68 6.0 136 72 2.00 2.007 72 4.0 144 84 2.00 3.008 74 2.0 148 96 2.00 6.009 72 -2.0 144 108 2.00
10 68 -4.0 136 120 2.00
input price = $12; output price = $2
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Applying the Marginal Principles
Given prices for irrigation water andfor corn, the principles from the lasttwo sections can be used to determinethe amount of water and the correspondingamount of corn that will maximize profit.
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Table 7-4 Determining the Profit-Maximizing Irrigation
Level for Corn Production
Marginal Margianl Marginal Irrigation Corn yield physical value input Marginal Marginal
water per acre product product cost revenue cost(acre-inch) (bu) (MPP) (MVP) (MIC) (MR) (MC)
10 104.012 116.8 6.4 16.00 3.00 2.50 0.4714 128.6 5.9 14.75 3.00 2.50 0.5116 138.2 4.8 12.00 3.00 2.50 0.6318 144.8 3.3 8.25 3.00 2.50 0.9120 149.0 2.1 5.25 3.00 2.50 1.4322 151.8 1.4 3.50 3.00 2.50 2.1424 153.6 0.9 2.25 3.00 2.50 3.3326 154.2 0.3 0.75 3.00 2.50 10.00
water at $3.00/acre-inch, corn at $2.50/bu
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Equal Marginal Principal
In some situations an input may belimited so that the profit-maximizingpoint cannot be reached for all possible uses. A limited input shouldbe allocated among competing uses insuch a way that the marginal value products of the last unit used on eachalternative are equal.
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Table 7-5 Application of the Equal Marginal Principle to
the Allocation of Irrigation Water
Irrigation Grainwater Wheat Sorghum Cotton
(acre-inch) (100 acres) (100 acres) (100 acres)
04 1,200 1,600 1,8008 800 1,200 1,50012 600 800 1,20016 300 500 80020 50 200 400
Marginal value products ($)
Each application of 4 acre-inches on a crop is a total useof 400 acre-inches (4 acre-inches times 100 acres)
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Figure 7-2 Illustration of the equal marginal system
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Summary
Economic principles using the conceptof marginality provide useful guidelinesfor decision making. MVP and MIC areequated to find the profit-maximizing inputlevel. MR and MC are equated to findthe profit-maximizing output level. The equal marginal principle is used when alimited input must be allocated amongcompeting uses.
