CHAPTER THREE

Producer Decision making

3.1 Introduction
In this chapter particular attention will be given to:
(i) the factors which influence the supply of agricultural product
(ii) the factors which govern the usage of productive inputs (labor, fertilizer,
machinery, etc…)
(iii) the efficiency of resource use and
(iv) the impact of technological change.
Let us remind ourselves that these topics are central to the role of agricultural markets
and in particular to the design of effective development policies aimed at motivating
agricultural producers, mobilizing resources in the sector and spreading new
technologies. In this chapter we present the main elements of the theory of
agricultural production economics, which is concerned, with the allocation of scarce
resources to alternative uses.

Here the decision-making unit is either the firm in commercialized agricultural

production or the peasant in non-commercialized peasant agriculture.

Microeconomics provides few basic principles, laws and relationships applicable to

agricultural production and resource use. The following table summarizes these
fundamental relationships in agricultural production economics.

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 Box 4
Principles of Economics Explaining Management decision

1 Principles of Diminishing Factor-Product How much to produce?

Returns or Increasing costs relationship [optimal level of resource use]
2 Principle of substitution or Facto-Factor How to produce? [Least-cost
least cost combination relationship method]
3 Principle of opportunity Product–Product What to produce? [Enterprise
cost or equi-marginal relationship Selection]
returns

3.2 Physical and Economic Relationships of Agricultural production

Production in agriculture can be defined as the process of combining resources (labor,
fertilizer, mechanical implements….) in the creation of agricultural products. Producing a
ton of wheat, for example requires in addition to suitable climatic conditions, some amount
of arable land, seed, fertilizer, equipment such as ploughs, and human labor. From this, we
can understand that production varies in a systematic way with the level of input usage, and
economists call this relationship as production function, which mathematically can be
expressed as: Q = f (x1, x2,…,xn)
Where Q = quantity of specific product
x1,…,xn = quantities of n inputs used in the production process
The function purely states that output is related to the levels of input usage. The
production function is purely physical concept: it depicts the maximum output in physical
terms for each combination of specified input in physical terms. It relates to a given state
of technology. The technical aspects of production are discussed in terms of.
1. Factor- product relationships
2. Factor- Factor relationships
3. Product - product relationship

3.2.1 Factor-Product Relationship

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If it is assumed that all inputs except one (fertilizer denoted as x1) are held fixed, the
relationship between output and single variable factor can be denoted as:
Q = f (x1 / x2,…, xn )
The above relationship is represented by the Total Physical Product (TPP) curve in the
following figure. For inputs like fertilizer, irrigation water, weedicides, etc, one would
expect some level of output even if there were zero application of input and the graph
starts at some level above the horizontal axis. For other inputs like seed, labor or land, a
zero input would cause zero output and the production function begin at the origin of the
graph.

Qty of output

TPP
A
Q0

Stage 1 Stage 2 Stage 3

0 X’1 X01 X’’1

X1/x2…xn
Fertilizer input

APP and
MPP
Stage I Stage II Stage III

APP

X’1 X01 X’’1 X1/x2…xn

MPP

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The relationship states that as more of fertilizer (x 1) is applied, output (Q) increases until
maximum, associated with input usage (x’’1) is reached. Further application of fertilizer
will only serve to reduce the total output.
Three aspects of factor-product relationship will be of interest:
i) Marginal physical product (MPP)
ii) Average physical product (APP)
iii) Input elasticity (partial elasticity of production)

I. Marginal Physical Product (MPP) of the variable input

From the very beginning, we have noted that our production function is constructed
keeping other resources such as land, labour, and production technology constant. Under
such conditions though output grows with successive increases in fertilizer application,
the amount by which it grows changes because of the existence of fixed quantities of
resources

The concept, which measures the quantity of additional output obtained for each
successive additional input is called the Marginal Physical Product (MPP). It is defined
as the change in output resulting from a small change in the variable input expressed per
unit of the input; alternatively it is the slope of the total product curve at any point.
For a discrete change:
MPPx1 = ∆Q where ∆ signifies “change in”
∆x1

For an infinitesimal change:

MPPx1 = δQ where δ signifies “derivative of”
δx1

The slop of the TPP curve, i.e. MPP first increases and is maximum (the slope of TPP is
at greatest) at the point of inflection of the curve (x’ 1), it is zero at the point of maximum
TPP (x’’1) and becomes negative at input levels beyond x’’ 1. MPP curve slopes

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continuously downward reflecting lower and lower additional output for each successive
unit of input.
II. Average Physical Product (APP) of the variable input
There is a very important measure of productivity of factors of production the average
productivity. It is defined as total product divided by the total amount of the variable
input (fertilizer) used in production. APPx1 = Q 
x1

The APP is the slope of the line from the origin to the relevant point on the TPP curve
(A) at input level x01, where APPx1 = MPPx1, i.e., the slope of the TP curve equals to the
slope of a line from the origin at x01.

III. Input elasticity

Another important measure of the physical relationship between an output and a single
variable input is the input elasticity (partial elasticity of production). It is defined as the
percentage change of output resulting from a given percentage change in the variable
input.
E = % change in output
% change in input
E = dQ/Q = dQ*x1
dx1 /x1 dx1*Q

E = MPP *  1 = MPP

APP APP
The relationship between E, MPP and APP can be summarized as:
 The area of diminishing marginal returns on production function occurs When
MPP<APP, but it is not negative, i.e., 0< E< 1.
 E > 1 and E < 0 define areas of the production function in which it would not be
economically logical for the farmer to operate.

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- The first case (E>1) is because output grows more than proportionately with any
increase in input, which means the farmer could always gain by using more of the
input.
- The second case (E<0) is because output decreased as a consequence of using more
input and the farmer clearly does better by reducing input use.
When summarized, the discussion on the physical relationship of factors and products, all
production functions must satisfy two conditions to make economic justification
acceptable:
a. The MPP should be positive and declining, i.e. the equation should have a positive
first derivative [dQ/dx > 0]
b. The equation should have a negative second derivative [d 2Q /dx2< 0], i.e. the
response of output to increasing level of input must be rising but at a decreasing rate.
Notice that the TPP, MPP and APP curves have been divided into three stages. Since you
are very well familiar with these stages, let us remind you with the following summary:
 Stage 1 is defined to be that in which APP of x 1 is rising, and MPP is above APP.
With each additional units of fertilizer, more is being added to total product. In
this stage, the fixed input is not utilized efficiently.
 In stage 2 both APP and MPP of x1 are falling but are positive
 In stage 3 MPP of x1 is actually negative. In this stage additional units of fertilizer
reduce total product i.e. the marginal product of fertilizer is negative. The fixed
inputs are overloaded and the producer’s interest would be better served by using
less fertilizer (moving back out of stage 3).

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It would therefore be predicted that the optimum position in terms of variable input usage
will lie somewhere in stage 2
Given the production function Q = 2200 + 25x 1 - 0.10x12, where x1 is the variable input, fill in the TPP.
After constructing the APP and MPP equations, compute and fill the corresponding values in the blank
columns.

Units of
Fertilizer (x1) TPP (tones) APP MPP
A 0
B 25
C 50
D 75
E 100
F 125
G 150

Economic Optimum level of resource use

The most efficient level of variable input depends on the relationship between the price of
the input and the price of output. Then in deciding the economically optimal usage of a
single variable input, the farmer requires three pieces of information:
(i) the MPPx1, which indicates the contribution of the variable input to total
output;
(ii) the price per unit of the final product (Py); and
(iii) the price per unit of the variable input (Px1).

The value of an additional unit of the input to the producer is the extra revenue, which
will be forthcoming as a result of greater input usage. This is measured by the value
of marginal product (MVPx1) where:

MVPx1 = MPPx1*Py [When the farmer is price taker in competitive market]

Economic Optimum yielding maximum profit will be attained where the value of the
marginal product of the variable input is equated to its price:
MVPx1 = Px1; or MPP x1 = Px1
Py

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At the particular level of input usage associated with the optimal condition, the farmer is
said to be in equilibrium (no incentive to alter the production plan).

 When MVPx1 > Px1, an additional unit of the input would yield more to the
producer interns of extra revenue than it would cost, thus more profit would be
obtained if an extra unit were employed
 When MVPx1 < Px1, the last unit of the input employed contribute less to revenue
than it added to cost, hence less of the input should be used.

Activity??
To grasp a clear picture on the economic optimum of resource use, assume that the
market prices for the variable input (fertilizer) and the final product (maize) are $1.00 and
$0.10 per unit respectively. Now taking the information in the above activity, attempt to
find the level of input use (economic optimum) where the value of marginal product of
the variable input is equal to price of the variable input i.e.
VMPx1 = Px1; or MPP x1 = Px1
Py

3.2.2 Factor-Factor relationship

The physical interaction between inputs

Typically in a given production period, there would be more than one variable factor of
production. For example in the production of wheat, fertilizer, seed, and labor services
may be variable, while land and mechanical implements may remain fixed. Now our
main interest is in the relationship between output and the set of variable inputs and the
extent to which one variable factor may be substituted for another.

In this case, the idea that two or more variable inputs may be combined in different
quantities to produce the same output is called the principle of factor substitution (or the

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law of variable factor proportion). It applies whenever alternative combinations of input
can produce the same level of output.

Assuming two variable inputs, the production function is defined as:

Q = f (x1, x2 / x3…xn)

This relationship will be illustrated by an isoquant map (or iso-product curve). It is a

contour line or locus of different combination of the two inputs, which yield the same
level of output.

Qty of x1

A
X10

X11 B Q = 15
Q = 10

Qty of x2
X20 X21

From the above figure one can easily understand that both the input combination at point
A and that at point B can produce ten units of output.In moving from A to B, the amount
of x1 decreased from x10 to x11 and that of x2 increased from x20 to x21, i.e., x2 substitute for
x1.

The rate at which one input substitutes for another at any point on the isoquant is called
Marginal Rate of Substitution (MRS) and it can be measured as the slope of the isoquant
curve. MRS measures the rate at which one input must be substituted for the other if
output is to remain constant.

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 Numerically, MRS of x2 for x1 = ∆x1 or δx1
∆x 2 δx2

MRS is negative since more usage of one input is associated with less of another, i.e., the
isoquant is downward sloping. However, the negative sign is often omitted.

Isoquants are convex to the origin. This means that MRS tends to diminish as more of
one factor is used to replace the other. The Diminishing Marginal Rate of Substitution
(DMRS) results from the principle of Diminishing Marginal Returns (DMR) which states
as substitution proceeds it requires more and more of input x 2, to replace a single unit of
x1 in order to maintain the same level of output.

There are different rates of substitution between inputs:

I. Decreasing Rate of Substitution, the input being increased substitutes for
successively smaller amount of the input being replaced. MRS of x 2 for x1 at
A is greater than at B

X1
A

B
Q

X2

II. Constant Rate of Substitution, the amount of x2 required to replace a unit of

x1 remains the same. MRS is constant

X1

=∞

X2
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 III. Complementary Substitutes, there are no substitution possibilities since the
inputs must be used in fixed proportions.

X1

=0

X2

However, the MRS as a measure of the degree of substitutability of inputs has a serious
defect in that it depends on the units of measurements of the inputs. A better measure is
provided by the elasticity of substitution () which is defined as:-

 = Percentage change in x1 /x2

Percentage change in MRS

This is a pure number, which is independent of units of measurement. The numerator is

the percentage change in input, the input ratio, or factor intensity

In the decreasing rate of substitution, the factor intensity at A in the figure above is
given by the slope of the ray (OA) from the origin to the isoquant. In the above diagram,
when we move from A to B, the ratio of x 1/x2 falls and as x1 intensive production is
replaced by an x2 intensive production. Similarly, the denominator is the percentage
change in MRS as we move along the Isoquant.

In constant rate of substitution, where inputs are perfect substitutes, the denominate for
MRS is zero, hence  = ∞. In complementary input, since inputs are in fixed proportion,
numerator is zero, hence = 0
Economic Optimum Level of Resource Combination

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To determine the appropriate level of input use when there are two variable factors of
production, a producer must know the rates at which input are exchanged in the market
[their relative prices] as well as the rates at which they can be exchanged in production
[their MRS].

To illustrate the former, we introduce iso cost line, which is the locus of all
combinations of two variable inputs, which the producer can purchase with a given cost
outlay.
X1
Co
Px1

Co = PX1X2 + PX2X2

Co X2
Px2
The slope of the isocost line is the ratio of input prices = (-) Px2
Px 1
The least cost combination of the two inputs occurs at a point of tangency between
isocost line (C0) and an isoquant line (Q). At this point the slope of the isocost line is
equal to the slope of isoquant.
X1

X2
At point A, MRS of x2 for x1 = (-) PX2
PX 1
Mathematical implications, in summary, on the factor-factor relationships can be looked as:

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 Y = f (X1, X2)
MPPx1 =  dy and MPPx2 =  dy  
dx1 dx2
Inverse ratios of MPP = MRS
MPPx1= dy . dx2 = dx2 = MRSx1x2
MPPx2 dx1 dy dx1
The inverse ratio of MPP of each input equals the inverse ratios of their prices. Therefore,
MPPx1 = P1 by cross-multiplying
MPPx2 P2
MPPx1 = MPPx2
P1 P2
Critical thinking
Assuming the reality in your locality, how do peasants choose the type of crops when there is
differences in soil type or differences in season (short or long rain) or when there will be
shortage or excess labor supply?

3.2.3 The Product-Product Relationship

(Enterprise choice or physical interaction between outputs)
Now our analysis is extended to the multi- product firm, since most farmers have a range
of alternative crops they could grow for a given availability of input. As an example we
can take the following:
 Growing two different successive crops with short growing seasons on the same land.
 Utilizing different kind of land for the crops most suitable to the different soils.
 The practice of mixed cropping which permits a fixed labor resource to cultivate
simultaneously several different crops.
It is assumed that the producer can produce two products, Wheat and Maize, each output
being produced by a set of n inputs.

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Production function for wheat and maize can be specified as:
QW = f1 (X1, X2, ……..,Xn)
QM =f2 (X1, X2 ……….Xn)
A Production Possibility Frontier (PPF) or [transformation curve] can illustrate the
production options, which are technically feasible for the above two production
functions. This curve is the locus of combination of outputs [wheat and maize], which
can be produced with a set of given inputs and assuming a particular state of technology.

PPF
Qty of W0 a

c
b

Qtity of M0
The slope of the PPF represents the Marginal Rate of Transformation (MRT) of Maize
for wheat
MRTMW =  QW
 QM
It is the amount of wheat on the vertical axis (dy 1), which can be obtained by giving up
one unit of Maize on the horizontal axis (dy2). In other words, MRT measures the
increase in y1 (wheat), which results from a small decrease in y2 (Maize).

It should be noted that an efficient farmer would chose to operate at some point on the
PPF. A point inside the PPF would mean an inefficient use of resources, since with the
same level of inputs, more of at least one of the product could be forthcoming specially in
the ab segment of the carve.

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Economic Choice of Enterprises
W Iso-revenue lines

W0

W*

1500
1000
500
M
M* M0
Iso-revenue lines are different combination of outputs (wheat and maize) which yield a
given levels of total revenue. The slope of the Iso- revenue lines equals the inverse ratio
of output prices. The slope is negative because for total revenue to remain constant
increased income from one output is associated with decreased income from the other.
The optimum combination of enterprise occurs at the point of tangency of an iso- revenue
line with the PPF, since any iso-revenue lines to the left of this point would represent
lower returns. Therefore, the optimal allocation point is at: W*. Pw + M*. Pw = 1500 birr
In General
Taking Y1 = f(X1) the single variable input, x, has two
Y2 = f(X1) MPPs, one for each function
MPP (y1) = dy1/dx1
MPP (y2) = dy2/dx1
The MRT of output y1 into output y2 is MRT12 that is equal to
MPPy1 = dy1 * dx1 = dy1
MPPy2 dx1 dy2 dy2
The MRT equals the ratio of MPPs for a given resources between the two enterprises.
MRT12 = P (y2)
P (y1)
Therefore at the optimum point,
= MPP(y1) = P(y2)
MPP(y2) P(y1)
= MPP (y1)*P(y1) = MPP(y2) *P(y2)
MVP (y 1) = MVP (y2)

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When the above mathematical applications are summarized, the optimum choice of
enterprise occurs when the Marginal Value Product (MVP) per unit of a variable resource
is equal in both enterprises. This is called the principle of Equal-Marginal Returns. It
says that a variable input should be transformed from one enterprise to another up to the
point where the MVP of each unit of the input is equal for both enterprises. The two
concepts mostly associated with the economic choice of enterprises are Opportunity cost
and Comparative advantage

A. Opportunity Cost: Opportunity cost of any resource may be defined as the maximum
income that the resource could have obtained in an alternative use. For example, if
farmland could earn more by turning into a holiday resort then the opportunity cost of
continuing to use it in farming is the income, which could have been obtained by leasing
it to a hotel resort.

B. Comparative Advantage: It refers to the physical resources best suited to the

production of different crops/livestock which exist in different locations e.g. at the level
of a single farm which has land of difference qualities, it makes sense to grow alternative
crops on the land economically best suited to each crop.

Both on-farm and off-farm sector comparative advantage may change over time due to:
a) Change in technology (new variety, equipment, etc)
b) Land improvement (drainage, irrigation, etc)
c) Change in relative input costs or output prices in different location
d) Changes in transport cost (opening of new roads)
e) Development of substitute outputs (synthetic fibers)

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