Chapter 3

Producer Decision-Making in Agriculture

3.1. Introduction
A production function expresses the relationship between an organization's inputs and its
outputs. It indicates, in mathematical or graphical form, what outputs can be obtained from
various amounts and combinations of factor inputs. In particular it shows the maximum
possible amount of output that can be produced per unit of time with all combinations of factor
inputs, given current factor endowments and the state of available technology. There are
numerous input-output relationships in agriculture because the rates at which the inputs are
transformed into outputs will vary among soil types, animals, technologies, rainfall amount and
so forth. Unique production functions can be constructed for every production technology. The
general production function can be portrayed below:

Y = f (X 1, X 2 , X 3 , X 4 ,.........X N ) ; Where Y is output, and X1, X2, X3, X4….Xn are inputs

required to produce the given quantity of output Y.

Alternatively, a production function can be defined as the specification of the minimum input
requirements needed to produce designated quantities of output, given available technology.

3.2. Fixed and variable inputs

Variable costs and fixed costs, in economics, are the two main types of costs that a company
incurs when producing goods and services. Variable costs vary with the amount of output
produced, and fixed costs remain the same no matter how much a company produces.

3.2.1. Fixed costs

Fixed costs are the costs associated with the business's products or services that must be paid
regardless of the volume you sell. Thus, a company cannot avoid fixed costs. Examples of a
fixed cost is overhead; these may include rent for the space a company occupies, such as office
space or a factory space. Below are few examples of the fixed costs:

o Depreciation: the gradual deduction of an asset's decline in value.

 o Amortization: the allocation of the cost of an intangible asset over a period of
time.
o Insurance: the liability insurance you hold on your business.
o Rent: the rent you pay on your office, factory, and storage space.
o Utilities: electricity, water, and other utilities.

Suppose Mrs. Lilian Mutoni has established a company that produces Mangoes juice. However,
she is renting a space for her factory as well as offices. She is currently paying Rwf500,000 per
month for the rent. Meanwhile, if her company does not produce any juice, she would still need
to pay Rwf 500,000 per month for the cost of renting a space.

3.2.2. Variable costs

variable costs are a company's costs that are associated with the number of goods or services it
produces. These are the costs directly related to the sales volume of a particular business. A
company's variable costs increase and decrease with its production volume. When production
volume goes up, the variable costs will increase. On the other hand, if the volume goes down,
so too will the variable costs.

Variable costs are generally different between industries. Therefore, it's not useful to compare
the variable costs of a car manufacturer and an appliance manufacturer, for example, because
their product output isn't comparable. So, it's better to compare the variable costs between two
businesses that operate in the same industry, such as two car manufacturers.

Variable costs can be calculated by multiplying the quantity of output by the variable cost per
unit of output. This calculation is simple and does not take into account any other costs such
as labor or raw materials. Examples of variable costs may include labor, utilities (water and
electricity), commission, packaging, and related raw materials for production. From the same
example above, suppose Mrs. Lilian Mutoni owns a company that produces Mangoes juice for
a cost of Rwf200 per liter. If she produces 1500 liters, then her variable costs will be
Rwf300,000. But if she decides not to produce any amount of juice, then she will not have any
variable costs. Similarly, if she produces additional amount of juice say 2500 liters; the variable
cost will increase to Rwf500,000.
3.3. Short-run and Long-run production

A firm’s production costs depend on the time frame over which the firm plans to produce
output. There are two decision time frames facing firms:
3.3.1. Short run

The short run is a time frame in which the quantities of some resources are fixed. In the short
run, a firm can usually change the quantity of labor it uses but not its technology and the
quantity of capital. The resources that cannot be changed are called fixed factors of production.
Fixed factors of production are the firm’s technology, capital, and management and are called
the firm’s plant. The factors that can be changed are called variable factors of production.
Variable factors of production include labor. To change output in the short run, firms must
change the quantity of variable factors it uses.
Short-run costs
Total Cost
o There are three total cost concepts:
o Total cost (TC) is the cost of all the factors of production used by a firm. Total
cost divides into two parts: total fixed cost and total variable cost.
o Total fixed cost (TFC): costs that do not change as output increases and are
incurred even if no output is produced at all, e.g. interest, depreciation, fire
insurance, land, capital, entrepreneurship etc.
o Total variable cost (TVC) is the cost of the variable factor of production used
by a firm whose costs do increase as output increases. These may include the
cost of labor, fertilizer, seeds, etc.
o Total cost = total fixed cost + total variable cost.

There are three average cost concepts:

 o Average fixed cost (AFC) is total fixed cost per unit of output. AFC = TFC 
Q. The AFC curve is downward sloping.
o Average variable cost (AVC) is total variable cost per unit of output. AVC =
TVC  Q. The AVC curve is U-shaped.
o Average total cost (ATC) is total cost per unit of output, which equals average
fixed cost-plus average variable cost. The ATC curve is U-shaped and lies above
the AVC curve. The vertical distance between the ATC and AVC curves is
average fixed cost.
o The MC curve intersects the ATC curve and the AVC curve at their minimum
points.

Graphical relations- Marginal cost and average costs curves

Cost

MC AC

AVC

AFC

Time

The Average cost curve is U shaped. The Marginal cost curve rise from below the average cost
curve and crosses it from where it is lowest. Where the MC is equal to Ac, which is where AC
is minimum, will be called a Break Even Point later. The MC is straight after crossing the
AC. It is a portion that depicts the behaviour of the supply curve. The Average Variable Cost
is lower than the Average Cost. This is obvious because the Average Cost is composed of the
Average Fixed Cost plus the Average Variable Cost. Therefore, it should be less or lower in
this regard. The MC cuts the AVC at its minimum point, which we shall call a shutdown point.
Shifts in the Cost Curves
Cost curves shift in response to changes in two factors:
o Technology.
A technological change that increases productivity shifts the product curves upward
and the cost curves downward. If a technological change results in the firm using
more capital, the average fixed cost curve shifts upward and at low levels of output,
the average total cost curve may shift upward. At large output levels, average total
cost decreases.
o Prices of factors of production.
An increase in the price of a factor of production increases costs and shifts the cost
curves upward. An increase in fixed cost does not affect the variable cost or marginal
cost curves (TVC, AVC, and MC curves). An increase in variable cost does not affect
the fixed cost curves (TFC and AFC). The total cost curves (TC and ATC curves) are
affected by a price change for any factor of production.

3.3.2. Long run

The long run is the period of time when all costs are variable. In the long run, the firm can vary
all of its inputs. The long run depends on the specifics of the firm in question—it is not a precise
period of time. If you have a one-year lease on your factory, then the long run is any period
longer than a year, since after a year you are no longer bound by the lease. No costs are fixed
in the long run. A firm can build new factories and purchase new machinery, or it can close
existing facilities. In planning for the long run, the firm will compare alternative production
technologies (or processes). The long run cost curve helps to understand the functional
relationship between output and the long run cost of production

Long-Run Cost

In the long run, the firm can vary both the quantity of labor and the quantity of capital.
When a firm changes its plant size, the firm’s scale changes and its cost of producing a given
output changes. When a firm changes the size of its plant, it might experience:
1. Economies of Scale
 Economies of scale is a condition in which, when a firm increases its plant size and
labor employed by the same percentage, its output increases by a larger percentage
and its average total cost decreases.
a. Economies of scale result from the specialization of labor and capital.
2. Diseconomies of Scale
Diseconomies of scale is a condition in which, when a firm increases its plant size
and labor employed by the same percentage, its output increases by a smaller
percentage and its average total cost increases.
3. Constant Returns to Scale
Constant returns to scale is a condition in which, when a firm increases its plant
size and labor employed by the same percentage, its output increases by the same
percentage and its average total cost remains constant.

The Long-Run cost curves

A long-run cost curve shows the minimum cost impact of output changes for the optimal plant
size in the present operating environment. The long-run cost curves are u shaped for different
reasons. It is due to economies of scale and diseconomies of scale. If a firm has high fixed
costs, increasing output will lead to lower average costs. However, after a certain output, a firm
may experience diseconomies of scale. This occurs where increased output leads to higher
average costs.
6.5 Long run equilibrium

Cost

LRMC

LRAC

Time

The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is drawn on the
assumption of their being an infinite number of plant sizes. It shows the firm’s lowest cost per
unit at each level of output, assuming that all factors of production are variable.
The LRAC curve assumes that the firm has chosen the optimal factor mix, for producing any
level of output. The costs it shows are therefore the lowest costs possible for each level of
output.

3.4. Isoquant

The prefix iso comes from the Greek isos meaning equal. Quant is short for quantity.
Therefore, an isoquant is literally a line representing equal quantities. Every point on the line
represents the same yield or output level, but each point on the line also represents a different
combination of the two inputs. An isoquant, in a two-input case, is a curve that shows all the
ways of combining two inputs so as to produce a given level of output (see diagram below).
Movement along an isoquant depicts a constant rate of output produced for each combination
of output.

Many combinations of same group of variables will result in exactly the same level of output
production. As one moves along an isoquant, the proportions of the two inputs vary, but output
(yield) remains constant.

There are many ways of producing a given level of output. You can use a lot of labour with a
minimal amount of capital. This is what we call labour intensive techniques. Alternatively,
you could invest heavily in capital equipment that requires a minimal amount of labour to
operate. This we called capital intensive techniques. Normally it will be any combination in
between. For most goods, there are more than just two inputs. For example, in agriculture, the
amount of land, water, and fertilizer can all be varied to produce different amounts of a crop.

Input K

Input L

An isoquant such as QQ slopes from the left downwards to the right. It is convex to the origin.
Any two isoquants do not cross each other. The slope of an isoquant changes at every point.
The slope is called the Marginal Rate of Technical Substitution (MRTS). Ideally, MRTS is a
measurement of how well one input substitutes for another as one moves along a given
isoquants.
Figure: Isoquant

Input K

Input L

A unique isoquant can be constructed for every level of output, and a family of isoquants can
be created to represent various output levels. It is called isoquant map (As shown by the
diagram above). Isoquants further from the origin represent greater amounts of output.

Characteristics of isoquants.

o The slope of an isoquant at any point represent marginal rate of input substitution
(MRITS). In the figure the slope of an isoquant at a given point shows the quantity of
capital that can be replaced by one extra laborer. The calculated rate of substitution of
labor for land is given in the third column of the table. It is obtained by dividing the
increase in land i.e the increase in hectares of land by the increase in labor.

o Isoquants generally have a negative slope. So, the slope of the curve is negative of the
marginal rate of input substitution. This is so because when we use more of one input,
we would expect to use less of other variable input in producing a given level of output.
a proportion of an isoquant which slopes upwards and to the right represent the
irrational area for production since the quality of output for the proportion of the
isoquant can be produced with less for both inputs.

o Isoquants for higher levels of output normally lie above and to the right of isoquant for
lower levels of output. This means that it requires more of either or both inputs to
produce more output.
 o Isoquants are convex to the origin. This means that the marginal rate of input
substitution diminishes as more of one factor is used to replace the other. In our example
each added unit of labor substitutes or replaces less land than the previous unit. The
reason for diminishing rate of substitution is that one input is rarely a perfect substitute
for the other. In our example labor cannot land and land cannot substitute labor to
produce maize. Some land and some labor must be used to produce maize.
o The spacing of the isoquant tells us the effects on TP of increasing inputs of both factors
together. If isoquants are equally spaced it means that there is a constant return as the
two inputs are increased together. Where isoquants get closer there are increasing
returns due to increased inputs for both factors. Conversely where isoquants become
further apart implies diminishing returns to increases in both inputs.

1.5. Isocosts

An isocost shows all the combinations of inputs that can be purchased, at given prices, for a
single amount of money. Iso is latin for the same. Isocost is a straight line joining same cost
that can purchase different combinations of inputs to produce the same level of ouput. It is
similar but not the same as a budget line we saw under indifference curves.

The slope of an isocost is the price of the input on the horizontal axis divided by the price of
the input on the vertical axis. An isocost parallel and to the right of another shows a higher
level of costs for higher combinations of inputs.

Figure: Isocost

Input K

. Input L
 1.6. Producers Equilibrium

The goal is of a producer either to produce as much output as is possible with a given amount
of money or to produce a given amount of output with as little money as possible. Both goals
can be represented by a diagram showing the interaction of isocosts and isoquants (analogous
to, but not the same as, the diagram showing budget lines and indifferences curves)

The input combination that maximizes production for a given cost or minimizes cost for a given
output is the combination at which the slope of the isocost is equal to the slope of the isoquant.

The equilibrium condition is again that the slope of the isocost must be equal to the slope of
the isoquant. It is at a point where the isocost is tangential to the highest possible isoqant. This
is the point where the producer will maximise output (highest isoquant) and minimise cost
(within the available resources defined by the isocost)

Figure: Combination between Isoquant and Isocost

Input K

k E

Input L

At point E the slope of the isoquant is its MRTS which is equal to the ratio of the marginal
product of the input on the horizontal axis to the marginal product of the input to the vertical
axis.

1.7. Law of diminishing returns

The law of diminishing marginal returns states that as units of a variable input are added to
units of one or more fixed inputs, after a point, each incremental unit of the variable input
produces less and less additional output. The law of diminishing marginal returns is a theory
in economics that predicts that after some optimal level of capacity is reached, adding an
additional factor of production will actually result in smaller increases in output. The law of
diminishing returns is not only a fundamental principle of economics, but it also plays a starring
role in production theory.

Successive addition of variable inputs on fixed in puts in production, will result in increased
output only to a point. After the point, further increase will result in less than proportionate
increase in marginal output. Through this relationship; the following are observed:
i. Law of constant marginal returns (productivity),
This is said to happen when each marginal unit of a variable input is added produces the same
level of output.
ii. Law of increasing marginal returns (productivity)
This happens if each marginal of a variable factor is added to the production brings more and
more quantity of output.
iii. Law of decreasing marginal returns (productivity)
This is where each unit of a variable input is added to production leads to less quantity of
output.

Below is the table explaining three relationships

Fixed input Variable input Total output Marginal Average

(say 1 acre of (fertilizer) (say bags of Output Output
land) maize) Y (
X
)
1 0 0 0 0
1 1 10 10 10
1 2 22 12 11
1 3 36 14 12
1 4 48 12 12
1 5 59 11 11.4
1 6 68 9 11.3
1 7 73 5 10.4
1 8 73 0 9.1
1 9 72 -1 8
In the example above consider a corn farmer with one acre of land. In addition to land, other
factors include quantity of seeds, fertilizer, water, and labor. Assume the farmer has already
decided how much seed, water, and labor he will be using this season. He is still deciding on
how much fertilizer to use. As he increases the amount of fertilizer, the output of corn will
increase. It may also reach a point where the output actually begins to decrease since too much
fertilizer can become poisonous. The law of diminishing returns starts to operate after the third
lot of fertilizer. The marginal output falls from 14 to 12. In fact, there can be a point where the
marginal output from an addition of fertilizer will be 0. This is at the eighth unit of fertilizer
used. After that point even total output will start to decline. Note also, that after the marginal
product has started to decline, the average output also follows suit. Ideally it starts to fall shortly
after the falling of the marginal output. Generally, the diminishing returns occur in the short
run when one factor is fixed (e.g. capital) because, in the long run, all factors are variable.

1.8. Total, Average and Marginal Products

The total product (or total physical product) of a variable factor of production identifies what
outputs are possible using various levels of the variable input. This can be displayed in either
a chart that lists the output level corresponding to various levels of input, or a graph that
summarizes the data into a “total product curve”. The diagram shows a typical total product
curve. In this example, output increases as more inputs are employed up until point A. The
maximum output possible with this production process is Qm. (If there are other inputs used in
the process, they are assumed to be fixed.)

Total Product

TP

Qm

Time

The average physical product is the total product divided by the number of units of variable
input employed. It is the output of each unit of input. If there are 10 employees working on a
production process that manufactures 50 units per day, then the average product of variable
labour input is 5 units per day.
The average product typically varies as more of the input is employed, so this relationship can
also be expresses as a chart or as a graph. A typical average physical product curve is shown
(APP).

The marginal physical product of a variable input is the change in total output due to a one unit
change in the variable input or alternatively the rate of change in total output due to an
infinitesimally small change in the variable input (called the continuous marginal product). The
discrete marginal product of capital is the additional output resulting from the use of an
additional unit of capital (assuming all other factors are fixed). The continuous marginal
product of a variable input can be calculated as the derivative of quantity produced with respect
to variable input employed. The marginal physical product curve is shown (MPP). It can be
obtained from the slope of the total product curve.

Because the marginal product drives changes in the average product, we know that when the
average physical product is falling, the marginal physical product must be less than the average.
Likewise, when the average physical product is rising, it must be due to a marginal physical
product greater than the average. For this reason, the marginal physical product curve must
intersect the maximum point on the average physical product curve.

Marginal,

Average Product

APP

MPP

The diagram if well drawn should show that the MPP cuts the APP where APP is maximum.
From the diagram we can revisit the law of diminishing returns again. These curves illustrate
the principle of diminishing marginal returns to a variable input. This states that as you add
more and more of a variable input, you will reach a point beyond which the resulting increase
in output starts to diminish. This point is illustrated as the maximum point on the marginal
physical product curve. It assumes that other factor inputs (if they are used in the process) are
held constant. An example is the employment of labour in the use of trucks to transport goods.
Assuming the number of available trucks (capital) is fixed, then the amount of the variable
input labour could be varied and the resultant efficiency determined. At least one labourer (the
driver) is necessary. Additional workers per vehicle could be productive in loading, unloading,
navigation, or around the clock continuous driving. But at some point, the returns to investment
in labour will start to diminish and efficiency will decrease.

Total Product

TP

Qd Qm

Marginal,

Average Product

APP

MPP
3.8.1. Three stages of production

The classical production function can be divided into three regions or stages, each being
important from the standpoint of efficient resources use.

Stage-I occurs when marginal physical product (MPP) is greater than average physical product
(APP). At this level; APP is increasing throughout this stage, indicating that the average rate
at which X is transformed into Y, increases until APP reaches its maximum at the end of Stage-
I.

Stage-II occurs when MPP is decreasing and is less than APP but greater than zero. The
physical efficiency of the variable input reaches a peak at the beginning of Stage–II. On the
other hand physical efficiency of fixed input is greatest at the end of Stage-II. This is because
the number of fixed input is constant and therefore the output/ unit of fixed input must be the
largest when the total output from the production process is maximum.

Stage-III occurs when MPP is negative. Stage III occurs when excessive quantities of variable
input are combined with the fixed input, so much, that total physical product (TPP) begins to
decrease.

1.8.2. Elasticity of production.

Elasticity of production can be applied to the production function or to the input-output

relationship. It is defined as a percentage change in output resulting from a percentage change
in input. Elasticity of production is denoted by EP and it can be represented in the equation
form as follows;

EP= ∆ Y/Y ÷ ∆X/X = ∆Y / ∆X. X/Y = MPPX/APPX

Where, ∆Y/∆X = MPPX, and Y/X = APPX

The point of diminishing returns occurs when MPPX=APPX and EP =1. The amount of
variable input at the point of diminishing returns is the minimum that would be rationally used
because the efficiency of the input is maximum at that point. Thus, using the definition of the
diminishing returns it can be said that even without input and output prices, input use will
always be extended to the point of diminishing returns. When the TPPX is maximum and
MPPX=0 EP is also zero.
Applications of Price Elasticity of Demand in Production

The concept of Price elasticity of Demand allows a firm to determine how to change price to
increase total revenue.

If the demand for the good produced by a firm is price elastic, the firm can decrease the price
to increase the total revenue as the quantity demanded will increase by a larger percentage.

If the demand for the good produced by a firm is unit price elastic, the firm cannot change the
price to increase the total revenue as the quantity demanded will change by the same
percentage.

In addition to firms, the concept of price elasticity of demand may be useful to the government.
The main source of revenue for the government is tax revenue. If the government imposes a
tax on a good, the cost of production will rise which will lead to a decrease in the supply. When
this happens, the price will rise which will lead to a fall in the quantity demanded. If the demand
for the good is price elastic, the quantity demanded is likely to fall by a large extent. As the tax
revenue is the product of the tax per unit of the good and the quantity, a large decrease in the
quantity demanded is likely to limit the amount of tax revenue which the government is able
to collect. Therefore, if the government wants to collect a large amount of tax revenue from
imposing a tax on a good, it should do so for a good with a price inelastic demand. Examples
of goods with a price inelastic demand include tobacco and alcohol due to their addictive
nature. The government may also impose a tax on a good to reduce the consumption. This is
generally a good which society deems undesirable and the government thinks people should be
discouraged from consuming, commonly known as a demerit good. Examples of demerit goods
include tobacco and alcohol. However, due to the addictive nature of tobacco and alcohol
which makes the demand price inelastic, a tax on these goods is likely to lead to a small
decrease in the quantity demanded. Therefore, for a tax on tobacco and alcohol to be effective
for reducing the consumption, the government should ensure that it is sufficiently high.

Applications of Income Elasticity of Demand in Production

The concept of income elasticity of Demand allows a firm to determine the future size of the
market for the good and hence its production capacity. Suppose that the income elasticity of
Demand for a good is positive. If a firm predicts an economic expansion which is a period of
time during which national income is rising, it should increase its production capacity in order
to be able to meet the higher demand when the economic expansion comes. Furthermore, the
higher the income elasticity of Demand is, the larger will be the increase in the demand and
hence the larger the extent the firm should increase its production capacity. Conversely, if the
firm predicts an economic contraction which is a period of time during which national income
is falling, it should decrease its production capacity to minimise excess capacity when the
economic contraction comes.

The concept of Income elasticity of Demand may enable a firm to determine how to formulate
its marketing strategy. Suppose that a firm sells two goods. Further suppose that one of the
goods is a normal good and the other good is an inferior good. If the economy is expanding
and hence national income is rising, the firm should focus its marketing strategy on the normal
good. Conversely, if the economy is contracting and hence national income is falling, the firm
should focus its marketing strategy on the inferior good.

Applications of Cross Elasticity of Demand in Production

The concept of cross-elasticity of demand allows a firm to determine how a change in the price
of a related good produced by another firm will affect the demand for its good. For example, if
a rival firm decreases its price, the demand for the good produced by the first firm will fall due
to the positive cross-elasticity of demand between substitutes. To avoid a decrease in sales, the
firm may need to decrease its price. However, if this is likely to lead to a price war, the firm
may consider engaging in non-price competition such as product promotion and product
development instead of decreasing its price. If a rival firm increases its price, the demand for
the good produced by the first firm will increase if it keeps its price constant. However, the
firm may not experience an increase in sales if it has no or little excess capacity.

The concept of cross-elasticity may enable a firm that produces two or more goods which are
complements to increase total revenue. For example, a telecommunications firm may reduce
the price of its mobile devices even if the demand is price inelastic. Although the revenue from
the sale of its mobile devices will fall as the quantity demanded will rise by a smaller
proportion, the demand and hence the revenue from the provision of its mobile network
services will rise due to the negative cross-elasticity of demand between mobile network
services and mobile devices. Therefore, the total revenue of the telecommunications firm may
increase.