Agrculutrale Economics

AGRICULTURAL ECONOMICS MODULE
CHAPTER ONE
1. The Role of Agriculture in Economic Development
1.1 Introduction
Dear distance learner! As you know agriculture plays a significant role for the over
all economic development of the less developed countries, like Ethiopia. It was
observed that the success stories of East Asia began their drive towards
industrializing by first developing the agricultural sector. Currently our country also
follows agricultural lead industrialization policy. It is clear that there is a strong
association between growth in agriculture and growth of GDP.
In this chapter we will see rural livelihood diversification and the role of agriculture
in the economic development of a country. Agriculture contributes to the economy in
a number of ways: product contribution, market contribution, raw material
contribution, foreign exchange contribution and etc. Agriculture also has a linkage
with the other sectors. Therefore, we will see the forward and backward linkage
effects of agriculture.
The discussions in this chapter are supported by questions and activities, There are
Summary and self assessment questions at the end of this chapter for your better
understanding of the chapter. You are advised to work on all of these access devices
since they are quite helpful in mastering the subject matter of the chapter.
Objectives:
After completing your study on this chapter, you should be able to:
 Define the term livelihood
 Explain reasons for rural livelihood diversification
 List and explain the contribution of agriculture for the over all economic
development
 Discuss the forward and backward linkage effect of agriculture with other
sectors.
ADAMA UNIVERSITY, DEPARTMENT OF ECONOMICS 1

1.2. Rural livelihood diversification

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Activity1.1
 Distance learner! How do you define livelihood in general and rural
livelihood
in particular?
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In line with the sustainable livelihoods framework, a livelihood is defined as “the

activities, the assets and the access that jointly determine the living gained by an
individual or household”. Rural livelihood diversification is then defined as “the
process by which households construct a diverse portfolio of activities and social
support capabilities for survival and in order to improve their standard of living.
The causes of the adoption by rural families of diversified livelihood are better
understood in terms of consideration of risk spreading, consumption smoothing,
labor allocation smoothing, credit market failures, and coping with shocks can
contribute to the adoption, and adaptation over time, of diverse rural livelihood.
Less developed countries agriculture is nature dependent. When ever there is

drought, flood and other natural calamities there are low yields. Involvements in
other income generating activities, such as trade, wage work, and other off farm
activities are used for risk spreading. Family labor demand of agriculture is not
uniform throughout the year. During harvesting time there is high demand for labor
power but during off seasons there is no much demand for labor power. During this
time farmers engage in other activities and diversify source of income. Therefore, by
doing so rural farm households diversify rural livelihood.

1.3 Contribution of Agriculture

Development economists have been accused of “urban bias” during 1950s as they
strongly pushed the development of other industry as the key to overall economic growth
and development. The problems encountered to sustainable industrial development in
developing countries coupled with the inability to alleviate the poverty of the majority of
the population residing in rural areas has forced to look back at the issue of agriculture
and its role in poverty reduction and overall economic development.
It was observed that the success stories of East Asia began their drive towards
industrialization by first developing their agriculture sector. This brought a clear
consensus that the strategy of industrialization during 1960s and 1970s could only be
successful because of agricultural productivity and farm income was significantly
increased in the initial phase of industrialization. This consensus emerged as a result of
thorough theoretical and empirical research on the potential contribution of agriculture to
the industrialization effort
It is clear that there is a strong association between growth in agriculture and growth of
GDP. The parallels between agriculture and GDP growth suggest that the factors that
affect agriculture performance may be linked to economy wide social and economic
policies. Expanding agricultural production through technological change and trade
creates important demand for the outputs of other sectors, notably fertilizer,
transportation, commercial services and construction. At the same time, agricultural
households are often the basic market for a wide range of consumer goods that appeared
to be large in the early stages of industrial development, such as textiles and clothing,
processed food, kerosene and vegetable oils, and construction materials for home
improvements.
The following are the economic benefits that come in the way of industry from a
growing and productive agriculture, coupled with the immediate concern of alleviating
poverty as the initial force that pulls the wheels of economic growth and development of
developing countries.

? Dear distance learner, list what you think are contributions of agriculture for the over all
economic development of a country
(You can use the space left below to write your answer)
 _______________________________________________________________________
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Good! We hope that you have listed some of the contributions of agriculture. Here are
some of the contributions that you might have not listed.
Product Contribution
Expansion of non-agricultural sectors is strongly reliant on agricultural sector, not only
for a sustained increase in the supply of food but also for raw materials used in
manufacturing products. The domestic farm sector is the principal source of food for
consumption by growing numbers of non food producers employed in industry. In
general product contributions of agriculture are:
 Food for the industrial work force (thus avoiding deterioration of the terms of
trade for industry)
 Raw materials for agro-processing industries
 Export earnings that pay for imported capital equipment and intermediate inputs
Food Market Linkage

For both micro and macroeconomic reasons, no country has ever sustained the process
of rapid economic growth without first solving the problem of food security. At the
micro level, inadequate and irregular access to food limits labor productivity and the
income per capita and further reduces investment in human capital. At the macro level,
periodic food crises undermine political and economic stability, reducing both the level
and efficiency of investment.

Raw Material Contribution

The importance of agricultural raw materials for industry is extensively documented.
Once food supply is secured, the agricultural market surplus is available as input for
domestic agro-processing industries, which is used for consumption or production of
intermediate goods. A domestic supply of raw materials stabilizes fluctuations in the
availability and prices of imported inputs. Moreover, it saves foreign exchange. Thus, it
promotes self-sustained development of the industrial sector, particularly in the early
stages.
Foreign Exchange Contribution
? Dear distance learner! Many countries export different goods and earn foreign
exchanges. What are the main export earnings of less developed counties in general and
Ethiopia in particular?
(Use the space left below to write your answer)
 _______________________________________________________________________
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Developed countries export industrial products to the rest of the world. Therefore, main
export earnings of developed countries are export of industrial products. Unlike
industrial countries, developing countries export agricultural products. So, main export
earnings of less developed countries, like Ethiopia, are agricultural products. Ethiopia
exports coffee, oil seeds, live animals, flower, and other agricultural products.
Activity 1.2
 Do you think that there is some relationship between food supplies and inflation in
the less developed countries? How responsive is agricultural product supply to
the
change in agricultural product prices?

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Food Supplies and Inflation

There are a number of arguments linking food supplies with inflation in LDC’s
a. Because in LDCs supply bottlenecks are more characteristic than underutilized
productive capacity due to deficient demand, the effect of income augmenting
polices, such as employment creation, may result in excess demand and inflation,
rather than higher real output
b. Because agricultural product prices are largely determined by market forces and
because the demand for most food products is relatively price inelastic, excess
demand for agriculture and food products generally results in steeply rising
prices
c. Although industrial product prices tend to be “administered” by firms rather than
being determined by the market, they are usually inflexible downward (due to
trade union resistance to wage reduction). However, because higher food prices
are likely to result eventually in higher industrial wages, industrial products
prices can also be expected to rise after a time-lag.
Capital Contribution
This refers to the transformation of capital resources from agricultural sector to non-
agricultural sectors. Because the incremental demand for capital resources in the non-
agricultural sector is high in developing economy.
The other argument is also the assumption that agricultural sector is the sole domestic
source of saving and investment during the initial stage of development since it is the
dominant sector in the economy of less developed counties.
A higher income for rural population means higher potential rural saving, which
provided that there are adequate financial institutions, can be geared forwards
investment in the industrial sector that is constrained by lock of capital
Labor Contribution

Transfer of labor from agricultural sector is subject to the constraint that agricultural
labor is redundant in the sector. The migrant of redundant agricultural labor form rural to
urban areas is taken as potential industrial workers. Availability of surplus agriculture
labor in LDCs is supposed to take the form of disguised unemployment. With the
existence of redundant labor in the sector, some agricultural workers could be withdrawn
from the sector with no consequent fall in aggregate agricultural products. The increase
in labor productivity in agriculture would necessarily mean a decrease in marginal
productivity of labor in the excess population residing in rural areas leading to migration
to the cities looking for urban wages. This in turn will increase the supply of labor to
industrial sector easing the pressure on wages.
1.4 Linkage Effect of Agriculture (Backward and Forward linkages)

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Activity 1.3
 Do you think that agriculture has linkage effect with other sectors in the
economy? If agriculture has linkage with other sectors of the economy, what
type of linkage does agriculture have with other sectors of the economy?
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The broader view of agriculture’s product contribution via related industries leads on to
an application of the concept of inter-industry linkage (which describes inter-sectoral
inter-dependence). Formally expressed, inter-sectoral production linkage measures the
effect of an autonomous increase in final demand for the products of a given industry not
only on the output of that industry but also the outputs of yet other industries.
Distinctions may be made between backward, forward and total linkages. Backward
linkage measures the ratio of intermediate inputs purchased from other industries to a
particular industry’s total value of production; forward linkage measures the ratio of
intermediate output sales to other industries to a particular industry’s total sales
( including sales to the final consumption); total linkage is the sum of backward and
forward linkages. Thus a hypothetical industry which purchased nothing from other

industries and sold the whole of its output directly for final consumption would register
zero coefficients for its backward, forward and total production linkages.
In practice, even in developing countries, virtually all industries add values to some
quantity of purchased inputs, as well as selling a proportion of their output in the form of
intermediate output. Hence the linkage effects are non-zero and positive.
Figure1.1: Forward and backward linkage effect of agriculture
Forward linkage
effect of agriculture
Output sold to other

Sectors
Other sectors of
Agriculture sector the economy
Input purchased
from other sectors
Backward linkage
effect of agriculture

Summary
Livelihood is defined as the activities, the assets, and the access that jointly determine
the living gained by an individual or households. Rural farm households diversify
income or livelihood. The reasons for rural livelihood diversification are risk spreading,
consumption smoothing, labor allocation smoothing, credit market failures, and coping
with shocks. Agriculture contributes to the economy in a number of ways: product
contribution (food for the industrial work force, raw material for agro-processing
industries, and export earning that pays for imported capital equipments). The
agricultural population is also a market for the industrial sectors and agriculture
contributes capital to the other sectors. The surplus agricultural labor move to the
industrial sectors for better job opportunity and therefore, agriculture contributes labor
power in addition to capital.
Agriculture sector is linked with the other sectors in different ways. Agriculture supplies
its products to the other sectors (forward linkage effect) and agriculture also buys other
sectors’ product like fertilizer, chemicals, farm equipments and the like (backward
linkage effect). Total linkage effect is the sum of forward and backward linkage effect.
Virtually all industries add some values to purchased inputs and sell proportion of their
output in the form of intermediate output. Hence, for most industries the linkage effects
are non-zero and positive

Checklist
√
Dear learner! Below are some of the most important points drawn from the chapter you
have been studying. Please put a tick (√) mark in front of the point you have understood
well in the box under “Yes” and in the box under “No” for points you have not
understood well yet. And if the tick marks under “No” are more than those under “Yes”
it means you are left with a lot to understand the unit and you have not yet achieved the
objectives indicated at the beginning of the unit. This tells you to go back and read the
sections you passed through.
I can: Yes No
1. Define the term livelihood
2. Discuss the concept of livelihood diversification
3. List and explain product contribution of agriculture
4. Discuss the food supplies and inflation linkage
5. Identify main export earnings of developing countries
6. Explain forward and backward linkage of agriculture

SELF ASSESSMENT QUESTIONS

Part I: Multiple Choice Questions
Direction: This part consists of multiple choice questions. Read the questions
carefully and encircle the letter of your choice.
1. From the following alternatives, which can be the best definition of livelihood
A. the activities, the assets and the access that jointly determine the living
gained by an individual or household
B. the living gained from farm production
C. the living gained from the sales of agricultural products
D. income earned from the sales of assets
2. The reasons for rural livelihood diversification are:
A. risk spreading,
B. consumption smoothing,
C. labor allocation smoothing,
D. Credit market failures, and coping with shocks.
E. All of the above
3. Which of the following is not true about contribution of agriculture in an
economy?
A. Product contribution
B. Raw material contribution
C. Labor contribution
D. Capital contribution
E. None of the above
4. There are a number of arguments linking food supplies with inflation in less
develop counties (LDCs). Which one of the following can be an argument
linking food supplies with inflation.
A. Because in LDCs supply bottlenecks are more characteristics than
underutilized productive capacity due to deficient demand.
B. Because agricultural product prices are largely determined by market forces
and the demand for most food products is relatively price inelastic

C. Higher food prices are likely to result eventually in higher industrial wages,
following this wage increase, industrial product prices can also be expected
to rise after a time-lag
D. All of the above
5. Which of the following is not considered as the economic benefits that come in
the way of a growing agricultural sector?
A. Raw materials for industry
B. Food for the industrial work force
C. Markets for industrial products
D. Export earnings
6. Which of the following is/are not true statements?
A. There is strong association between growth in agriculture and growth of
GDP
B. There is transfer of capital resources from agricultural sector to non
agricultural sectors because there is high capital resource demand in non
agricultural sectors
C. Inadequate and irregular access to food limits labor productivity, income per
capita and further reduces investment in human capital
D. None of the above
7. If agriculture sells all its products to consumers directly, its forward linkage
effect coefficient is
A. zero
B. greater than zero
C. less than zero
D. indeterminate
8. _________measures the ratio of intermediate inputs purchased from other
industries to a particular industry’s total value of production;
A. Forward linkage
B. Backward linkage

C. Total linkage effect

Part II: True or False Type Questions
Direction: For the following statements write “true” if the statement is true or
“false” if it is not true statement
1. Expanding agricultural production through technological change and
trade creates important demand for the outputs of other sectors,
2. Developing countries have to develop their agriculture because there is a
strong positive correlation between growth in agriculture and growth of
GDP.
3. Most developing counties, like Ethiopia, mainly imports agricultural
products
4. No country has ever sustained the process of rapid economic growth
without first solving the problem of food security.
5. Agriculture in developing countries has both forward and backward
linkage effect. But in developed countries agriculture has only forward
linkage effect.
6. A domestic supply of raw materials by the agricultural sector stabilizes
fluctuations in the availability and prices of imported inputs.
Part III: Discussion Questions
For the following questions give your answer briefly
1. Discuss the labor and capital contribution of agriculture to the other
sectors in the economy
2. There are a number of arguments linking food supplies with inflation.
Discuss the arguments linking food supplies with inflation in less
development countries.
3. What contribution can agriculture make to Sub-Saharan African
country’s development?
4. Discuss the forward and backward contribution of agricultural in
Ethiopian economy

CHAPTER TWO
2. Economics of Agriculture (Farm Production)
2.1. Introduction
This chapter discusses the basic tools of analysis of the neoclassical economic theory of
farm production. The theory begins with the farmer as an individual decision maker
concerned with question such as how much labor and other resources to devote to the
cultivation of crops. This is the theory of farm production, which is the varying level of
outputs corresponding to different levels of variable inputs. Farm production decision
also requires factor-factor relationships- the varying combination of two or more inputs
required to produce a specified output.
Farmers in less developed countries involved in the production of many crops and
livestock, given limited resources of the farmer. Therefore, we will see the product-
product relationship or enterprise choice. There are risks and uncertainty in farm
production and therefore risk and uncertainty are discussed under this chapter. This
chapter is almost similar to the theory of production that you have learned in the course:
Microeconomics I. If some of the points are not clear to you, you are advised to refer
your lecture note on Microeconomic I. There are questions, activities in each part of the
chapter and finally there are self assessment questions. You are advised to work on all
these access devices to understand the subject matter of the chapter.
Objectives:
Upon the completion of this chapter you will be able to:
 Define production function
 Determine the optimum level of resource use given production function and
factor costs
 Determine best input combination that minimize cost of production
 Define the best enterprise combination using linear programming approach
 Explain risk and uncertainty from the point of view of farm production.
 List types of uncertainties in farm production.

2.2. Theoretical Foundation: Neo-Classical Theory of Farm Production

Farm decision making
Dear distance learner! This chapter sets out the basic tools of analysis of the neoclassical
economic theory of farm production. A grasp of these analytical tools is indispensable
for understanding a wide range of topics and debates in the economics of peasant
agriculture. They are applied and extended in many different ways in later chapters of
the module
The theory begins with the farmer as an individual decision maker concerned with
questions such as how much labor to devote to the cultivation of each crop, whether or
not to use purchased inputs, which crops to grow in which fields, and so on. It thus
centers on the idea that farmers can vary the level and kinds of farm inputs and outputs.
What are the different kinds of relationship between farm inputs and outputs that
?
require the decision making capacity of a farmer?
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Three kinds of relationship between farm inputs and outputs are typically recognized as
encompassing the economic decision making capacity of the farmer. These three
relationships also correspond to three main steps in construction of the theory of the
farm firm. They are as follows:
a. The varying level of output corresponding to different levels of variable inputs
(e.g. variation in maize output resulting from different levels of nitrogen
fertilizer). This is called the factor- product or input-output relationship. It is
also the production function i.e the physical relationship between inputs and
output to which all other aspects of the production process are ultimately related.
Distance learner! This is almost similar to theory of production function that you
have learned in Microeconomics I

b. The varying combination of two or more inputs required to produce a specified

output (e,g the difference amounts of land and labor which could result in the
same quantity of maize production). This is called the factor-factor relationship.
It is also sometimes referred to as the methods or technique of production. This is
best explained using isoquant( production with two or more variable inputs)
c. The varying outputs which could be obtained from a given set of farm resources
(e,g the different quantities of coffee and tea which could be obtained from the
same area of land). This is called the product- product relationship. It is also
termed enterprise choice or enterprise combination.
These threefold capacities for varying the way in which farm production is organized
only attains analytical relevance when placed in the context of the goals of the farm
family and the resource constraints of the individual farm. In practice farm families may
have many different goals: long term income stability, family food security, achievement
of certain preferences in consumption, fulfillment of community obligations and so on.
The farm may also face constraints of resources which limit the capacity to vary the
organization of production. An evident constraint is the land area of the farm which in
many cases is fixed over considerable periods of time. However, for peasant farmers in
the tropics this may be the least of problems; working capital may be scarce and
expensive, purchased inputs variable in availability, quality, and price;
2.2.1. Production Function (Physical Relationship between Inputs and Output)
? A farmer wants to produce maize using land, labor, maize seed, fertilizer, oxen power.
List the output and inputs of this production process.
 _______________________________________________________________________
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Production function shows the physical relationship between inputs and outputs. It is
sometimes called factor-output relationship. Example, how much capital and labor is
?
required to produce a given agricultural output. Consider, for example, the response of
rice output to change in the application of nitrogen fertilizer. Commonsense would
suggest that output rise with increasing quantities of fertilizer, but only up to a certain
point. Beyond that point an imbalance occurs between the fertilizer and other plant
nutrients in the soil so that output levels off, and eventually declines if even more
fertilizer is applied.
The relationship between rice output produced and fertilizer input used is a production
function. This relationship may be illustrated by figure 2.1. The graph shows that,
holding other inputs(for example, land, labor, tractor power etc) at a constant level, rice
output is 2200kg with no fertilizer; it rises to a peak of 3762kg as fertilizer is increased
by up to 125kg, and it falls thereafter. The graph shows the production function of rice
output for varying levels of fertilizer use. This production function is described as the
total physical product (TPP) curve.
Figure 2.1: Production function of rice output for varying levels of nitrogen fertilizer
Rice output Y (kg)
4000
Maximum output = 3762 kg
3500
TPP
3000
2500
Base output = 2200kg
2000
Rice output Y (kg)
0 25 50 75 100 125 150
30 Fertilizer X1 (kg)
2
20
10
APP
0 25 50 75 100 125 150
Fertilizer X1 (kg) MPP

The same relationship can also of course be described mathematically, either in a general
form which says that rice output (Y) is some function of different levels of a variable
input(X1) or ; or in a specific form which tries to give the exact relationship
between output and input. The exact mathematical relationship which describes the
graph shown in figure 2.1 is a quadratic equation which is written as follows:
An equation of this kind is fairly common for describing the response of a crop output of
fertilizer use, and the numbers in it are obtained by sample measurements. However, this
is not the only mathematical form a farm production function can take, and it is
sufficient at this stage to be a ware that the production relationship can be specified in
this way. In this example the land input is held constant at one hectare, so that what is
described in the graph is the per hectare yield response to successively greater
application of fertilizer.
In general, the production function in economics describes the technical or physical

relationship between output and one or more variable inputs. This is so no matter how
many variable inputs are included in the function. Inputs are rates of resources used and
output is rate of production over a specified time period. A function describes the
response of output to a single input, as in our example. What is true of this example is
also more generally true of the production function as a theoretical device, and is
described in the following:
i. There is the output which would occur without any application of fertilizer. This
is described in the figure 2.1 as the base output and it is given as 2200kg. For
some kinds of farm inputs, for example fertilizers, irrigation water, weedicides,
pesticides etc, one would often expect some level of output to occur even in the
complete absence of the input. For others, for example seed, labor, or land, a zero
level of input would cause zero output and the production function would in this
case begin at the origin of the graph
ii. There is the highest output which can be achieved by successive increase in the
application of fertilizer, holding all other production inputs constant, and this is

given as 3762 kg. This peak output is sometimes referred to as the technical
maximum level of production.
iii. The shape of the curve is crucial. It describes a situation in which although
output grows with successive equal increase in fertilizer application, the amount
by which it grows gets less and less. This is because of the Law of Diminishing
Marginal Return. This is shown by the marginal physical product (MPP) in the
lower graph in the above figure 2.1
iv. There is the productivity measure given by the average physical product (APP)
of the input. It is defined as the total physical product divided by the total amount
of the input used (in our case nitrogen fertilizer) in the production ( ). The
APP decrease as more variable inputs are used
v. The other measure of the physical relationship between output and a single
variable input is the input elasticity (E), also known as the partial elasticity of
production. This is defined as the percentage change of output resulting from a
given percentage change in the variable input:
We know from Microeconomics I course that
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Activity 2.1
 In the theory of short run production function, there are three stage of production:
Stage I, stage II and stage III. Which stage is a rational stage of Production? How do
you describe this stage in terms of input elasticity?
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The point about elasticity is that by taking the ratio of two proportional changes we
obtain a measure of the impact of one variable on another which is independent of the
physical units in which the variables are denominated. The relationship between the
input elasticity (E), the MPP and the APP should be noted. We hope you know that a
rational stage, in theory of production, is stage II where there is diminishing return. The
area of diminishing marginal returns on the production function occurs when MPP <
APP, but is not negative, i.e when E is between 1 and zero:
E >1(stage I in short run production function) and E < 0 (stage III in the short run
production function) define areas of the production function in which it would not be
economically logical for the farmer to operate.
Therefore, a rational stage is a stage in which the input elasticity is between 0 and 1(0 <
E < 1)
Economic Optimum Level of Resources Use
? Dear distance learner! You have learned the optimum level of resource use in the course
Microeconomics I. How do you describe the optimum level of resource use in farm
production when there is only one variable input and two or more fixed inputs?
(You can use the space left below to write your answer)
 _______________________________________________________________________
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The most efficient level of use of a variable input depends on the relationship between
the price of the input and the price of output. In the figure 2.2 the information of our
previous example has been converted to value terms assuming an output price of rice of
Birr 0.10 per kg at the farm gate, and input price of Birr 1.00 per kg of fertilizer. The
shape of the product curves remains the same: they are simply the physical product
curves multiplied by the rice price of Birr 0.10 and the vertical axis of the graphs are

relabeled in value terms accordingly. They thus become total value product (TVP),
average value product (AVP), and marginal value product (MVP).
The additional information contained in the figure 2.2 is the total factor cost (TFC) line
in the upper graph, and the marginal factor cost (MFC) line in the lower graph. Total
factor cost simply traces out the cumulative cost incurred as fertilizer use increase. Each
25 kg of fertilizer increase total cost by Birr 25 (since price of fertilizer is Birr 1.00 per
kg of fertilizer), and this is a linear relationship. The marginal factor cost is just another
way of describing the price of the variable input. This is a straight line at the level of Birr
1 on the lower graph: each successive unit of fertilizer costs the same.
Figure 2.2: Optimum use of a single input.
Rice value (in Birr)
400
TFC
A
350
TVP
300
B
250
Rice value (in Birr)
200
0 25 50 75 100 125 150
Fertilizer X1 (kg)
2
2
E Marginal factor cost (MFC)

1 (Factor price)
AVP
0 25 50 75 100 125 150

Fertilizer X1 (kg) MVP
The economic optimum level of input use occurs when the marginal value product of the
input is equal to the price of the input (MVP = factor price) (point E on the lower graph).

This is commonsense. In the area to the left of point E the additional return generated by
an extra unit of input is greater than the unit cost of input, MVP > MFC, and it pays to
increase the level of the input. In the area to the right of point E the additional return
obtained from an extra unit of the input is less than the unit cost of the input MVP <
MFC, and profits are being reduced. MVP = MFC in the lower graph (point E)
corresponds in the upper graph to the point “A” where a line parallel to the total factor
cost curve is tangent to the production function, i.e where the slope of the two curves is
equal. This makes sense given that MVP is the slope of the production function, and
MFC is the slope of the total factor curve. At this point the surplus between total cost
and total revenue, the gap AB, is at its maximum: profit is being maximized.
With the aid of some simple mathematics this optimum level of a single input can be
usefully expressed in several different ways. Defining
Px = price per unit of input X ( i.e MFC)
Py = price per unit of output Y
Then, MVPx = MPPx *Py, i.e the marginal value product of input X equals its marginal
physical product multiplied by the output price. There are then three ways of looking at
the optimum point:
a. At the economic optimum extra return equals extra cost , MVPx = Px. If MVPx
> Px then the farmer is applying too little of the variable input; if MVPx < Px
then the farmer is using too much of the variable input.
b. By rearranging this ( ) expression, the optimum condition can also
be stated as MVPx/Px = 1. The ratio of the marginal value product to the price of
the input should equal one. If MVPx/Px >1 the farmer is applying too little of an
input; if MVPx/Px <1, the farmer is applying too much input.
c. Since MVPx = MPPx *Py the optimum condition can also be stated as MPPx =
Px/Py. The marginal physical product should equal the factor-product price ratio.
Distance learner, this is what you have learned in the course Microeconomics I. If you
don’t understand the concept, please refer your lecture note on Microeconomics I.

Example: Consider the following production function
Where Y is the output and X is the variable input

a. Find the level of X at which Y(output) is maximized
Solution: output (Y) is maximized when the first derivative of the production
function (marginal physical product) is zero
Therefore, output maximizing level of input is 50 units of X

b. Calculate average physical product (APP), marginal physical product (MPP) and
input elasticity of production (E), when X = 10
Solution:
c. Find the level of X maximizing net return when

Solution:
At net return (profit) maximizing point
Profit maximizing level of input use is 37.5 units of X
2.2.2. Factor Combination (Factor-Factor Relationship)

_______________________________________________________________________
Activity 2.2
 In the theory of production, different inputs are used to produce a given unit
of output. Is there only one combination of inputs that can produce a given output
(example, 100kg of wheat) or are there different combinations of inputs to produce
a given unit of output?
_______________________________________________________________________
Distance learner! This choice deals with the relationship between resources or the factor-
factor relationship. Any production function relating output to two or more inputs
contains the possibility that a given level of output could be produced with more than
one combination of the variable inputs. The idea that two or more variable inputs may be
combined in different quantities to produce a given output is called the principle of
technical substitution or the law of variable factor proportions.
Graphically this is indicated using isoquant curve. Isoquant curve shows the different
combinations of two or more inputs producing the same amount of output.
Suppose there are two inputs: and producing output (Y)
Figure 2.3: Isoquant curve
Isoquant
X2
Y= quantity of a given output
X1

The slope of the isoquant curve measures the rate at which one input can be substituted
for another input along an isoquant in order to maintain a given output (Y). It is also
known as the marginal rate of technical substitution or marginal rate of input substitution
(MRTS).
The equation of an isoquant can be represented by:
(Since we are on the same isoquant)
This representing the number of units of input 2 (X2) that must be substituted for input 1
(X1) in order to maintain the given level of output.
Optimum Combination of Inputs

In order to derive the optimum combination of inputs, we need to bring together what
the producer is willing to produce (isoquant) and what the producer can produce (isocost
line). The isocost line shows the locus of combination of inputs that can be purchased
when all expenditure is spent.
The lease cost combination of two inputs occurs when the marginal rate of technical
substitution of input (slope of isoquant) is equal to the ratio of inputs prices ( slope of
isocost). The least cost combination of inputs occurs at the point of tangency between
the isocost curve and the isoquant line, graphically,

Figure 2.4: Optimum combination of inputs
E Y=Isoquant of a given
output
Isocost
X1
On the above figure, point “E” illustrate the optimum combination of inputs where
marginal rate of input substitution (the slope of isoquant) is equal to price ratio (the
slope of isocost curve)
Suppose C is cost of production and P x1 and Px2 are price of X1 and X2 respectively.
Therefore, the cost function is
………. This is the isocost line and is the slope of the
isocost line.
At the economics optimum point ”E” (see figure 2.4)
The slope of isoquant = the slope of isocost
Example:
Consider the following production function

Where Y= output, X1 and X2 are inputs

Find the least cost combinations of X1 and X2 to produce 8 units of Y, given that price
of X1( ) is birr 4 and price of X2( ) is birr 2.
Solution:
at the optimum point the slope of isoquant is equal to the slope of isocost.
X2
E
X2*=16
Y = 8units
Isocost line
X1*=16 X1
Therefore, the optimum level of input use to produce 8 units of output Y is 16 units of
X1 and 16 units of X2.
2.2.3. Enterprise Combinations (Product-Product relationship)

_______________________________________________________________________
Activity 2.3
 Farmers in LDCs are not specialized in the production of one crop but they
produce two or more products. All these productions are competing to the limited
resources of the farmer. How do farmers combine different productions or
enterprises in order to maximize there profit. More briefly how do they decide on a

range of alternative crops they could grow and livestock they could keep?
_______________________________________________________________________
Distance learner! as you might know, most farmers or peasants are faced with a range of
alternative crops they could grow and livestock they could keep. The different section of
the farm, each devoted to production of one kind of crop or animal are known as
enterprise. Enterprise combination is usually referred to as the product- product
relationship.
In theory, if a farmer has access to unlimited resources, enterprises would be
independent of each other, and increase in one product would be neither aid or hinder
another. However, there are almost always some resources, which are limited to a fixed
amount. In such circumstances, enterprises will compete with each other for some of the
fixed resources and hence expansion of one enterprise must be accompanied by
reduction of another.
Generally, enterprises can be categorized in different divisions;
a. Complementary enterprises:- production of one product increases as the other
product increases. Example, beef and skins
b. Substitute enterprises:- increase in the production of one enterprise decrease
production of the other, example maize and wheat
c. Joint enterprises:- production of outputs that are increased by the same
proportion.
d. Supplementary enterprises:- the change in production of one product or
enterprise has no effect on production of another.
Ridged line
Complementary
Enterprises
Figure 2.5: Production Possibility frontier showing enterprise combination
Substitute
Enterprises
Ridged line
Product (Y2)
(Enterprise 2)
Supplementary
Enterprises
Product (Y1)
(Enterprise 1)
In the above production possibility frontier (PPF)

 In the complementary enterprises when product (Y 1) increases so does
product (Y2). When product Y1 decreases so does product Y2
 In the substitute enterprises when product (Y1) increases product (Y2)
decreases. When product Y1 decreases, product Y2 increases
 In the supplementary enterprises, increase in production of one (example
Y2 ) has no impact on the production of another (example Y 1). Increase in
production of Y2 does not affect(increase or decrease) production of Y1
The above enterprise combination can be shown mathematically as follows:

Suppose there are two products or enterprises Y1 and Y2 that can be produced using the
available resource X (where X represents all resources of the producer such as land,
labor, capital, tractor, fertilizer, etc). Therefore, products Y1 and Y2 are both function of
X. Because the farmer allocate his limited resources, which is represented by X, for two
enterprises.
At the equilibrium point the slope of production possibility frontier, which is marginal
rate of technical substitution (MRTS) is equal to the slope of the isorevenue line ( ).
In other worlds, the optimum point is the point where the iso-revenue line is tangent to
the production possibility frontier (PPF), point “E” in the figure 2.6 below.

(Y1)
Figure 2.6 Optimum point for enterprise combination
Enterprise one
Y1* E
Iso- revenue line
PPF
Y2*
Enterprise two (Y2)
Slope of production possibility frontier or Marginal rate of technical substitution

(MRTS) is
Total revenue function (TR) is also constructed using both production function and
prices(P) of each products.
Where P1 and P2 are prices of product one (Y1) and product two (Y2) respectively
Hence indicates the slope of isorevenue line
The economic optimum of the two products is determined when the marginal rate of
transformation of the two products is exactly equal to their price ratio ( )

Example: A farmer has 100 kilograms of nitrogen fertilizer (N) to allocate between
wheat (Yw) and maize (Ym) production. The relationship between wheat production and
nitrogen fertilizer and maize production and nitrogen fertilizer respectively are
a. How many units of nitrogen should the farmer allocate to each of the crops if the
price of wheat is birr 3.00 per kg and price of maize is birr 2.50 per kg?
b. Determine the optimum possible choice of the crop.
Solution:
Given nitrogen fertilizer N = 100kg
Price of wheat (Pw) = Birr 3.00
Price of maize (Pm) = Birr 2.50
Let Nw = quantity of nitrogen fertilizer (N) allocated to wheat production
Nm = quantity of nitrogen fertilizer (N) allocated to maize production
a. The allocation equation would be :
Thus, (3.00)(1.084-0.006Nw) = (2.50)(0.830-0.004Nm)

3.252 - 0.18Nw = 2.075 - 0.01Nm
0.018Nw - 0.01Nm = 1.177, we know that N=Nw + Nm 100 = Nw +Nm Nw =
100 - Nm
0.018(100 - Nm) - 0.01Nm = 1.177, Nw is substituted by 100 - Nm
1.8 - 0.018Nm - 0.01Nm = 1.177
0.028Nm = 0.623
Nm = 22.25

Nw = 100 – Nm
Nw = 100 – 22.25
Nw = 77.75
Therefore, the wheat production would get 77.75 kgs of nitrogen fertilizer and the
maize would get 22.25kgs of the nitrogen fertilizer.
b. Substituting Nw = 77.75 into Yw and Nm = 22.25 into Ym we will get the

optimum choice of Yw = 131.69 units and Ym = 85.55units. To maximize profit
the farmer has to produce 131.69kg of wheat and 85.55kg of maize.
Constrained Production: The Linear Programming Approach

An approach to resource use which can usefully be introduced in connection with the
preceding concepts of production possibility frontiers is linear programming. Linear
programming (LP) is an operational method for studying the allocation of resources
between enterprises when inputs are limited in their total amounts.
In linear programming, the level of output is determined by the most limiting input, and
this level of output in turn determines the level of use of other inputs. Suppose we have
two outputs, sugarcane ( ) and rice ( ). We also have three variable inputs in
limited amounts, which are labor ( ), type “A” land ( ) which is more suitable for
rice than for sugarcane, and type “B” land ( ) which is more suitable for sugarcane
than for rice.
The amount of each output which can be obtained per unit of the inputs, and the
maximum level of each input, are set out in table 2.1 below
Table 2.1
Units of output per unit of input Total input
Input available
Labor ( ) 2 100 1.5 person-years

Type“A” land ( 3 50 2 hector
)
Type “B” land ( 0.5 80 5 hector

When placed on a PPF-type graph, these production conditions yield the situation shown
in figure 2.7. A total of 1.5 person-years of labor permit either 3 metric tons of rice to be
produced or 150 metric tons of sugarcane, or some combination between these limits.
This is the labor constraints. Similarly 2 hectares of type “A” land permit a maximum of
either 6 metric tons of rice, or 100 metric tons of sugarcane; 5 hectare of type “B” land
permit a maximum of either 2.5 metric tons of rice, or 400 metric tons of sugarcane.
These are the type “A” land and type “B” land constraints respectively.
Figure 2.7: Enterprise choice using linear programming approach (graphical solution)
Rice Y2 (metric tons)
4.0
3.5
Type “A” land constraint
3.0
2.5 A
B
Type “B” land constraint
2.0
1.5 c
Feasible region
1.0
Labor constraint
0.5
D
O 50 75 100 150 200
Sugarcane Y1 (metric tons)
The feasible region is indicated by the shaded area. Therefore, potential solution point
(corner points) are A, B, C and D. To find these points we need to find equation of each
constraint and then the intersection of type “B” land constraint and labor constraint to
find point B and the intersection of type “A” land constraint and labor constraint to find
point C. Point A and point D are easy to find.
Solution:
First we have to find the equation of each constraint:
Slope of labor constraint=∆Y2/∆Y1
Labor constraint equation: (where 3 is the intercept-Y2

intercept)
Slope of type “A” land constraint = ∆Y2/∆Y1
Type “A” land constraint equation: (where 6 is the intercept-Y2

intercept)
Slope of type “B” land constraint = ∆Y2/∆Y1
Type “B” land constraint equation: (where 2.5 is the intercept-Y2

intercept)
Potential solution points are A, B, C and D
Point A is already known, at A (Y1=0, Y2= 2.5)
To find coordinates of point B we have to solve simultaneously the labor constraint and
type “B” land constraint as follows
Therefore, 36.36 metric tons of sugarcane should be produced

When we substitute Y1 in one of the above two equations we get

Metric tons of rice
To find coordinates of point C we have to solve simultaneously the labor constraint and
type “A” land constraint as
When we substitute Y1 in one of the above two equations we get

metric tons of rice
If price of rice ( is Birr 250 per metric tons of rice and price of sugarcane is ( )
is Birr 10 per metric tons of sugarcane than the best enterprise combination is the one
which maximize the total revenue (TR) of the farm. We know that if a farm produces
two products only: rice (Y2) and sugarcane (Y1). The total revenue function (TR) is:
Enterprise combination and total revenue at potential points
Point Y1 Y2
A 0 2.5 625
B 36.36 2.27 931.6
C 75 1.5 1125
D 100 0 1000
As we can see on the table above, the best enterprise combination is indicated on point
“C” which is 75 metric tons of sugarcane (Y1) and 1.5 metric tons of rice (Y2), because it
is the combination which maximize the total revenue (TR = Birr 1125) of the producer.
Summary of optimum resource use in farm production

The three components of the farm production model that we have seen so far yield
three conditions of economic efficiency:
1. For any variable inputs in farm production, the optimum level of its use
occurs when the extra return just equals the extra cost per unit:
This means that the rate of technical transformation of factor into product
( ) should equal the factor-product price ratio ( ), where X
Is the factor and Y is the product

2. For any single enterprise, and several variable inputs, the least cost method of
production occurs when the marginal product per Birr one spent is the same
for each resources:
This also coincides with the point where the rate of technical substitution
between inputs
3. For a single variable input used in several enterprises, the maximum profit
combination of enterprises occurs when the marginal value product is the
same in each enterprise:
This is called the principle of equi-margianal returns. It also coincide with the
point where the rate of technical transformation between outputs
Combining these results, efficient farm production means that the marginal value
product per unit of outlay on inputs should be equal for all resources in all
enterprises.
2.2.4. Risk and Uncertainty in Agriculture

_______________________________________________________________________
Activity 2.4
 Farmers are exposed to a number of risks and uncertainties in farm production.
What are the different risks and uncertainties that farmers are exposed in their

Farm production?
_______________________________________________________________________
Distance learner! It is widely recognized that a high level of uncertainty typifies the lives
of people in peasant farm households in developing countries. This uncertainty is more
pervasive and serious for them than for farm families in temperate zones for several
reasons
 Variations of climate are more unpredictable and tend to be more severe in
their impact on crop yields in tropics than in temperate zones.
 Markets are more unstable where information is poor in tropical developing
countries, like Ethiopia
 Insecurity of poor peasant families due to low social and economic status
The pervasiveness of various kinds of uncertainty in peasant production has important

implication for its economic analysis and for the interpretation of its future prospects.
The following points summarize some of the propositions and arguments which
surround uncertainty
a. It results in sub-optimal economic decisions at the microeconomic
level of production ( absence of profit maximization)
b. It results in unwillingness or slowness to adopt innovations ( peasant
conservatism)
c. It is the reason for various farming practices like mixed cropping
d. It is reduced by increasing market integration due to improved
information, communication, market outlet etc.
Types of uncertainty
Uncertainty is a condition which is varying degree surrounds all forms of activity in a
market economy. It is considered more of a problem to agricultural production than for
industrial production due to influence of climate and other natural factors and length of
production cycle.

Natural hazards:- unpredictable impact on output of weather, pests and diseases and
other natural calamities
Market fluctuations:- the lengthy gap between the decision to plant a crop or start up a
livestock enterprise and the achievement of output means that market prices at point of
sale are unknown at the time of decision are made. This is the main reason for state
interventions. The problem is more severe where information is lacking and markets are
imperfect.
Social uncertainty: mainly insecurity caused by differences of control over resources

within the peasant economy and the dependence for survival of some peasants on the
other through such device as sharecropping, this occurs where there is unequal
ownership of land in peasant.
Definition of Risk and Uncertainty
? Distance learner! Before we define risk and uncertainty, give your own definition for
risk and uncertainly. What are the main differences between risk and uncertainty?
(Use the space left below to write your response)
 _______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Risk is restricted to situation where probabilities can be attached to the occurrence of

events which influence the outcome of decision making process
Uncertainty refers to situation where it is not possible to attach probabilities to the
occurrence of events. The likelihood of their occurrence is neither known by the decision
maker nor by anyone else.
Risk still refers to probabilities but these are now the subjective probabilities attached by
farm decision makers to the likelihood of occurrence of different events. Hence the term

risk is used to describe the entire mechanisms by which farmers make decisions with
respect to uncertain events.
Analysis of Risk Behavior

Within the above definition of risk there are two distinct approaches to subjective
probability. One is to treat probability, and hence risk, as variance either side of the
expected average outcome of uncertain events. Hence reference is often made in the
context of farm production to risk as the income variance which results from uncertain
events. Variance is of course a concept of statistics which measures the average
deviation of set of figures from their mean.
Figure 2.8: Production decision under risk
a
Total value product Y
f TVP1
c g
E (TVP)
TFC
b
h
d
i
e
j
TVP2
X2 XE X1
Input(X)

Note: TVP1 = total value product in “good” year

TVP2 = total value product in “bad” year
E(TVP) = expected total value product
=
and are the probabilities of good and bad years occurring
(Hence: assuming P1 = 0.60 and P2 = 0.40)
The above graph is simple production function graph showing three different response
curves of output Y to single variable purchased input X, say fertilizer. The response
curves are in value terms that are total value product (TVP) curves, so that features of
profit and loss are shown. The figure is designed to explore the income variance
approach to risk. It can also be used to illustrate the principle of disaster avoidance
approach. The risk situation which it describes is one of uncertainty about the weather in
which there are only two events which can occur: the weather may be “good” with the
pattern of rainfall being just what is required to obtain the best crop yields; or the
weather may be “bad” signifying lack of rainfall and poor crop yields. The graph
contains alternative output response curves to describe the outcome of these two events
as well as the farmers’ subjective assessment of the balance between them according to
the flowing definitions.
TVP1 = the total value product response to increasing of the input X in a good year.
TVP2 = the total value product response to increasing the level of input X in a bad year
E(TVP) = the expected total value product given the farmers subjective views about the
likelihood occurrence of good and bad seasons.
In this example the farmer expects 3 years out of every 5 years to be “good’, and 2 years
out of 5 years to be “bad”. Hence the probabilities and calculation of the expected total
value product, E (TVP), are as follows
P1 (probability of a “good” season) = 3/5 = 0.6
P2 (probability of a “bad” season) = 2/5 = 0.4
E (TVP) = 0.6(TVP1) + 0.4(TVP2)

The probability of the expected total value product, E(TVP), is computed as:
Where P1= probability of a good season

P2= probability of a bad season
TVP1 and TVP2 are described as outcomes of events or states of nature. In figure 2.8 the
shape of the curves reflect the impact of good and bad weather conditions on the
response of output to varying levels of input X. Good weather condition resulting good
output response depicted by TVP1. Lack of rainfall results in the very poor output
response is depicted by TVP2. The subjective probabilities attached by the farmer to the
occurrences of good and bad years are P1 and P2 respectively.
These probabilities must sum to 1 since the example only recognizes two states of
nature, and one or either of these must occur. E(TVP) is a weighted or balanced average
of the two outcomes, TVP1 and TVP2, where the weights are the probabilities, P1 and P2
respectively.
A total factor cost (TFC) lines represents the increase in total production costs as more
input X is purchased and used. The impact of risk on the efficiency calculation of the
farmer can be examined using the line (TFC)
The figure 2.8, displays three alternative operating positions: X 1, XE and X2, each of
which is allocatively rational depending on the farmer’s subjective preferences with
respect to risk:
a. Input use X1: this is consistent with allocative efficiency on TVP 1. It means that
if TVP1 occurs the largest possible profit, ab, is obtained. On the other hand if
TVP2 occurs, a substantial loss, bj, is incurred. A farmer choosing to operate at
this position is described as risk-taking. This is because a farmer prefers to take
a chance at the largest possible profit, even thought it only has a probability in
his own mind of, for example, 0.60 of happening, than taking a safer position
with less possibility of incurring large loss.
b. Input use X2: this is consistent with allocative efficiency on TVP 2. It means that
if TVP1 occurs a profit, ce, is obtained; and if TVP2 occurs the farm still makes a
small profit, de, as shown in the graph. A farmer choosing to operate at this
position is described as risk-averse. This is because a farmer prefers the safety

of acting as if the worst possible outcome will happen, even though in his own
mind this only has a probability of 0.40.
c. Input use XE: this represents allocative efficiency consistent with a balanced
assessment of the average outcome of good and bad seasons. It means that if
TVP1 occurs, a profit, fh, is obtained but this is not the largest profit possible on
TVP1. Similarly if TVP2 occurs a loss, hi, is incurred, and this is not the smallest
loss possible on TVP2. A farmer choosing to operate here is described as risk-
neutral. The choice of operating position is consistent with the average outcome
of good and bad years taken together.

Summary
The neoclassical economic theory of farm production begins with the assumption that
farmer as an individual decision maker concerned with questions such as how much
labor to devote to the cultivation of each crop, whether or not to use purchased inputs,
and so on.
Three kinds of relationship between farm inputs and outputs are typically recognized as
encompassing the economic decision making capacity of the farmer.
The varying level of output corresponding to different levels of variable inputs (theory of
farm production). The varying combination of two or more inputs required to produce a
specified output called the factor-factor relationship. The varying outputs which could be
obtained from a given set of farm resources which is called the product- product
relationship. In the theory of production there are different measures of productivity like
total physical product(TPP), average physical product(APP), marginal physical
product(MPP) and input elasticity. The economic optimum level of resource use is
where marginal value product is equal to the marginal factor cost (MVP=MFC). The
different combinations of two or more inputs(factor-factor relationship) which produce
the same unit of output is best explained using the isoquant curves.
The lease cost combination of two or more inputs occurs when the marginal rate of
technical substitution of input (slope of isoquant) is equal to the ratio of inputs prices
( slope of isocost). The least cost combination of inputs occurs at the point of tangency
between the isocost curve and the isoquant line.
The different section of the farm, each devoted to production of one kind of crop or
animal are known as enterprise. Enterprise combination is usually referred to as the
product- product relationship. We can categories enterprises under: complementary,
substitute, joint and supplementary enterprises.
The economic optimum level of enterprises combination occurs when the marginal rate
of transformation of the two products is exactly equal to their price ratio(e.g for three
enterprise Y1, Y2, Y3)

Linear programming is also another method of finding the best enterprise combination.
a high level of uncertainty typifies the lives of people in peasant farm households in
developing countries. This uncertainty is more pervasive and serious for farmers in
tropical zone than for farm families in temperate zones for several reasons, such as
climatic conditions, market information, low social and economics status.
Uncertainty is a condition which is varying degree surrounds all forms of activity in a
market economy. Natural hazards, market fluctuations and social uncertainty are some of
the uncertainties that our farmers face.
Risk is restricted to situation where probabilities can be attached to the occurrence of
events which influence the outcome of decision making process
Uncertainty refers to situation where it is not possible to attach probabilities to the
occurrence of events. The likelihood of their occurrence is neither known by the decision
maker nor by anyone else.

Checklist
√
Dear learner! Below are some of the most important points drawn from the units you
have been studying up to now. Please put a tick (√) mark in front of the point you have
understood well in the box under “Yes” and in the box under “No” for points you have
not understood well yet. And if the tick marks under “No” are more than those under
“Yes” it means you are left with a lot to understand the unit and you have not yet
achieved the objectives indicated at the beginning of the unit. This tells you to go back
and read the sections you passed through.
I can: Yes No
1. Define production function
2. Determine the profit maximizing level of input use,
given production function, price of inputs and output
3. Define isocost and isoquant curves
4. Identify the main categories of enterprises
5. Determine the best enterprise combination using
linear programming approach
6. Define risk and uncertainty in farm production
7. List sources of risk and uncertainty

SELF ASSESSMENT QUESTION

1. In farm production, farm families may have many different goals, of the
following which one of the can not be the goal of farm families
A. long term income stability
B. family food security
C. achievement of certain preference in consumption
D. fulfillment of community obligation
E. none of the above
2. Which of the following best describes the situation of peasants in developing
nations
A. capital markets are non-existence and credit is tied to other factors price
B. market information is poor and incomplete
C. market for some factors of production may not exists
D. Production is subsistence and the proportion of farm output is directly
consumed by the household rather than sold in the market.
E. All of the above
3. A rancher sells hides and beef. The two goods are assumed to be produced in
fixed proportion. The marginal cost for beef-hid product package is given by
The demand equations for the two products are:

Beef: Hides:
Answer question number 3 and 4 based on the above information
In the production process of beef and hid, the two products are
A. Complementary enterprises
B. Joint enterprises
C. Substitute enterprises
D. Supplementary enterprises

4. Which of the following is not true about the production process indicated above
A. the marginal cost of the two products is equal
B. the price of the two products is also the same
C. the two outputs produced in some fixed proportions
D. none of the above
5. Allocating resources(or consumption expenditure) in different possible uses so as

to maximize net economic benefit (satisfaction) is called
A. Technical efficiency
B. Allocative efficiency
C. Economic efficiency
D. Pricing benefit
E. B and C
6. The enterprise relationship that shows the increase in one output when the other
product increase refers to as
A. substitute enterprise relationship
B. product-product relationship
C. complementary enterprises
D. factor-factor relationship
E. factor product relationship
7. The varying combination of two or more inputs required to produce a specified
output is referred to as
A. factor-factor relationship
B. product-product relationship
C. factor-output relationship
D. enterprise combination
8. A producer has the following production function to produce barely (Y) using
labor (L) and capital (K) resources.

If price of labor is Birr 10 and price of capital is Birr 1000,

The best input combination to produce 200 units of barely is
A. L=1000, K=10
B. L=125, K= 5
C. L=100,K =10
D. L=100, K=25
9. A measure of the physical relationship between output and a single variable input
which is defined as the percentage change of output resulting from a given
percentage change in the variable input is :
A. Input elasticity
B. Marginal physical product
C. Average physical product
D. Price elasticity of demand
10. Type of uncertainty which has unpredictable impact on output of weather, pests
and diseases and other natural calamities is
A. natural hazard
B. market uncertainty
C. social uncertainty
D. price uncertainty
11. Optimum resource use in farm production occurs when
A. the extra return just equals the extra cost per unit
B. the marginal product per Birr one spent is the same for each resources, for
any single enterprise, and several variable inputs
C. for a single variable input use in several enterprise, the maximum profit
combination of enterprise occurs then the marginal physical product is the
same in each enterprise
D. all of the above

Part II True or False Type questions

“false” if it is not true statement
1. the relationship between resources and their product is called production
function
2. The economic optimization of product-product relationship is determined
at the point of tangency of a production possibility frontier and
isorevenue line.
3. In the production function in which there is only one variable input, the
economic optimum level of the input occurs when the marginal value
product of the input is equal to the price of the input.
4. Because of high risk and uncertainty in farm production, farmers are
willing to adopt innovations and there is no peasant conservatism.
5. Uncertainty refers to situation where probabilities can be attached to the
occurrence of events which influence the outcome of decision making
process.
Part III. Discussion Question and workout problems

Direction: For the following questions give your answer briefly
1. Discuss the neoclassical theory of production
2. Most small farmers in the less developed counties are risk averse. Explain
the reason why most farmers in less developed countries are risk averse.
3. Discuss the concept of risk and uncertainty in agricultural production. List
types of uncertainties in agricultural production
4. suppose the production function(other things being constant) of potato is
given by
Where Q = quantity of potato produced in Kg

N = nitrogen fertilizer input in Kg
a. determine the level of nitrogen fertilizer that maximizes output

b. Compute production elasticity at nitrogen fertilizer input level of 10kg?

c. Find the profit of the production at the equilibrium point, if the price of
nitrogen is Birr 25 and price of potato is Birr 100 per kg.
5. A peasant wants to produce two products orange and banana for sale. Price
of orange is Birr 300 and price of banana is Birr 200. Production of these
output require labor power, land and tractor power of the peasant. The
units of output per unit of inputs and the available resource are:
Units of output per unit of input Total input
Input available
Orange Banana
Labor 3 150 3person-year
Land 4.5 75 4 hector
Tractor 0.75 120 10 hours
Find the best enterprise combination for the peasant given the above
information, use graphical approach

CHAPTER THREE
3. Agricultural Policies
3.1 Introduction
This chapter is about agricultural policy which is concerned with the methods used by
governments of developing countries to change the agricultural environment. The
agricultural policies considered in this chapter are farm output policy, input policy,
marketing policy, credit policy and food policy. As we all know, most developing
countries, including Ethiopia are food self insufficient. Food security and food demand
estimation are also included in the analysis. We will try to see the concepts, objectives
and instruments of each policy and how effective are these policies in achieving the
goals. Finally the effectiveness of these agricultural policies is also analyzed using
partial equilibrium analysis and the policy analysis matrix.
There are questions and activities under each sub-topic. At the end of this chapter there
is summary and self-assessment questions for your better understanding of the chapter.
Objectives:
Upon the successful completion of this chapter you will be able to:
 Define agricultural policy
 Distinguish macroeconomic policies and sectoral policies
 Explain the concept or the essence of agricultural policies
 Identify the objectives, instruments, impact and effectiveness of input, output,
marketing, credit and food polices
 Assess problems or drawbacks of agricultural policies in achieving their targets
 Analyzes effectiveness of policies using partial equilibrium analysis and the
policy analysis matrix

3.2 The Concept of Agricultural Policies
? We hope that you are familiar with the term policy, especially fiscal and monetary
policies. Please give your own definition of agricultural policy
(use the space left below to write your response)

_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Distance learner! The term policy is generally defined as a deliberate course of action, as
contrasted with a haphazard type of activity, chosen and followed by a public body,
private firm, family or individual.
Agricultural policies are concerned with the methods used by governments of
developing countries to change the agricultural environment. The change in agricultural
production would take place by altering the prices of farm inputs and outputs, by
changing the institutions in which factors of production and output markets operate or by
promoting and adopting new technologies in agricultural sector.
_______________________________________________________________________
Activity 3.1
 Policies are designed to achieve their objectives. What are the different
factors need to be considered while setting policy objectives.

_______________________________________________________________________
The task of agricultural policy is to select the best instruments to achieve the selected
targets given constraints such as productive resources, administrative capacity and the
presence of certain external factors over which the decision maker may not have control.
The selected targets or objectives may include consideration of economical, political and
social stabilities, integration of national economy with international, increased food

security and prevention of malnutrition, increased terms of trade and foreign exchange
earnings; employment generation, economic growth and development, and so on.
The interventions may be local in scope to raise the incomes of small poor farmers,
provincial in scope to improve input delivery in regions, or nationwide, for example, to
overcome balance of payment deficits. It is assumed that most social objectives fall into
two main categories: goals of economic growth and goals of improved income
distribution. These two types of goals are also sometimes called efficiency and equity
goals respectively.
Macroeconomic policy: refers to the economy wide policies which include fiscal
policy, monetary policy and exchange rate policy.
Sectoral policy: this refers to the policy that aims at affecting the economic and social
development of a sector. Output price policy, input policy, marketing policy, credit
policy, land use policy, mechanization policy, research policy and irrigation policy are
examples of agricultural polices, which is sectoral policy
Let us discuss the major sectoral policies in agriculture as follows.
3.3 Sectoral Policies in Agriculture
3.3.1 Farm Output Price Policy
Activity 3.2
 If government has to influence farm output prices using agricultural policies, what
are the objectives and instruments to affect prices of farm outputs?
_______________________________________________________________________
Farm output price policies are aimed at influencing the level of prices received by
farmers and the price paid by consumers for farm outputs. Farm output prices are
generally recognized as having three main functions in the economic system. These are:
i. To allocate farm resources,
ii. To distribute incomes, and

iii. To encourage or retard investment and capital formation in agriculture.

These functions have also been described as the signals, incentives, and instruments for
the allocation of resources and incomes.
The resource allocation function of farm prices follows from the optimizing behavior of
producers in a market system as described by neoclassical production economics. An
increase in the general level of output prices, ceteris paribus, increases returns to all
inputs in production, encouraging higher use of variable inputs, as well as providing
higher returns to the fixed inputs of land, capital and family labor. A change in the
relative price level of one output against other results in substitution between outputs as
farm household adjust to the changing relative profitability of different outputs.
The income distribution function of output prices has many dimensions. There is fairly
direct implication for staple foods that high farm prices raises producer incomes and
lower the real incomes of consumers. However, the income distribution effects of high
food prices are never in reality as simple as that.
The investment capital accumulation role of farm output prices relates to their long-run
cumulative effects. High farm output prices relative to those in other sectors increases
the rate of return to capital in agriculture and encourage investment in agriculture
Agricultural policies have their own objectives. What are objectives of farm output
?
price policy?
(Use the space left below to write your answers)
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Objectives of output price policy: There are three primary objectives of farm output
price policy, which correspond to the three roles or functions of output prices already
identified.
 To influence agricultural output

 To achieve desired changes in income distribution
 To influence the role and contribution of the agricultural sector to the overall
process of economic development.
There are many different secondary objectives of output price intervention which are
always related to one of the above primary objectives.
(a) To increase aggregate agricultural output across all crops and enterprises.
(b) To increase the output of individual crops of outputs, for example export versus
food crops for domestic use, perennial crops versus annual crops, drought-prone
grains versus drought-resistant grains.
(c) To stabilize agricultural prices, both in order to reduce uncertainty for farmers
(and thus to raise output), and to ensure stable food prices for consumers and
stability in the macroeconomic price environment.
(d) To stabilize farm incomes, as distinct from price stability, since stable prices may
or may not stabilize incomes depending on the cause of price fluctuations and the
degree of market engagement of different types of farm household;
(e) To achieve food self-sufficiency, this being an aggregate food security objective
with links to both (a) and (b) above;
(f) To generate government tax revenue either from export taxes or import taxes
(g) To generate or save foreign exchange, and thus to contribute to the balance of
payments;
Instruments of price policy: Farm output prices can be altered by government

intervention in many different ways. Instruments are grouped here according to their
type of impact on the level and stability of farm prices.
Trade policy instruments: These affect domestic agricultural prices by operating on the
prices or quantities or either import or exports. They include:
(a) Import taxes or subsidies which increase or decrease domestic prices by raising
or lowering the cost of imports on domestic currency.
(b) Quantitative restrictions on imports, which raise the domestic price above the
import price.

(c) Export taxes which are taken out of the fob (free on board) export price and
which lower the domestic price passed back to producers.
Exchange rate policy: The official conversion rates between the national currency and
foreign currencies have a major impact on the domestic prices of tradable agricultural
commodities, and this impact is the same in direction for both import substituting and
export commodities.
Taxes and subsidies: In addition to import or export taxes, already mentioned, farm
output price levels can be affected by many types of domestic tax or subsidy imposed at
differing points in the marketing chain. Some examples are:
(a) Local government impose tax on producers when they sell through specified
marketing agents, this levy being deducted from the farm-gate price;
(b) Tax on the unprocessed commodity at the point of entry in to processing;
(c) Consumption tax levied on the commodity in whole sale markets or at retail
outlets;
(d) Consumption subsidy applied to the commodity at retail outlets, either generally
or for specific retail outlets selling food to target groups of consumers.
Direct interventions: In addition to fiscal or exchange rate policies, government

frequently seeks to influence prices by direct controls on the price formation, marketing,
and storage of agricultural commodities. These controls require the creation of public
marketing agencies in order to secure control over part or all of the marketed supply of
designated commodities. Some common direct controls are as follows:
(a) Marketed output confined to sale through state channels at fixed prices, these
often being uniform fixed farm-gate prices announced in advance of the crop
season;
(b) Fixed or maximum retail prices for staple foods, with supplies being confined
mainly to state outlets and penalties for illegal pricing by private retailers;
(c) Fixed minimum prices to producers (floor prices) linked to state procurement
from the market of all supplies offered at the floor price;

(d) Fixed floor prices to producers and ceiling prices at wholesale or retail, linked to
the operations of a buffer stock authority which buys at the floor during the
harvest season and sells at the ceiling price at times of seasonal shortage.
Impact and effectiveness of price policy

Whether price policy is the most effective instrument for achieving desired goals
depends on comparisons with alternative instruments. For example, an output increase is
desired for a particular crop might be achieved by:
i) an increase in its output price
ii) a reduction in its inputs prices
iii) research into higher yielding varieties or
iv) investment in an irrigation schemes similarly.
Income stabilization for farmers may perhaps be achieved by stabilizing farm-gate
prices, but might be achieved more efficiently by growing crops with more stable yields
in the face of climatic variations.
In the short run, do you think that farm outputs are responsive to changes in the
?
level of prices ? Give your reasons.
(Use the space left below to write your answers)
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Price policy and farm output

The response of aggregate farm output to changes in the general level of farm prices is
likely to be low in the short-term, rising only gradually in the longer term. The reason
for this is that some farm resources (land and fixed capital) and technology are fixed in
the short term, but can be increased or made more productive in the longer term. It
means that price policy is rather a blunt instrument for effecting growth in total farm
output. Other longer-term policies such as research policy and irrigation investment are
likely to have a more powerful direct effect on growth. This does not mean that positive
farm prices can be neglected for aggregate output growth

Price policy and stabilization

Stabilization is one of the oldest and most common reasons given for state intervention
in agricultural markets, and it features strongly in the agricultural policies of the
industrial countries as well as developing countries. Free markets in farm products are
notoriously prone to volatile price changes. These occur due to variability in the nature
conditions of farm production (rainfall winds, floods, pests, diseases) and due to the lag
between planting decisions and the harvesting of the output.
Activity 3.3
 Agricultural price polices are used to stabilize prices. Are these polices
always bring about net welfare gain to the society?
The simple analytics of price stabilization can be examined using the partial equilibrium
methods. Figure 3.1 displays the case where price instability is caused by supply
variability. The intersection of the supply curve (not shown) with the demand curve
oscillates between point A and B. The price is stabilized at the mid-point of the two
extremes by the operation of a buffer-stock authority. The figure may be interpreted in
three steps as follows:
(a) If a deficit supply situation develops, and supply falls to Q 2 – i.e. the price would
have raised to P2 –sales are made from the buffer stock to keep the price at Pe.
Consumer surplus gain = a+b

Producer surplus loss =a
Buffer-stock income =d+g (from sales)
(b) If a surplus supply situation develops, and supply rises to Q 1 – i.e the price
would have fallen to P1-purchases are made by the buffer stock to keep the price
at pe.
Consumer surplus loss = c+d+e
Producer surplus gain =c+d+e+f
Buffer-stock costs =e+f+h (from purchase)

(c) The summary position of these welfare and resource changes is as follows:
Buffer stock cancels out: d+g=e+f+h ( income = cost)
Consumer surplus loss = d (because c+e=a+b)
Producer surplus gain =d+e+f
Net welfare gain =e+f (accrues to producers)
Thus the conclusion is that price stabilization yields a net social welfare gain. Moreover,
when price instability is caused (as in figure 3.1) by supply shifts rather than demand
shifts, producers gain and consumers lose, but producers would be able to compensate
the consumers and still come out ahead.
Figure 3.1 Welfare effects of price stabilization when supply shifts.
D
p
A
P2
a b
Pe
e f
c d
P1 B
h
g D
0
Q2 Qe Q1 Q
One further point often raised in the context of price stabilization is whether it stabilizes
or destabilizes farm incomes. At the level of the farm, the gain from price stabilization
depends upon whether a farmer is a deficit or a surplus food producer. Peasants who are
food-deficit gain from price stabilization, but those who are surplus food producers may
experience more income instability, depending on their elasticity of demand for output.

Price policy and income distribution

Governments often invoke income distribution as a reason for price intervention. It is
necessary to go behind the gross income transfers that are measured in the partial
equilibrium analysis of policies. The following points are essential to reveal the possible
impacts of price policy on income distribution.
a. Peasants are not the only rural dwellers and they vary greatly between each other
as well as differing from other rural households;
b. Higher food prices directly benefit only food surplus farmers, and they reduce the
real incomes of landless laborers and food-deficit farmers;
c. Amongst food surplus farmers, higher prices increase the incomes of those with a
large marketed surplus more than those with a small marketed surplus, with the
pure commercial farmer gaining most of all;
d. Urban consumers are not homogeneous either, they are usually divided for
purposes of investigation into at last three: high income group, middle income
group and low income group.
e. The effect of higher food prices is most severe on poor consumers who spend a
large proportion of their income on food;
f. The proportion of income spent on food declines with rising incomes, and this
means that higher food prices cause a lower proportional decline in real incomes
for richer consumers.
3.3.2. Input Policy

This section concerns the ways governments try to influence the quantities and
combinations of purchased variable inputs used by small farmers in developing
countries, purchased variable inputs include chemical fertilizers (nitrogen, phosphate,
potassium, sulfate, etc), Pesticides, weedicides, seeds of improved and high yielding
varieties, fuel, animal feeds, and others.

? Governments use input polices to influence agricultural productivity. List and

explain the dimensions and objectives of input policies in the agricultural sector.
(use the space left below to write your answer)
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Variable input policies have three main dimensions:

 The first is the price level of variable inputs and concerns state actions to
influence the prices paid by farmers for inputs like fertilizer or pesticides.
 The second is the delivery system for variable inputs, and concerns state actions
to improve the physical flow of inputs to farmers.
 The third is the information available to farmers concerning the type, quantity,
and combination of inputs appropriate for their farm systems.
Objectives of input policy

Some of the objectives of state intervention in input markets are:-
a. In general, to accelerate and to make more uniform the successful adoption of new
technology by farmers,
b. To overcome risk-averse behavior by farmers, which causes them (to underestimate
or over-discount) the returns to using new inputs.
c. To avoid mistakes in input use by farmers, which might happen on a trial-and–error
basis.
d. To provide a delivery system for inputs under conditions where private markets in
farm inputs are non-existent, unevenly developed, or uncompetitive.
e. To combine input delivery with credit provision in order to alleviate the working
capital constraint on the adoption of new inputs.

Instruments of input policy

Instruments used by governments in order to implement input policies may be grouped
according to the three dimensions of input policy already identified.
The first of these is to influence the prices that farmers pay for variable inputs,
especially the critical inputs like seed and chemical fertilizers.
The second group consists of interventions in the delivery of farm inputs, whereby the
state may wholly or partially replace private agents in the distribution system for inputs.
The third group concerns the provision of information on inputs to farmers, which in
most developing countries is the task of the state agricultural extension service.
_______________________________________________________________________
Activity 3.4
 Farm inputs are essential for farm production. However, there are a number of
problems in farm inputs. What policy intervention do you suggest to alleviate these
Problems?
_______________________________________________________________________
Input price policy interventions

Input price policy intervention in the level of prices paid by farmers for variable inputs is
widespread throughout the developing countries, prices may be fixed ex-factory when
delivery takes place through private channels, or may be fixed at the farm-gate when
delivery is by state agencies. Price fixing may apply only to major strategic inputs such
as fertilizer, or may be implemented across a range of purchased variable inputs.
Provided that delivery systems are working, price fixing can serve the purposes of
removing one of the risk elements of input purchase (price instability) and of ensuring
that all farmers pay the same price, irrespective of location, social status, or season.
In addition to fixing prices, most governments have also in the past subsidized them for
inputs such as fertilizer. The subsidy may be paid at importation (for imported inputs), to
the domestic manufacturing industry (in order to ensure an agreed level of ex-factory
price), or to the state input distribution agency in those cases where a state agency has
exclusive rights of input delivery to farmers.

In relation to objectives, input subsidies are designed to provide an incentive for the
more rapid adoption of modern inputs than would occur in their absence. They do this by
raising the net income gains from a given level of input use, and by moving outwards the
profit maximizing level of input use. Input subsidies may also be used as a method for
maintaining adequate levels of return in farm production in the face of low output prices
intended to benefit urban consumers.
Input price fixing may occur even if delivery is in private hands. For example, fixed ex-
factory prices are often imposed on fertilizer manufacturers. However, it is more
common for fixed prices to be associated with state control over the delivery of inputs to
farmers.
Policy interventions in input delivery systems

State delivery agencies for farm inputs can take many different forms, between as well
as within countries. At one end or the spectrum there may be an agricultural
development corporation with wide ranging responsibilities for input delivery, credit
provision and extension services to farmers.
In other cases these functions may belong to separate institution, or input delivery may
be fragmented between a number of project agencies for particular crops or particular
regions. In some cases, input delivery is combined with crop marketing research and
extension in crop-specific parastatals. In others, input delivery is handled by branches of
the state credit agencies, while extension is run from the central ministry of agriculture;
in still others the cooperative system has a role to play as exclusive final distributor of
inputs to farmers.
Policy interventions in information on inputs

Lack of practical and relevant information has long been recognized as an important
barrier to rapid and widespread adoption of innovations by farmers. This applies not
only to variable inputs, but also to the cultivation practices and farming systems
appropriate to new seeds.

The traditional method of conveying new information to farmers relies on the

government extension service. An extension system is composed of a body of trained
extension officers, each of whom is allocated a district or area within which to provide
advice and to carry out training for individual farmers or groups of farmers.
Aside from extension services, information on inputs can be conveyed to farmers in
several other ways: field days run by research stations, widely distributed information
leaflets, radio programs for farmers, and so on. It is accepted that the state should play a
role in these channels of farmer education. For farming communities making the
transition from non-purchased inputs to purchased inputs, reliance solely on commercial
information provided by competing private sector agents could be misleading or
confusing.
______________________________________________________________________
Activity 3.5
 Policy makers use different policies, like input policy, to achieve some well defined
objectives. Are these agricultural policies with out problems?
_______________________________________________________________________
Input policy problems

Input subsidy problems: A range of problems and side-effects associated with
subsidies on the prices of variable inputs are now recognized. In part this recognition
follows the more general trend of skepticism about the efficacy of state controls. In part
it results from the inability of many developing countries to continue to bear the
financial burden of open-ended input subsidies. The net effect, including the result of
pressure from donors like the World Bank, is that input subsidies are tending to be
lowered or eliminated in many countries. Some main problems with input subsidies are
as follows:
(a) The border pricing argument: the divergence between a low domestic price to
farmers and a high import price is socially inefficient. These result in a misallocation of
resources because farmers are not making their production decisions according to the
opportunity cost to society of the resources employed.

(b) The cost control problem: the long-term budgetary cost of input subsidies grows
over time and is difficult to predict. It grows over time precisely because the subsidized
price induces a rapidly growing volume of sales, but the rate of this growth (the
accelerated uptake by farmers) is not known in advance. A subsidy which begins as a
minor budgetary item at low levels of sales can quickly become a drain on state
resources, reaching as high as 20 or 30 percent of the government budget in a poor
country.
(c). Farm resource misallocation problems
This includes:
i. excessive use of an input (e.g. too much urea so that the crop falls over);
ii. Inefficient substitution of scarce for abundant factors of production (e.g.
substation of chemical –intensive for labor intensive disease control methods);
iii. Diversion of subsidized inputs from the target crop of government subsidy
policy (e.g. an export crop like coffee) to other crops favored by the farmers
(usually staple food crops).
(d). Problems of delivery failure or diversion, including:
(i) Failure of supply to meet demand at the subsidized price, causing formal or
informal rationing of the input.
(ii) Illegal marketing of the input at unofficial prices, usually reflecting supply
failures either locally or nationally;
(iii) Smuggling of the input across the border with an adjacent country, reflecting
the price gap between the countries created by the subsidy.
(e). Equity problems. An input subsidy is progressive in its effect on income

distribution
since it benefits most of those farmers who use more of the input and these will tend
to be the wealthier farmers.
State delivery problems

The delivery of variable inputs to farmers by state agencies is prone to many difficulties.
Indeed, sometimes input delivery and crop marketing functions are located within the

same parastatal agency. These problems are well recognized and do not need to be spelt
out in great detail. They include;
(a) Biases of rationing when the input is in short supply, typically favoring wealthy
clients who are in a position to pay the ‘under-the-table’ costs of acquiring input
supplies;
(b) Biases against small and poor farmers even when supply is unconstrained,
usually due to the linkage between state credit provision and input delivery;
(c) Cumbersome and sometimes unworkable bureaucratic procedures for the release
and delivery of inputs to farmers or cooperatives, which tend to favor those who
can afford to persist with the paperwork or can pay others to do so;
(d) Underpaid and poorly motivated officials who have no incentive to conduct
transactions with speed and efficiency;
(e) Failures of delivery to remote and outlying, causing erratic availability even
when overall supply is unconstrained;
3.3.3 Marketing Policy

_______________________________________________________________________
Activity 3.6
How do you explain the marketing of agricultural product? Do you think that the
 agricultural product marketing is working properly? If not what policy intervention

do you suggest?
_______________________________________________________________________
Concepts in the study of Marketing
The marketing of farm output is typical though to play a dual role. One dimension is the
transmission of price signals between consumers and producers. The other dimension is
the physical transmission of the commodity from points of production by farmers to
points of purchase by consumer.
The physical movement of the commodity from farmer to consumer itself has three
further dimensions, and it is recognition of these that is the cornerstone of many type of

policy analysis of marketing. The marketing system transforms the commodity in time,
space and form, which means that the customer is able to buy the commodity
i. at the different time from its harvest and sale by farmers,
ii. at different place from its point of sale by farmers, and
iii. in a different form (e.g. maize flour) compared to its sale by formers (e.g. maize
grain)
Each of those dimensions has special attributes of its own, which distinguish one from
the other, and which between them describe the range of activities that are involved in
crop marketing.
The time dimension refers to all aspects of storage across seasons (inter-seasonal
storage) and across year (inter-year storage). Storage has costs and risks. Storage costs
consist mainly of the money tied up in the stocked commodity (interest changes), the
quantity and quality losses of commodity in store that rise over time, and the accounting
costs (depreciation, etc) of capital invested in storage facility. Storage is risky because
future prices may not rise sufficiently to compensate for the costs involved. In many
countries household storage by peasants is an important proportion of the costs of the
total volume of inter seasonal storage.
The space dimension refers to all aspects of the transport of commodities from location
of sale to location of final purchase. Transport distances may be local (to nearby village
market), medium distance (to provincial centers), or long distance (to capital cities or
ports of export). Distances and costs depend on the location of surpluses and deficits,
and on the commodity (for example light versus bulky commodities, durable versus
perishable commodities). Like storage, transport involves risk concerning price
differences between origin and destination, and for perishables, the condition of the
commodity on the arrival. These risks are such greater in situations of disintegrating
infrastructure, shortages of fuel and spare parts, commodity movement restrictions and
related difficulties.
The form dimension refers to all changes in physical attributes of the commodity
between farmer and consumer. It includes not only direct processing (e.g. milling), but

also cleaning, sorting, labeling, packaging, canning and so on. The form dimension
varies greatly between commodities, and also the one that changes most as development
proceeds due to changing demand patterns as incomes rise. The cost and therefore the
margins, involved in changes of form can therefore vary over a wide range.
The overall difference between the purchase price of the commodity by consumers and
its sale price by producers is called the marketing margin. The marketing margin
covers all three dimension of marketing.
Objective of marketing policy
The objectives of government intervention in agricultural marketing are closely related

to perceptions about the structure, conduct and performance of private marketing
channels. Also important are the links between marketing interventions and other
objectives, especially those of price polices. The view that private traders are able to
exploit farmers or consumers by the exercise of local monopoly power is widely
prevalent as a reason or an excuse for marketing interventions. The objectives most
commodities advanced for government marketing policies are as follows:
(a) To protect farmers or consumers from parasitic traders: this is the age-old
reason for marketing interventions, based on the idea that middlemen are able to extract
monopoly profits from their position between scattered and ill-informed producers, on
the one hand, and captive consumers on the other hand.
(b) To stabilize or increase farm-gate prices: Output price polices designed to

stabilize or increase producer prices may require state marketing intervention to achieve
their aims.
(c) Reduce the marketing margin: This links to the first objective stated above. The
state may intervene specially to narrow the gap between consumer and producer prices.
Reducing the size of the gross marketing margin may be part of trying to raise producer
price by increasing the producer share of given retail or export price or it may related to
reduce urban food prices for consumers.

(d) To improve quality and minimum standards: A common objective of marketing

intervention is to try to raise the quality of farm output, especially for export crops which
confront rigorous quality norms in international markets.
? Governments of developing countries have used many different instruments to
influence the working of agricultural marketing channels. List these instruments
used to influences the working of agricultural marketing channels.
(use the space left below to write your responses)


_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Instruments for marketing policy
Governments of developing countries have used many different instruments to influence

the working of agricultural marketing channels. This range from attempts to replace
private channels almost entirely by state institutions, through partial involvement of sate
bodies, licensing of approved traders and processors, minor regulatory functions
concerning quality standards grading and hygiene. The following list describes various
types of intervention without going into a lot of detail on specific forms each type can
take:
(a) Monopoly Parastatals: This category includes all those government-owned

institutions that represent some form of monopoly control over one or other stage of the
marketing system. It includes marketing boards.
(b) Non-monopoly parastatals: this category includes a wide range of different

institution that provide one particular channels, but not exclusive channel, through which
crops sales by peasants are transformed to customers. The predominant form of non-
monopoly parastatals is the state buffer-stock authority for staple food grains. The tasks
of such an authority are to implement floor and ceiling prices for major food grains. This

is done by buying in all grain offered by farmers or traders at floor price or delivery
price and by selling grain out of public store in order to prevent retail market prices from
going above an agreed ceiling..
(c) farmer cooperatives: This may seem a strange category to include amongst state
marketing intervention, but also marketing cooperatives are rather rarely devised and run
by farmers themselves; Sometimes it is compulsory for all farmers in a particular
location or growing a particular crop like coffee or cocoa, to belong to the designated
cooperatives.
Impact on prices of changing the margin
The gross marketing margin between producer and consumer prices can be changed by
the state in several different ways. One way is to impose, eliminate or vary the level of
the sales tax, for example a retail sales or a producer levy per kilogram sold. A second
way is to reduce transport costs say by opening a new truck road or reducing the price of
fuel. A third way might be to reduce storage costs by offering private storage agents
credit terms as subsidized interest rates. The gross marketing margin is presented on a
supply and demand diagram (Figure 3.2 (a)), by the prices differences when supply and
demand at the farm level (SF and DF) are equated at the same quantity as supply and
demand at retail level (SR and DR). In Figure 3.2 (a)) the equilibrium quantity is Q e, and
the gross marketing margin (M) is PR minus PF. This diagram assumes linear demand
and supply curves, and margins that stay the same over every range of quantity. This
assumption may not be very realistic but this is not important for grasping the basic
analysis involved.

Figure 3.2 (a) Marketing margin in terms of supply and demand (b) result on narrowing
the margin P
(a) SR
PR
SF
M
PF
DR
DF
0
Qe
Q
pR
(b) S
pR’ R
pF’ SF
PF
0 DR DR
Q
Qe Qe’
The impact of reduction in the margin can be represented by the retail supply curve (S R)
moving closer to the supply curve at farm level (S F) and farm level demand curve (D F)
moving closer to the retail demand curve (D R). This is shown in figure 3.2(b), where the

change of position of those two curves is shown by the arrows. It is clear from this
diagram that the producer price has fared differently from the retail price after this
change. More specifically, there has been a relatively small increase in the producer
price, from PF to P’F, and a much larger decline in the retail price from PR to PR’
? Of the different agricultural policies that we have studied so far, which policies are
being implemented by Ethiopian government? How do you explain effectiveness of
these policies?
_______________________________________________________________________
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3.3.4 Credit Policy

Credit is a sum of money in favor of the person to whom control over it is transferred.
The provision of credit involves two parties; a lender and a borrower. It also involves a
price for the transfer of control over money, which is the interest rate charged by the
lender to the borrower. At a simple level, neoclassical economics treats the market for
credit like any other market: it contains a demand schedule, a supply schedule, and a
price-the interest rate-that adjusts to bring demand and supply into balance. In addition
to lenders and borrowers, the other main actors in a rural financial system are savers.
The saver is the person, or household, or institution that is prepared to supply funds to be
held by a financial institution in return for an income flow in the form of interest
payments.
Objectives of old credit policy

In the 1950s and early 1960s, credit provision was considered a key instrument for
breaking the ‘vicious circle’ of low incomes, low savings, and low productivity.
However, in that period emphasis was far more on market-orientated farmers and
commercial agriculture (plantations and estates) than on peasants. From the mid-1960s
and up to the present time small farmers and the rural poor has increasingly become the

chief target of credit interventions. The objectives of credit policies, and the reasons for
their popularity with governments and aid donors alike, are summarized as follows:
(a) To alleviate a critical constraint hampering growth in agricultural output, this

constraint being lack of cash to make needed farm investments (irrigation,
drainage, pumps, tractors, buildings) and to purchase ‘modern’ variable inputs
(fertilizer, pesticides, fuel, feeds, etc.)
(b) To replace the fragmented and incomplete rural financial market represented by
private moneylenders these credit sources supposedly having the effect of
impoverishing their clients rather than assisting them to improve their
productivity
(c) To accelerate the adoption of new technology by peasant farmers by providing
working capital for the seasonal purchase of variable inputs, and hence
optimizing the complementarities between input essential for the success of
Green Revolution Technology.
(d) To assist small farmers to overcome their inability to borrow from commercial or
informal credit sources, due to lack of collateral and lack of information
(e) To provide short-term credit in order to bridge seasonal and temporary cash
shortfalls of small farmers, compared to the medium- and long-term lending
preferences of commercial financial institutions
(f) To achieve equity goals whether these are related to intra-rural, inter-regional, or
rural-urban income distribution
(g) To offset the disincentive effects for small farmers of policies unfavorable to
them including low output prices over-valued exchange rates and inefficient
market interventions by the state
(h) To gain favor with farmers for political purposes, including forthcoming
elections, and so on.
(i) To take advantage of the sometimes overwhelming generosity of foreign aid
donors, who seem to be prepared to pump large amounts of money endlessly into
rural credit projects.

____________________________________________________________________
Activity 3.7
farmers need finance for their farm production, especially for the purchase
 of farm inputs like fertilizer, high yielding verities, and chemicals. Is it possible
for these small farmers to get credit from financial institutions like commercial
bank?
_______________________________________________________________________
Instruments of old credit policy

The institutions created or regulated by the state in order to deliver credit to farmers use
instrument for implementing credit objectives. The ways these institutions operate, and
the constraints imposed on them by government policy, also involve more specific
instruments for achieving goals such as output growth, equity, small farm coverage, and
short-term credit. Some main instruments of state credit policy in developing countries
are:
(a) Low interest rates
One of the most popular instruments of credit policy in developing counties has been to
subsidize the rate of interest on loans to farmers. The reason for this is the belief that the
demand for credit by small farmers is highly sensitive to the interest rate.
(b) Credit targeting
The orientation of credit policy towards small farmers involves extensive use of
targeting devices. Evaluations of earlier subsidized credit schemes commonly showed
that larger farmers were their chief beneficiaries, for a variety of reasons. In this case,
the target group may be defined according to various criteria such as farm area or family
income.

(c) Loan portfolio regulations
Various devices may be used by governments to restrict the decision-making flexibility

of financial institutions, or to try to enforce compliance with state objectives. One device
is to set a minimum to the proportion of agricultural sector loans out of total loans.
Another device is to stipulate maximum permissible loan sizes, in order to avoid too
large a share of total loans going to large borrowers. A third device is to place
restrictions on the term structure of the loan portfolio, such that the major proportions of
total loans are short-term loans. The reason for this is the view that small farmers mainly
require short-term loans, i.e. as working capital for input purchase, while large farmers
require medium and long-term loans for capital investment.
Defects of old credit policy

Since the mid 1970s, a considerable volume of critical literature has appeared
concerning credit policies in developing countries. The central components of the
critique are set out in the following paragraphs.
(a) Fungibility
The fungibility attribute of credit, and of loanable funds more generally, invalidates most
state targets and regulations for credit delivery. Fungiblity exists in all tiers of the credit
system, from the farmer, to the financial intermediary, and to the central bank.
At farmer level, fungibility means that loans targeted for specific purposes (e.g. fertilizer
use in cotton cultivation) may be used by the household for quite different ends (e.g.
purchase of a sewing machine to make garments).
(b) Low interest rates
Subsidized interest rates create several negative effects for the long-run viability of rural
financial institutions as well as for borrowers and savers. First, a negative real rate of
interest virtually causes a transfer of real resources from leading institutions to
borrowing farmers, thus undermining possibly decisively the viability of lenders.
Second, low interest rates to borrowers make it impossible to offer attractive interest
rates to savers. Third, low interest rates may mean that it is impossible for the lending

institution to cover the transaction costs of making loans within the margin between the
borrower interest rate and the rate lender must pay for securing funds from the central
bank, or from its own savers. This further damages lender viability, and may result in
transaction costs being transferred, as non-interest costs, to borrowers. In addition, it
may result in diversion of loans to big borrowers since unit transaction costs are always
much lower for big loans than for small loans. Fourth, low interest rates cause an excess
of demand over supply of credit, resulting in formal or informal credit rationing which
tends to favor the big and rich borrower over the small and poor borrower.
(c) Transaction costs
High transaction cost was a critical defect of credit policies in the past. This was partly
due to large number of small borrowers and lengthy paperwork. High transaction costs
threaten the viability of lending institutions, cause transfer of costs to borrowers or
savers, and result in lender preference for few big loans rather than many small ones.
(d) Loan recovery
Studies published in the early 1980s indicated average loan failure rates across samples
of credit schemes at around 25 per cent, rising to 80 per cent in some cases. Loan default
is typically considered to be caused by two main factors: (i) inability to repay (e.g. due
to crop failure or (ii) unwillingness to repay (e.g due to viewing the loan as a grant, or as
political patronage).
(e) Savings failure

Saving was some time ago dubbed ‘the forgotten half of rural finance’. The argument is
that since rural credit agencies fail to encourage rural saving, they also fail to possess
funds that can make them independent of central or external funding. Thus they are also
incapable of surviving as self-sustaining financial institutions in the long term.
3.3.5 Food Policy

The concept of food policy

Food policy concerns the integration of state actions affecting the supply, distribution,
and consumption of food in order to ensure continuity of access to enough food for all
the people in a country. In this context, supply refers not just to domestic production but
also to the potential that exists for supplementing food production by commercial
imports or by food aid. Distribution refers to the way food marketing channels work, and
to the effectiveness of the time, place and form functions of domestic marketing systems.
Consumption refers not just to the aggregate volume of staple foods consumed by the
population at large, but to the distribution of this volume between people, and to the
ability of different groups of people to acquire staple foods given their patterns of
employment and incomes, and the levels and trends of food prices.
On the supply side, food policy is concerned with food production and its rate of
growth, with food imports, and with food aid. Food production encompasses the inputs,
outputs and technology of farm production, as well as instruments aiming to change the
size and composition of food output. Food imports provide an alternative to domestic
production for the achievement of a given level of total supply. Food aid provides yet a
third alternative source of food supplies.
On the demand side, food policy is concerned with the adequacy of food consumption
across all groups of people and individuals in society. It is concerned with the aggregate
and average nutritional status of the population. With identifying those groups and
individuals whose nutritional status is below the minimum required for healthy
survival, with the purchasing power of different groups of people over food, and with
policy instruments designed to improve the access to food of sections of the population
that are vulnerable to inadequate levels of food consumption.
Food policy instruments

The shift in emphasis from a food availability to a food entitlement view of food security
leads also to a shift in the combination of policy instruments that are considered
appropriate for an integrated food strategy. In what follows, policy instruments related to
food supply are considered separately from policy instruments related to food demand.

? Most developing countries in Africa are food self insufficient. Is our country food
self- sufficient? If not what are the reasons not to be food self sufficient.
(Use the space left below to write your opinion)
_______________________________________________________________________
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Food supply
Previous mainstream ideas about food policy emphasized the supply side of food
markets, and placed priority on domestic production rather than trade. In addition, price
stability for consumers and producers has always featured strongly in conventional food
policies.
(a) Self-sufficiency
The focus on domestic self-sufficiency in staple foods is based in part on avoiding undue
reliance on unstable and unpredictable world food markets. Domestic food production is
promoted by the range of policies, including producer price policy, input policy, credit
policy, research policy and irrigation policy. Growth of domestic food production
towards self-sufficiency mainly addresses the problem of aggregate food availability. It
has some impact on chronic food insecurity to the extent that the employment and
income prospects of poor farmers and landless laborers are improved. It may also help
overcome some types of transitory food insecurity. For example, irrigation does this by
reducing the seasonality of output for participating farmers.
(b) Price stability

In conjunction with food self-sufficiency, price stability is typically approached by the

creation of a national food security stock, built up front domestic production. The food
security stock is used to stabilize; consumer prices by releasing grain out of stock to
defend a ceiling retail price. Many different ways of operating such a stock can be
found across the developing countries, some based on floor and ceiling prices-which is
the conventional buffer stock model-and some based on fixed producer and consumer
prices.
Price stability based on domestic production and domestic stocks requires the existence
of a parastatal authority with wide-ranging, some –times monopoly, powers to buy and
sell grain, and to regulate the quantity and price of imported supplies in years when
there is a short fall in the domestic market.
(c) Further points on the food supply approach

The conventional food policy model is aggregative in nature. It interprets food security
as the national balance of supply and demand, with the main objective being to bring
the growth in domestic production into line with the growth in domestic food demand.
Interpersonal inequalities of consumption are relatively down-played in this model.
The pursuit of domestic self-sufficiency is regarded nowadays as a potentially high cost
and socially inefficient method for achieving the supply side of food security. It is
pointed-out that self-sufficiency is neither a necessary nor a sufficient condition for the
achievement of food security. It is not a necessary condition, since imported supplies
can be used to cover the varying gap between domestic production and consumption. It
is not a sufficient condition because even with self-sufficiency there may be significant
categories of the population facing chronic or transitory food insecurity due to lack of
food entitlement.
Even if broad self-sufficiency can be justified in comparative advantage terms, the cost
of balancing supply and demand at the margin can be reduced considerably by making
more use of the world market rather than depending entirely on domestic stocks. This is
because the size of stock required to balance the domestic market using only domestic
supplies is many times larger than the size of stock needed if imports are utilized to
assist with balancing the market.

Food demand
The contemporary approach to food security emphasizes the demand side of food
market and the disaggregated access of people to food. This leads to emphasis on a
different set of policy instruments from those associated with the aggregate production
model, although it should be understood that these are matters of emphasis and degree,
not the wholesale abandonment of one set of policies in favor of another. In the
following paragraphs the major features and instruments of demand side food policy are
examined under the sub-headings of nutritional status and policy instruments.
(a) Policy instruments
Instruments for tackling lack of entitlement over food can take two forms either
lowering the price of food to improve exchange entitlement (food subsidies), or
increasing command over food (by employment creation, food for work programs, or
cash transfers). These instruments can be general in scope, i.e. they apply to all food
consumers, or can be targeted as precisely as possible to the social groups in need.
General consumer subsidies on food have been favored by some countries (Egypt is a
frequently cited example). This means that the problem of identifying vulnerable groups
is avoided. However, it also means that all consumers, whether rich or poor, benefit from
the subsidies. One problem with general consumer subsidies is that they have high
budgetary costs which are also open-ended- the subsidy must cover the growth in
demand induced by the low prices. This includes the substitution by consumers
(including richer consumers) of the subsidized food for higher priced foods. Another
problem is the impact on farm prices, and thus on the incentive to produce.
The alternative to general consumer subsidies is to target relief to groups known to be at

risk. Various instruments can be found indifferent countries including ‘fair price’ shops
food stamps, public employment programs, food for work schemes and so on. Targeting
that depends on providing low-cost food to eligible groups suffers from high
administrative costs and inevitable leakages and abuses. This category may be described
as administered targeting, and it includes any type of scheme where the rules of

exclusion or inclusion are determined and administered by specialized bureaucratic

agencies.
An alternative type of targeting-‘self-regulating targeting’ is to choose commodities for

subsidy, locations for subsidy, or employment programs such that anyone is eligible to
participate. An example would be to subsidize the price of an inferior staple food only
consumed by poor people. Another example would be to create food-for-work programs
in a location where the number of people requiring relief more or less corresponded to
the amount of work that can be offered.
The consensus on policy instruments designed to alter the food entitlement of people is
that target interventions are preferable to generalized interventions, and that self-
regulating targeting is preferable to administered targeting. Aside from bureaucratic
feasibility, government budgetary cost, and son on, the economic reason for preferring
targeting to generalized interventions is that the former avoids the creation of economy-
wide price distortions.
Integration of policy instruments

Ideally, both supply side and demand side instruments of food security should be
integrated in order to form a coherent and integrated food policy. This rarely occurs in
practice, not the least because different components of the overall food and nutrition
picture are often handled by different state agencies at central government level.
Domestic agricultural production is almost always handled by the ministry of
agriculture. Nutrition, on the other hand, may be located in the ministry of health, public
employment schemes or food-for-work projects may be in the domain of the ministry of
labor or the ministry of public works. The effort of coordinating the food security
activities of all these agencies is considerable and seldom achieved except, perhaps, in
food disaster situations.
There is general agreement in the literature that as far as the demand side of food policy
is concerned; the ultimate long-run objective is to eliminate poverty via a –combination
of overall growth, an attention to the income distribution dimensions of alternative
growth strategies. For example, one of the leading writers in the food policy area sees

the solution to the food entitlement problem to lie in employment-intensive

development, especially of the small-farm sector; leading to patterns of rising demand
for labor-intensive consumer goods, self-reinforcing growth of small-scale activity, and
rising employment and incomes for previously vulnerable social groups.
3.3.6 Food Security and Food Policy

Theoretical development of food security
The concept that helps to foster an integrated approach to food and nutrition problems is
that of food security. There have been many definitions of food security in the literature
over the years. However, the definition that is now days widely accepted as capturing the
spirit of the concept is that defined by the World Bank (1986). Food security is the
access by all people at all times to enough food for an active, healthy life. Its essential
elements are the availability of food and the ability to acquire it. As embodied in the
World Bank definition, these principles may be distinguished as follows.
First, the definition emphasizes access to food rather than supply of food. This is
consistent with the concept of food entitlement and it focuses on whether people have
sufficient command over food. Second, the definition emphasizes the access to food by
all people implying that an aggregate view is insufficient; the situation of individuals and
social groups at risk is of critical importance. Third, the definition refers to both
availability of food and ability to acquire food, corresponding to the food availability
versus food entitlement distinction mode.
Food insecurity, intern, is the lack of access to enough food. Over the last decade, there
has been an increasing trend in per capita food output in the world. But, a significant
proportion of the population particularly in less developing countries have been suffering
from hunger and malnutrition..
Conventionally, food security is defined as the access by all people, at all times, to
enough or sufficient food for an active and healthy life (World Bank, 1986). There are
four distinct concepts in this definition: sufficiency, access, security ,time

“sufficiency” indicates enough supply of calorie including necessary intake of proteins

and micro-nutrients
“access” marks the ability of households to get command over food through production,
purchase, exchange or gift
“Security” is access to sufficient food with the existence of risk which vary from natural
to manmade factors.
“Time” dimension describes the intensity and characteristics of household food
insecurity.
? Explain the importance of food demand estimation for food security in our country.
(Use the space left below to write your opinion)
_______________________________________________________________________
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Food Demand Estimation

The need for food and the effective demand for food are related but distinct concepts.
Food needs correspond to nutrient consumption required to maintain normal physical
and mental growth in children and to sustain healthy bodies and normal levels of activity
in adults. The effective demand (often called simply demand) for food is the amount of
food people are willing and able to buy at different price levels given their disposable
income
In less developed countries population growth is the major factor in the demand for food.
For example, the 3% growth of Ethiopian population entails that food supply must
increase by 3% at least to keep pace with the prevailing population growth. Moreover,
any increase in income results in high demand for food because of the high income
elasticity of demand for food at low level of economic development.
Balanced growth implies the equality of food consumption and food production in a
subsistence economy. Growth of demand for food depends on
Population growth
Per capita income

Net export
Considering the internal condition only (ignoring import and export)
Subsistence food demand

Where P = population
= per capita consumption of agricultural products
= agricultural production
This implies that
Where = growth rate of population
= growth rate of capita consumption
= growth rate of agricultural production
In market economy, the growth rate of per capita consumption ( ) depends, in tern,
on the growth of income. Then income elasticity of demand ( ) is:
Where, rate of demand growth (rate of growth in per capita consumption - )
= rate of growth of per capita income
is, therefore, the best substitute of . Hence, the final expression of balanced
internal growth (food self-sufficiency) is:
Therefore, the critical factors for balanced growth are growth rate of population, income
and income elasticity of demand.

Example
Suppose population growth rate is 3%, income elasticity of demand for consumption is
0.75 and income grows at rate of 5%. What should be the growth rate of agricultural
production for balanced growth of the economy?
0.03 + 0.75(0.05) =
0.03 + 0.0375 =
0.0675 =
6.75% =
Exercise 1
Suppose, for example, in an absolute agricultural country where the contribution of other
sectors is negligible, population has grown from 50 to 60 million and agricultural
production from 120 to 150 million quintals. What should be the growth rate of per
capita consumption of agricultural products to subsist the economy?
? Discuss the importance of food aid in food security program and distinguish main
categories of food aid
_______________________________________________________________________
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Food Aid
The importance of food aid in food security and food policy has long been a debatable
issue. Food aid is a method for disposing of food surpluses produced in developed
counties. Ghatak and K.Ingersent (1984) distinguished four main categories of food aid
for the purpose of food policy discussion. These categories are:

Program food aid: this is the largest category of food aid in quantitative terms, and is
food aid delivered for purpose of sale by recipient governments.
Project food aid: this food aid designed for use in specific food related projects in
developing countries including nutrition projects, food for work schemes, other types of
employment creation schemes and rural development projects
Emergency food aid: this is urgent food aid delivered in order to overcome acute local
or national food deficits, such as occur in famines, or as a consequence of natural
disasters or war.
Adjustment food aid: this is food aid delivered as part of a structural adjustment
package and designed to mitigate the effects on social groups whose access to food is
adversely affected by policy reform packages.
3.4. Agricultural Policy Analysis

The basic aim of agricultural policy analysis is to examine the extent and manner in
which national or international prices and markets should be allowed to affect domestic
prices of export products and import good to guide domestic prices and to determine
how food consumption and government revenue needs are to be met. In order to meet
these goals, the government intervenes in the agricultural sector through different
categories of policy analysis.
? Policies can be analyzed using producer surplus and consumer surplus. Define
producer surplus and consumer surplus and explain how these can be used to
measure social welfare ?
_______________________________________________________________________
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3.4.1. The Partial Equilibrium Analysis

the partial equilibrium analysis makes extensive use of two main concepts that permit
the rather abstract notion of social welfare to be translated in to something which can be

measured and quantified in terms of money. These two concepts are producer’s surplus
and consumer’s surplus. Both are partial means so far devised by economists for
measuring welfare implications of alternative. In development economists they are the
foundation both for assessing the welfare implications of alternative polices and for the
social cost-benefit analyses of development projects. Producer surplus is defined as the
area above the supply curve and below the price line of he corresponding firm or
industry. The authors also defined that consumer surpluses is the area under the demand
curve and above the price line.
In this section we need supply and demand equation to derive supply and demand curve
and see the way in which equilibrium price and output are determined. The quantity
supplied refers to the amount of output producers are willing and able to make available
in the market over a given period at certain price, other things being constant. On the
other hand, the quantity demanded refers to the amount of output consumers are willing
and able to purchase in the market over a given period of time, other things being equal.
Equilibrium prevails when economic forces balance. Market equilibrium is attained
when the price of output adjusts so that the quantity consumers will buy is equal to the
quantity producers are willing to sell at that price. The graphic analysis of supply of and
demand for output is illustrated as follows.
Figure 3.3 Partial Analysis
Price, P Supply curve
Consumer
surplus C E
P*
A
Producer
surplus
Demand curve
B
Q* Output, Q
The demand curve measures the marginal utility offered by each unit of output. The
supply curve measures the quantity of output available in the markets for sale. A close
examination of the graph clearly describes that at the intersection of the two curves
quantity supplied and demanded are equal indicating that the equilibrium level of output
and price are Q* and P* respectively. The difference between the supply curve and the
equilibrium price is a measure of producer surplus. The difference between the demand
curve or marginal utility curve which indicates the maximum price which the consumer
would be willing to pay for that unit of output, and the price actually paid, equilibrium
price, is a measure of surplus which is referred to consumer welfare or consumer
surplus. The concept of consumer surplus provides a measure of consumer welfare, as
the excess of the price the consumer would be willing to pay for each unit consumed
over the price, which is actually paid.
The figure 3.3 describes the market supply and demand curves for a farm output. The
output could be any farm output such as teff, wheat, maize or beans. The quantity of
output that farmers supply curve represents the total variable cost incurred by farm
households, when operating at a given point on the market supply curve. The total
revenue divides between an area under the supply curve, area “B”, and an area above the
supply curve but under the ruling market price, area “A”, which represents the gross
money obtained by selling Q*, at price P*. This gross margin, representing profit and
payments to fixed factors of production, which is called the producer surplus. Producer
surplus equals total revenue minus total variable cost, and thus equals the gross margin
for the farm household.
The equivalent measure to producer surplus is the demand curve for an agricultural
commodity or output. The demand curve has a negative slope. It indicates the consumers
purchase more of the commodity as its price falls. Assume that consumers are in
equilibrium at point of intersection of the two curves where the market price is P* on the

market demand curve. The total consumer expenditure is thus given by P* Q*.
Consumer expenditure can be calculated as that area under the demand curve bounded
by the market price and the quantity purchased at the price. The area below the demand
curve and above the ruling market price is the total consumers would have been willing
to pay for successive units of output and what they actually pay at the ruling market
price.
In agricultural price policy sense, if there is government intervention in determining

price level other than the market price, P*, the surplus conditions of both producer and
consumer would be affected. If government sets price above equilibrium price, consumer
surplus would be decreased, and vice versa.
Example
A farm produces output coffee for sale. The supply and demand equations of the output
are given as:
and
Where = Supply of coffee output
= Demand for coffee

= Price of coffee per unit
i. What is the equilibrium level that the producer supply coffee production at free
market economy?
ii. Suppose the government intervene in the market and impose a price of coffee at
Birr 7 per unit. Determine the policy effects on the producer
iii. What do you suggest about policy intervention in favor of coffee purchasers?
Solution
i. At free market economy, it is said that the two equations are equal. Thus,
=
9P-27 = 108-6P

15P=135
P= 9
= 9P-27
= 9(9)- 27
= 54 units of coffee
ii. Since a policy imposes price less than the price that market determines, the
intervention negatively affects the producer. The producer only supplies 36
units of coffee.
iii. Although the price of coffee is fixed at level less than the maker price, the
shortage of coffee exists in the market. The government, therefore, has only
one option in favor of consumers, i.e import to cover the shortage.
3.4.2. The Policy Analysis Matrix (PAM)

The policy analysis matrix is used to examine the impact of policy on competitiveness
and farm level profits; to understand the influence of policy on macroeconomic
efficiency and comparative advantage of the economy and to know the impact of
research policy on technological changes. The policy analysis matrix (PAM) is a system
of double entry book keeping which requires consistent coverage of policy influences on
returns, costs and profits.
Structure of PAM
Costs
Variables Revenue Tradable Domestic profit
Inputs Factors
Private prices A B C D
Social prices E F G H
Divergences/Transfers I J K L
Private refers to the observed revenue and costs reflecting actual market prices received
or paid by farmer, merchants or processors in the producing and selling system; where
the letters defined as follows:

A = the revenue from private prices expressed in terms of domestic currency i.e.
where and refers to the price and quantity of domestic output

respectively
B = the total sum of costs on tradable inputs that are required in the production system,
i.e where refers to the price of tradable input i; refers to

quantity of tradable input i.
C = the total sum of costs on non-tradable inputs; i.e C = where implies
domestic input prices that valued at actual prices; implies domestic non-tradable
inputs; such as land and labor.
D = the private profit from that particular output which is the difference between
revenue and costs. i.e D = A-B-C
E = the revenue from social prices expressed in terms of opportunity costs; i.e E =
where refers to world price of output; refers to quantity of output sold at

world price
F = the total sum of costs on tradable inputs at shadow prices; i.e F= where
indicates price of input i at shadow price; indicates quantity of input i .
G= the total sum of costs on non-tradable inputs at shadow prices; i.e
where implies shadow price of input j; implies quantity of input j.

H = the social profit derived from social revenue and social costs. i.e H = E-F-G
I = the divergence in revenue of private prices and social prices. It is also known as
output transfers; i.e I = A-E
J = the divergence in costs of tradable inputs between private and social prices. It is also
known as input transfers; J = B-F
K = the divergence in costs of non-tradable factors between private and social prices. It
is also known as factor transfers; i.e K = C-G
L = the divergence in profit of social prices from private prices. It is also called net profit
transfer; i.e L = D-H

By using the policy analysis matrix that is constructed for output production systems
considering agricultural policy reforms in line with structural adjustment policies one
can compute nominal protection coefficient, effective protection coefficient and
domestic resource costs.
Nominal protection coefficient (NPC)

It measures the ratio of its domestic private prices to its border price. The border price is
defined as the price in the international market converted in to local currency using an
exchange rate. Nominal protection coefficient can be nominal protection coefficient of
output (NPCO) and input (NPCI). The NPCO measures the ration of total revenue at
private prices to total revenue at social prices. It measures the degree of output transfer.
In other word, NPCO = A/E . The NPC is used to determine whether the private or
social receives more prices. The NPCI measures the ratio of actual private prices of
tradable inputs to its social prices. The NPCI measures the ratio of actual private prices
of tradable inputs to its social prices. NPCI = B/F, it is also used to compare private
prices with social prices
Effective protection coefficient (EPC)

By calculating the effective protection coefficient, an analyst attempts to capture the
incentive impact of policy on the production structure. The EPC also measures the ratio
of value added in domestic prices to value added in social prices considering the cost of
tradable inputs into account. It indicates whether the producer has incentive to produce
or not.
EPC <1 implying that the producers have no incentive to produce and sell at domestic
actual prices, If EPC > 1, then domestic producers are receiving greater return on their
resources given the intervention than they would without intervention. They are enjoying
positive protection.
Domestic Resource Cost (DRC)

The term comparative advantage has the sense that efficient in production is being
compared among two or more trading nations. Nations with the lowest opportunity costs
are relatively more efficient and have a comparative advantage. The comparative
advantage also refers to the efficiency of different kind of production within the
domestic economy, which are compared in costs of domestic production to the value
added that it generates. It indicates whether the country has incentive or comparative
advantage or not from producing and selling the output.
If DRC > 1, the economy is incurring costs in excess of what it gains or saves from the
production in terms of net foreign exchange. DRC = 1 indicates that the economy is on
balance. It neither gains nor saves foreign exchange through domestic production. DRC
< 1 implies that the economy saves foreign exchange from local production because the
opportunity of its domestic resources is less than the net foreign exchange it gains (in
export) or saves ( in substituting for imports). It also indicates efficiency and
international competitiveness
Calculation of DRC which results more than one clearly shows that the country does not
have comparative advantages in that product implying that, on efficiency grounds, the
country should import instead of producing it domestically.
Example
Suppose a policy analysis matrix (PAM) was constructed for maize production system in
Ethiopia considering agricultural policy reforms in line with structural adjustment
policy. The PAM has provided the following estimates in matrix. The estimates are
expressed in domestic currency per unit of output.
Variables Total revenue Costs of Costs of domestic Profit

tradable inputs resource
Private prices 90 25 40 A
Social prices 120 40 60 B
Transfers C D E F

Provided the above matrix, attempt the following questions

i. complete the incomplete estimates of the matrix
ii. calculate and interpret the following coefficient:
a. Nominal protection coefficient of output and input
b. Effective protection coefficient
c. Domestic resources cost
Solution
i)
ii) a. NPCO =
Interpretation
NPCO = 0.75 implies the actual price that the producer receives is less than the social
prices by 25 percent. The producer is receiving a lower price after policy intervention
than it would without intervention. This is called negative protection of the producer.
However, NPCO = 0.75 for a consumer denotes positive protection. Consumer pays a
lower price given intervention than without it. Here, the consumer is being favored.
NPCI
Interpretation
NPCI = 0.625 implies the actual private prices of tradable inputs are less than the social
prices. The private producer is paying a lower price than it would without policy
intervention. This is positive protection for the private producer. However, it is higher
opportunity cost for a society.
b. EPC=

Interpretation
EPC = 0.8125 describes that the producers receive the actual price returns which are less
than the social prices by 18.75 percent. The domestic producers are receiving a lower
return on their resources given the intervention than they would without policy
intervention. The producers are enjoying negative protection indicating no incentive to
produce and sell outputs at domestic actual prices.
c. DRC=
Interpretation
DRC = 0.75 indicates that the economy saves foreign exchange from local production,
because the opportunity cost of its domestic resources is less than the net foreign
exchange it gains from export or saves in substituting for imports. It also indicates
efficiency and international competitiveness. The country has an incentive to produce
and its economy shows comparative advantage from production.

Summary
The term policy is generally defined as a deliberate course of action, as contrasted with a
haphazard type of activity, chosen and followed by a public body, private firm, family or
individual.
Agricultural policies are concerned with the methods used by governments of
developing countries to change the agricultural environment. The task of agricultural
policy is to select the best instruments to achieve the selected targets given constraints
such as productive resources, administrative capacity and the presence of certain
external factors over which the decision maker may not have control.
The interventions may be local in scope to raise the incomes of small poor farmers;
provincial in scope to improve input delivery in regions, or nationwide, for example, to
overcome balance of payment deficits. It is assumed that most social objectives fall into
two main categories: goals of economic growth and goals of improved income
distribution. Policies could be macroeconomic like fiscal and monetary polices or
sectoral like agricultural policy. Agricultural policy includes: farm output price policy,
input policy, marketing policy, credit policy and food policy.
Farm out put price policy is aimed at influencing the level of prices received by farmers
and price paid by the consumers for farm output. It has three main functions: allocate
farm resources, distribute income and encourage or hinder investment on agriculture.
Trade policy, exchange rate policy and tax and subsides are some of output price policy
instruments.
Input policy is used to influence the quantities and combinations of purchased inputs,
such as fertilizer, used by small farmers in developing counties. Input price policy
influences price paid to variable inputs, the delivery of farm input and provision of
information on farm inputs to farmers. However, subsidies requiring high government
budget and farm resources misallocations are some of the problems of the input policy.
Marketing involves the physical movement of the farm outputs from the farmers to the
consumers. Marketing system transforms the commodity in time, space and form. The
objectives of marketing policies are: to protect farmers and consumers from parasitic
trader, to stabilize prices, to reduce marketing margin and to improve quality and
standards of products. Governments of developing countries have used many different

instruments to influence the working of agricultural marketing channels. This range from
attempts to replace private channels almost entirely by state institutions, through partial
involvement of sate bodies, licensing of approved traders and processors.
One main problem of small farmers in developing countries is unavailability of credit.
Credit is the sum of money in favor of the person to whom control over it is transferred.
Objectives of credit policy are: to alleviate a critical constraints hampering growth in
agriculture, to replace the fragmented and incomplete rural financial markets, to
accelerate adoption of new technology, etc. Credit targeting, loan portfolio regulation are
some of the instruments of credit policy. The defects of this policy are: fungibility, low
interest rate, transaction costs, loan defaults and saving failures.
Food security is the access by all people at all times to enough food for an active and
healthy life. Food policy concerns the integration of state actions affecting the supply,
distribution, and consumption of food in order to ensure continuity of access to enough
food for all the people in a country. Food policy instruments can take either lowering the
price of food to improve exchange entitlement or increasing command over food. The
supply side can be improved by increasing domestic production, import and food aid.
The main categories of food aid are; program food aid, project food aid, emergency food
aid and adjustment food aid.
Agricultural policy can be analyzed by the partial equilibrium analysis using the
concepts of consumer surplus and producer surplus. The other method of policy analysis
is the policy analysis matrix which is used to examine the impact of policy on
competitiveness and farm level profits by computing nominal protection coefficient,
effective protection coefficient and domestic resource costs.

Checklist
√
have been studying. Please put a tick (√) mark in front of the point you have understood
well in the box under “Yes” and in the box under “No” for points you have not
understood well yet. And if the tick marks under “No” are more than those under “Yes”
it means you are left with a lot to understand the unit and you have not yet achieved the
objectives indicated at the beginning of the unit. This tells you to go back and read the
sections you passed through.
I can: Yes No
1. Define policy in general and agricultural policy in particular
2. Identity output price policy objectives and instruments
3. Explain the concepts of input price policy and identify
objectives and instruments of input price policy
4. Assess intervention areas of government in the credit provision
and means of mobilizing rural savings
5. Define food security and food policy
6. Estimate food demand, given population growth rate,
income elasticity of demand and income growth rate
7. List categories of food aid
8. Analyze the effectiveness of a policy using partial and policy
analysis matrix

SELF ASSESSMNENT QUESTIONS

1. Which of the following is not true about agricultural policy?
A. Agricultural polices are concerned with the methods used by government
of developing counties to change the agricultural environments
B. The task of agricultural policy is to select the best instrument to achieve
the selected target given constraints
C. Agricultural polices may be local or provincial in scope
D. Agricultural policies are macroeconomic policy
2. Farm output price policy is used

A. To allocate farm resources
B. To distribute income
C. To encourage or hinder investment
D. All of the above
3. One of the following can not be instruments of farm output price policy, which
one?
A. Trade policy
B. Exchange rate policy
C. Tax and subsidies
D. Credit policy
4. Objective of marketing policy is/are?
A. To protect farmers and consumers from parasitic traders
B. To subsidize or increase farm-gate prices
C. To reduce marketing margin
D. To improve quality and standards of agricultural products
E. All of the above.

5. There are some main instruments of state credit policy in developing counties. Of
the following one can not be instrument of credit policy. Which one?
A. Low interest rate
B. Credit targeting
C. Increase in transaction cost
D. Loan portfolio regulation
6. Suppose population growth rate is 4%, income elasticity of demand for
consumption is 0.80 and income grows at rate of 6%. What should be the growth
rate of agricultural production for balanced growth of the economy?
A. 8.8%
B. 6.8%
C. 5.5%
D. 3.4%
7. Food aid delivered as part of a structural adjustment package and designed to

mitigate the effects on social groups is
A. Emergency food aid
B. Adjustment food aid
C. Project food aid
D. Program food aid
8. Farm input policy has main dimensions. Which one of the following can not be
the main dimension of farm input price policy
A. Price level of farm input
B. Income distribution
C. Delivery system for variable input
D. Information available to farmers concerning the type, quantity and
combination of inputs appropriate for their farm system

9. Which of the following is not true about food policy

A. Food policy is concerned with state action on supply, distribution and
consumption of food
B. On the supply side, food policy is concerned with food production and its rate
of growth with food import
C. Food aid provides alternative source of food supplies
D. Distribution in food policy refers to way food marketing channels work
10. __________ measures the ratio of value added in domestic prices to value added
in social prices considering the cost of tradable inputs into account.
A. Nominal protection coefficient
B. Effective protection coefficient
C. Domestic resource cost
Part II: True or false type items

write “false” if it is not true statement
1. Input policy is used to influence the prices that farmers pay for variable inputs,
especially the critical inputs like fertilizer.
2. Domestic self-sufficiency is neither a necessary nor a sufficient condition for the
achievement of food security.
3. Output price levels can be affected by many types of domestic tax or subsidies
imposed at different point in marketing chain
4. On the food demand side, food policy is concerned with food production and its
rate of growth, with food imports, and food aid.
5. The view that private traders are able to exploit farmers or consumers by the
exercise of local monopoly power is widely prevalent as a reason or an excuse
for marketing interventions.

Part III. Discussion Question and workout problems

For the following questions give your answer
1. In addition to fiscal or exchange rate policies, government frequently seeks to
influence prices by direct controls. List and explain some of the direct price
control mechanisms.
2. One of the main problems of farmers of less developed countries is lack of
finance to purchase farm inputs and requires credit policy. List and explain
the objectives of credit policies, and the reasons for their popularity with
governments and aid donors.
3. One of the objectives of farm input price policy is to influence agricultural
inputs. Give two specific instruments with which this objective can be
addressed
4. Suppose, for example, in an absolute agricultural country where the
contribution of other sectors is negligible, population has grown from 40 to
50 million and agricultural production from 130 to 195 million quintals.
What should be the growth rate of per capita consumption of agricultural
products in the economy?
5. A farm produces output wheat for sale. The supply and demand equations of
the output are given as:
and
Where = Supply of wheat output
= Demand for wheat
= Price of wheat per unit
a. What is the equilibrium level that the producer supply wheat production
at free market economy?
b. Suppose the government intervene in the market and impose a price of
wheat at Birr 6 per unit. Determine the policy effects on the producer
c. What do you suggest about policy intervention in favor of wheat
purchasers?

CHAPTER FOUR
4. Peasant Economy
4.1. Introduction
This chapter is about the economic analysis of agricultural production which we refer to
as peasant production. It begins by identifying components of the peasant definition
which reside in distinctive features of peasant society compared to other societies. It ties
these various components together and proposes a working definition of peasants. In this
chapter we also see the characteristics or distinctive features of peasant society
compared to other society. In peasant economy the farm household is taken as a decision
making unit in the farm production. We will try to see the distinctive feature of farm
household as a decision making unit in farm production.
Efficiency and profit maximization are two sides of the same coin. Therefore, technical
efficiency, locative efficiency and economic efficiencies of farm household production
are also considered here. There are questions and activities in each sub-topics and
students are advice to work on each activities and questions.
Objectives:
 Identify the distinctive features of peasant society compared to other societies
 Define farm household
 Define peasant which would be consistent with the rest of the topics
 Explain and identify technical, allocative and economic efficiency
 Assess the efficiency of a given farm production.

4.2. An overview of theories of peasant system of production

Dear distance learner! This chapter concerns the economic analysis of a kind of
agricultural production which we refer to as peasant production. Most of these large
proportions of human kind live in the developing countries where they sometimes
comprise as much as seventy percent of the population.
Peasant populations occupy the margins of the modern world economy, with one foot in
the market and the other in subsistence; they are neither fully integrated into that
economy nor wholly insulated from its pressure.
Therefore, peasant populations are rarely prosperous and contain among them some of
the poorest people in the world. In order to improve their life, especially in developing
nations, it is necessary to posses analytical methods which yields an accurate perception
of the nature of their problems.
The purpose of this chapter is to construct an economic definition of peasants which is
consistent with the rest of the topics.
We seek a definition designed to fulfill the following criteria:
a. It should serve to distinguish peasants not just from non-farm social groups, but
also from other kinds of farm production, example commercial farm.
b. It should contains a sense of time as well as of changes, in order to avoid
mistakenly identifying peasants with stagnation and tradition
c. It should encompass the household as a unit of analysis of the large economy,
and the interaction between them
d. It should possess relevance for economic analysis, in the sense of delineating
economic conditions of peasant life which differ analytically from those of
another social groups or farm enterprises.

4.3. Characteristics of Peasants/ Distinctive Features of Peasant Society

Compared to Other Societies
_______________________________________________________________________
Activity 4.1
 Do you think that peasants have distinctive features? If they have what are the
main characteristics or features of peasant society compared to other
societies.
Peasants have distinctive characteristics as compared to other societies:

Transition: peasants are seen as representing a transition from relatively dispersed,
isolated, and self sufficient communities towards fully integrated market economies.
Transition implies change and adoption but it must be stressed that the speed of change
and its outcome are neither known nor determined in advance.
Markets and Exchange: the idea of transition gives rise to several other relevant
features of peasant societies. One of these is that peasants as a social group are always
part of a large economic system. This means that peasant societies participate in
exchange with the larger system, and that peasant production is exposed in some degree
to market forces. The inputs and outputs of peasant farms are subject to valuation by the
wider market, at prevailing prices. Markets provide both opportunities and pressure for
peasants.
Subordination: the idea of subordination implies unequal social or cultural status,
coercion of one social group by another and unequal access to political power. Some
people define, peasants as “rural cultivators whose surplus are transferred to a dominant
group of rulers”
Internal difference: peasants are not a uniform, homogeneous set of farm families all
with the same status and prospects with in their communities. On the contrary, peasant
societies are “always and every where typified by internal differentiation along many
lines”

? Peasant production is both for consumption and for sell. Does this dual economic
nature have its own implication for its economic analysis? How do you explain
peasant farm household’s production?

(You can use the space left below to write your response)
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
The Peasant Farm household

The peasant farm household distinctive feature as a farm enterprise is the dual economic
nature of peasant production which is its central peculiarity.
The peasant unit of production is both a family and an enterprises; it simultaneously
engages in both consumption and production. This dual economic characteristic of the
peasants’ household has implication for its economic analysis.
Dominant economic activity: peasants obtain their livelihood from the land, mainly by
the cultivation of crops, although livestock may have varying degrees of importance
within their farm systems. When referring to peasant household, other categories of rural
dwellers such as landless, laborer, plantation workers are excluded from the definition.
Land:- by defining peasants as farmers it is implied that they have access to the resource
of land as the basis of their livelihood. In many peasants’ societies, families have
complex traditional rights of access to land.
Labor: it is widely agreed that reliance on family labor is defining economic
characteristic of peasants. The family labor basis of peasant farms is what distinguishes
them from capitalist enterprise. This feature does not rule out the use of hired labor in
say, peak periods of harvesting; nor the sale by members of the farm household of their
own labor outside the farm on an ad hoc basis; indeed for some peasants families this
may be essential for survival. The predominance of family labor in production also has
an effect on the working of labor markets in peasant communities, since various

subjective criteria peculiar to individual households are likely to influence both the
supply and demand for wage labor in the wider market.
Capital: capital input by household may have both production and consumption aspects.
Example purchased tractor used both for production purpose ( ploughing, deriving a
water pump etc) and for consumption purpose ( family transport, firewood carrying, etc )
Consumption:- peasants are characterized by subsistence basis of their livelihood.
Subsistence refers to the proportion of farm output which is directly consumed by the
household rather than sold in the market.
For the peasant farm family only a few, and possibly none, of these conditions is likely
to prevail:
 Capital market are fragment or non-existence , credit is obtained from local
landlords, merchants or money lenders
 Credit and rates of interest may be tied to other factor prices like land and labor
within a dependent economic relationship, thus factor markets may be locked
together contractually rather than being independently.
 Variable production inputs may be erratically available or unavailable, their
quality may vary, and access to them may involve formal or informal system of
rationing.
 Market information is poor, erratic, fragment and incomplete
_______________________________________________________________________
Activity 4.2
 Given the above characteristics and distinctive features of peasants society compared
to other societies; the resource structure and economic decision point of view,
give your own definition of peasant.
_______________________________________________________________________
Good! Here is a definition which is similar to your definition given above.
Peasants are farm households with access to their means of livelihood in land, utilizing
mainly family labor in farm production, always located in a large economic system, but

fundamentally characterized by partial engagement in markets which tend to function

with a high degree of imperfection.
Efficiency and Peasants

Efficiency and profit maximization are two sides of the same coin; at the level of the
individual production unit you cannot have one without the other.
The strict definition of economic efficiency also requires a competitive market. By our
very definition of peasant – their partial engagement in usually imperfect markets- strict
economic efficiency is ruled out.
There are, however, several valid reasons for examining what is meant by economic
efficiency in the study of peasants.
Allocative, Technical and Economic Efficiency

 Technical efficiency: - is the maximum attainable level of output for a given
level of production inputs, given the range of alternative technologies available
to the farmer.
 Allocative efficiency: - refers only to the adjustment of inputs and outputs to
reflect relative prices, the technology of production already having been chosen.
for any single variable input
Where MVP is marginal value product and MFC is marginal factor cost
MVP per unit of an input should be equal across different output (the principle of
equi- marginal returns)
 Economic efficiency: economic efficiency is the technical efficiency plus
allocative efficiency. There is economic efficiency when there are both
technical and allcoctive efficiencies
The same distinctions can be illustrated equally well on an isoquant diagram below

Figure 4.1: (a) Isoquant and efficiency (b) Production possibility frontier and efficiency
(a) (b
)
Output Y1
D B
Input X2
A
C D
Y2=100
C
A
B
Y1=100
PPF2 PPF1
Input X1 Output Y2
In both cases the subscript 1 (Y1 and PPF1) indicates the technically superior set of
production condition.
 The point D displays both technically and allocative inefficiency as it is on Y2
and PPF2
 Point C displays technically inefficiency but there is allocative efficiency at
point C as isocost line is tangent to isoquant (figure a ) and isorevenue line is
tangents to PPF (figure b)
 Point B is technically efficient (it is on Y 1 and PPF1) but there is no allocative
efficiency at point B.
 Point A displays both allocative and technical efficiency and therefore, there
is economic efficiency at point A.

Summary
This chapter concerns the economic analysis of a kind of agricultural production which
we refer to as peasant production.
Peasant population occupy the margins of the modern world economy, with one foot in
the market and the other in subsistence, they are neither fully integrated into that
economy nor wholly insulated from its pressure.
Therefore, peasant populations are rarely prosperous and contain among them some of
the poorest people in the world. In order to improve their life, especially in developing
nations, it is necessary to posses analytical methods which yields an accurate perception
of the nature of their problems.
Peasants are farm households with access to their means of livelihood in land, utilizing
mainly family labor in farm production, always located in a large economic system, but
fundamentally characterized by partial engagement in markets which tend to function
with a high degree of imperfection.
This definition serves to distinguish peasant not just from non-farm social groups, but
also from other kinds of farm production. It should contain a sense of time as well as of
changes. It should encompass the household as a unit of analysis.
Efficiency and profit maximization are two sides of the same coin; at the level of the
individual production unit you cannot have one without the other. Technical efficiency is
the maximum attainable level of output for a given level of production inputs, given the
range of alternative technologies available to the farmer. Allocative efficiency refers
only to the adjustment of inputs and outputs to reflect relative prices, the technology of
production already having been chosen. Economic efficiency is when there is both
technical efficiency and allocative efficiency.

Checklist
√
Dear learner! Below are some of the most important points drawn from the chapter you
have been studying so far. Please put a tick (√) mark in front of the point you have
I can: Yes No
1. Identify the distinctive features of peasant society
compared to other societies
2. Define farm household
3. Identify components of peasant definition
4. Define peasant which would be consistent
with the rest of the topics
5. Explain and identify technical, allocative and
economic efficiencies
6. Assess the efficiency of a given farm production.


Direction: For the following multiple choice questions choose the best answer and
encircle the letter of your choice
1. Peasant population occupy the margins of the modern world economy, with
one foot in the market and the other in subsistence, because,
A. They are neither fully integrated into that economy nor wholly insulated
from its pressure.
B. Their production is only for consumption
C. Their production is only for market
D. All of the above
2. The definition of peasant in this chapter

A. should serve to distinguish peasant not only from non farm social groups
but also from other kinds of farm productions
B. should encompass the household as a unit of analysis
C. it should possess relevance for economic analysis
D. all of the above
3. Of the following one can not be distinctive feature of peasant in LDCs.
Which one?
A. Homogeneity
B. Transition
C. Subordination
D. Internal difference
E. All of the above
4. Which of the following is very unlikely to prevail in peasant farm family in
LDCs
A. credit and rates of interest may be tied to other factors of production
B. market information is poor, erratic, fragment and incomplete
C. credit is mainly obtained from formal financial institutions like
commercial Bank

D. capital markets are fragment or non-existence

5. Which of the following is true about efficiency
A. there is no technical efficiency without allocative efficiency
B. there is economic efficiency without allocative efficiency
C. price of inputs and output are considered in allocative efficiency
D. all of the above
6. Allocating resources(or consumption expenditure) in different possible uses
so as to maximize net economic benefit (satisfaction) is called
A. Technical efficiency
B. Allocative efficiency
C. Economic efficiency
D. Pricing benefit
E. B and C
Part II: True or false type Questions

Direction: For the following statements write “true” if the statement is correct or
write “false” if it is not correct statement
1. Peasants are farm households with access to their means of livelihood in land,
utilizing mainly family labor in farm production,
2. Peasants are a uniform, homogeneous set of farm families all with the same
status and prospects with in their communities.
3. In any production process there is no allocative efficiency without economic
efficiency
4. Subsistence production refers to the production of farm output mainly for
consumption.
5. Allocative efficiency refers only to the adjustment of inputs and outputs to reflect
relative prices

CHAPTER FIVE
5. Agricultural Household Model
5.1. Introduction
The agricultural household model has focused on the impact for the logic of the model of
altering key assumptions, while extending its capacity to handle simultaneous
consumption and production decision. In this chapter three agricultural household
models are discussed briefly: New home economics model, The Barnum-Squire Farm
household model and the Low farm household model. A central feature of New Home
Economics model is that the utility function is redefined in several ways. A house hold
has a utility function which represents it preferences ordering between a range of final
characteristics of home produced goods and services. In this approach the household is
seen as a production unit which converts purchased goods and services, as well as
domestic resources into a set of final use values yielding utility in consumption.
The Barnum-Square farm household model is an important one since it provides a
framework for generating predictions about the responses of the farm households to
changes in domestic and market variables.
The Low farm household model is about how farm household allocate their family labor
power into on farm and off farm activities. Considering family members have the same
marginal physical products on farm, but have different wage rates in the labor market.
Objectives:
After this chapter has been successfully completed, you will be able to:
 Define household model
 Assumptions of each household models studied: the New home economics
model, the Barnum-Square model and the Low farm household model
 Explain the main essences of the three models
 Compare and contrast the three models studied in the chapter

5.2. New Home Economics Model

The models of farm household decision making which we will examine later in this
chapter are based on a branch of neoclassical economic theory often referred to as the
New home economics.
A central feature of the new home economics is that the utility function is redefined in
several ways. In conventional theory the individual consumer has a utility function
which represents his preference ordering between the range of market goods and
services which he can purchase. The utility or happiness resides in the goods or services
themselves. In the new home economics model the household has a utility function
which represents its preference ordering between ranges of final characteristics of home
produced goods and services. In this approach the household is seen as a production unit
which converts purchased goods and services, as well as domestic resources, into a set of
final use values yielding utility in consumption. Thus it is not carrots, potatoes, and
beans which yield utility, but the vegetable soup made from them which possess utility-
giving attributes. Moreover the consumption level of this vegetable soup is determined
not only by the relative market prices of its ingredients, but also by the relative cost of its
production to the household in terms of the time required for its preparation. The main
features of the new home economics can be summarized thus as follows:
a. The household, not the individual (unless the two coincide), is the relevant unit
for analyzing utility maximization
b. Utility is not only, or even generally, derived directly from market commodities,
it is obtained from the objects of final consumption (we shall call them use value)
produced within the household.
c. These use values are referred to in the theory as Z-goods to distinguish them
from purchased commodities (X-goods), and hence the utility function takes the
form
d. The production of Z-goods within the household requires inputs of household

time as well as purchased goods and services; hence a major emphasis of the

theory is on the time allocation of the household between Z- goods production

and wage work.
e. The household produces Z-goods from market inputs ( ) and time spent on
them( ), hence the home production function takes the form
f. The household maximizes utility, not subject to a simple budget constraint, but
subject to its production function, a total time constraint, and a money income
constraint.
g. The total time constraint (T) is given by work time outside the household ( )
and the sum of the times allocated to Z-good production ( )
h. The money income constraint (Y) is determined by the market wage rate (W)
multiplied by the time allocated to wage work ( ). In equilibrium this
money income must equal the value of X-goods (market commodities) used as
inputs into Z-good production ( ), where the are the prices of the X-
goods:
i. By valuing all units of the household’s time, T, at the market wage rate the time
constraint and money income constraint can be collapsed into a single constraint,
defined as the household “full income” (F)
j. It can be shown, and is intuitively in keeping with other microeconomic theory,

that the equilibrium of the household is given where the ratio of the marginal
utilities of any pair of Z-goods ( the marginal rate of substitution between them)

equals the ratio of their full marginal costs of production. Here the full marginal
cost of any Z-good, say Zi, is the sum of, first, the wage rate multiplied by the
marginal product of the household time allocated to its production, and , second,
the market prices multiplied by the marginal products of the market commodities
used in its production.
____________________________________________________________________
Activity 5.1
 The main resource of farm households is family labor. How do farm

households allocate their family labor so as to maximize the household’s
utility or satisfaction?
_________________________________________________________________
The logical structure of the new home economics is not different from farm
household models in this chapter. There is nothing intrinsically new or difficult in
the theory provided it is kept in mind that it consists of maximizing utility subject to
a production function and other constraints. Indeed if we construct a simple example
where (a) the household produces only one Z-good referred to simply as Z, (b) the
utility function contains only Z-good(Z) and leisure, and (c) a single price, p, is used
to value the market inputs, Xi, used in Z production; then the theory can be described
in a graph below.

Figure 5.1. The home production model
Home Production Z
Home Production Z
w’
B
C F
TPP
A
H
w D
Home Wage Leisure
Time available (T)
The components of figure 5.1 are described briefly as follows. The household has a
total time available for all activities given by T. This time is divided into the three
components of home work time (Tz), wage work time (Tw), and leisure (T H). The
opportunity cost of time is given by the real market wage ( ), where w is the
money wage, and p is the general price level of purchased goods. The line OF, with
slope , describes the rise in total real income as hours increase. Hence the point F
represents the full opportunity cost of household time obtained by valuing the total
hours available (T) at the real wage (w/p). It equals .
The figure 5.1 also contains a production function, representing the transformation of
home work time into final home output, Z; an indifference curve, representing a

given level of utility obtained by different combinations of leisure and Z, and a

shifted real wage line, ww’, representing the opportunity cost of time in terms of
market prices.
The equilibrium of the household in the production of Z is given at point A, where

the MPP of home work equals the real wage:
This is of course the same as in the theory of the farm as a firm, and it gives the
home component of the total cost of Z at H
The equilibrium of the household in the consumption of Z is given at point B, where

the marginal rate of substitution of leisure for Z (MUL/MUZ) equals the ratio of the
opportunity cost of leisure to the market price of the ingredient of Z( ).
Note how the diagram satisfies the various constraints on utility maximization of the
home economics model. The time constraint is satisfied by the sum of the three
components of total time along the horizontal axis ( . The money
income constraint is satisfied provided that the cash outlay on market purchases
( distance CH on the graph) equals the market wage, w, multiplied by wage-labor
time, Tw. House holds full income is given by point F shifted upward to w’ to take
into account the net product of labor in home production.
If wage rises then what is the effect of this wage increase on the home production
?
component of Z-good. Is the household full income increases or decreases?
(use the space left below to write your responses)


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The home economics model can be used to explore the impact of many different
changes in exogenous variables confronting the household.
(a) Consider the impact of an increase in the market wage on the model given in
figure 5.1. A wage rise increases the slope of the wage cost line, ww’. A first
effect will be to lower the home production component of the production of Z
and raise its market component, because the marginal cost of home time
increases relative to the marginal cost of purchased inputs. A second effect is that
full income is increased and the household attains equilibrium on a higher
indifference curve. A third effect, with two opposing components, is that the
extra time now available may be used either for more wage work, or for more
leisure, or for a combination of both.
(b) It is seen that a rise in wages, or a fall in market prices, involves several different
substitution and income effects. There is a pure substitution effects in home
production which results in lower home work time and higher market purchases.
There is a pure substitution effect in consumption which results in lower leisure
and more time available either for home work or for wage work. There is an
income effect in consumption which results in higher leisure, but unless this
income effect is very large it is unlikely to negate the double impact on the time
available for wage work of the two substitution effects.
5.3. The Barnum-Squire Farm Household Model

Barnum and Squire (1979) developed and apply a model of a farm household which has
its roots partly in the new home economics model. This model is an important one since
it provides a framework for generating predications about the responses of the farm
household to changes in domestic (family size and structure) and market (output prices,
input prices, wage rates, and technology) variables. The assumptions of the Barnum-
Squaire model are as follows:
a. There exists a market for labor so that farm households are able to hire in and
hire out labor at a given market wage.

b. Land available to the farm household is fixed, at least for the duration of the
production cycle under study.
c. Home activity (production of Z-goods) and “leisure” are combine and treated as
the same consumption item for the purposes of utility maximization
d. An important choice for the household is that between own consumption of
output (C) and sale of output in order to purchase non-farm consumption needs
(M for manufactures)
e. Uncertainty and behavior towards risk are ignored
This structure of the model closely follows the logic of the new home economics. The
main difference is that here we are dealing with a farm (`a production unit in the
conventional sense) as well as a household. This means that the production function
refers to farm output which can be traded, not just to “home” production for direct use.
Moreover the farm household has the option of hiring in labor at the market wage as
well as hiring it out. There are now three items in the utility function; time for the
production of Z-goods and for leisure combined (Tz), home consumption of output (C),
and purchased good (M). The utility function is thus;
The preference between these are influenced by the size of the household and its
composition between workers and dependents. The production function is:
Where A is land under cultivation (presumed fixed), L is total labor (both household and
hired) used in production, and V is other variable inputs into production.
Utility is maximized subject to the production function, a time constraint, and an income
constraint. The time constraint is of the familiar form:
Where Tz is time allocated to Z-goods and leisure (combined), T F is time allocated to

farm work, and Tw is wage work which may be positive or negative- if labor is hired in
(Tw>0) this increases the total time a available, if it is hired out (T w <0) it reduces total
time, T. For convenience we shall refer to the sum of the household’s own time, i.e. Tz
and TF, as G

The income constraint states that net household earnings should equal expenditure on
market goods:
Here P is the output price, (Q-C) is the quantity of total output (Q) sold rather than
consumed, w is the market wage and wTw may either represent an addition to income (if
labor is hired out) or a subtraction ( if labor is hired in), v is the price of variable inputs,
V, and m is the average price of market purchases, M.
As in the home economics model these last two constraints may be collapsed into a
single expenditure constant, F’, which is an augmented form of the ‘full income’
concept:
Where wTz is the opportunity cost of the time spent in Z-goods production, PC is the
market value of home consumption of output, and mM is the value of market purchase.
This must equal net farm income or profit, , plus the implicit value of total household
time, wG.
The equilibrium conditions of this model follow the standard microeconomics results for
production and consumption. They are that:
a. The marginal value product of labor(MVPL) should equal the wage rate(w)
b. The marginal product of other variable inputs (MVPv) should equal their average
price (v);
c. The marginal rate of substitution between home time (Tz) and purchase good(M)
should equal the wage/purchased goods price ratio(w/m)
d. The marginal rate of substitution between home consumption (C) and purchased
goods (M) should equal the output price/purchased goods price ratio (p/m).
The existence of two pairs of consumption trade-off and three resources in the
production function means that this model cannot be shown in a single graph. In figure
5.2 we illustrate those components of the model which involve:
a. The choice between higher consumption of farm output (C) and more time to
spend on non-farm activities (Tz)
b. The production function for a single farm output with labor as a single variable
input;

c. The case when labor is hired in rather than hired out by the farm household
In figure 5.2 the farm household utilizes a total quantity of time given by T along the
horizontal axis. This time is divided between the farm work of family members, T F,
hours of hired labor, Tw; and the home time of household members, Tz. The opportunity
cost of time is given by the relative market wage w/p, where w is the money wage, and p
is the farm output price. The line OF, with slope w/p, describes the rise in the total cost
of labor as its use increases. The point F represents the total implicit cost of all units of
time available to the household, no matter whether family or hired
Figure 5.2. Part of the Barnum-Squire farm household model.
Farm output Y
W’
Farm output Y
I1 TPP
B
Q F’
F
C A
I1
w
O
T1 T2 T
Family TF Hired Tw Family Tz
Farm work Home work
The graph also contains the production function of farm output(TPP), the indifference
curve for a given level of utility derived from different combinations of home time and
home consumption of farm output, and the shifted wage line, ww’, representing the
relative wage cost of farm production. The equilibrium of the farm household in
production is given at point B, and this also determines the augmented version of ‘full
income’, F’, for the production model. The equilibrium of the farm household in

consumption is given at point A, and this defines the level of own consumption of farm
output, C, and the level of marketed supply, Q minus C. Since market purchases do not
enter this simplified model, the expenditure constraint is satisfied provided that income
from market supply P(Q-C) is sufficient to pay for hired labor (wTw).
Even in this simplified form the model possesses considerable predictive power
concerning the impact of changes in the wage level or output price on farm household
decisions.
? We have seen the consumption and production equilibrium point in The Barnum-S
quire Farm Household the model. How do you explain the effect of a rise in wages
or a rise in prices?
(use the space left below to write your answer)


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Here we will consider briefly, and leave for the reader to trace out, the separate and
opposing effects of a rise in wages or a rise in prices:
a) A rise in the market wage rate increase the price ratio, w/p, and makes the shifted
wage cost line, ww’, steeper in slope. This causes:
i). a fall in output and corresponding fall in ‘full income;
ii). a rise in farm work by the household, and a decline in the use of hired labor
iii). an increase in home consumption, and a fall in market sales
b) A rise in the market price of output reduces the price ratio, w/p, and makes the
shifted wage cost line, ww’, shallower in slope. This causes:
i). a rise in output and a rise in “full income’
ii). A decrease in farm work by the household, and a rise in the use of hired labor
iii). A decrease in home consumption, and an increase in supply to the market.

With reference to the full model, a similar set of predictions can be derived concerning
the relative preference of the household between home time and market commodities.
This refers, of course, to the slope of an indifference curve, and it may be observed:
a) That if the household displays a relatively high preference for home activities,
then more labor must be hired, farm cash profits are reduced, and there is less
income to purchase consumer goods;
b) That if the household displays a relatively high preference for market
commodities, then less labor is hired, farm cash profits are higher, and the
household has more income to purchase consumer goods.
The independence of production and consumption decision in the Barnum-Squire model
allow it to be solved, for practical purposes, in a sequential way:
First, the production function is estimated, and this is used to generate the output and net
farm income available to the household.
Second, the demand functions for the three consumption choices in the utility function
are estimated. These demand functions contain the several variable(wage rate, prices,
size and composition of family) which have an impact on the consumption decisions of
the household. They are constrained in the model by the need to meet minimum
consumption levels of own output, home time, and purchased items respectively. In
other words, variations are only permitted above the provision of basic needs, and this
may be termed the discretionary choices open to the household. The demand function
yield estimates of the elasticties of demand with respect to the exogenous variables.
Third, the interaction between the production and consumption decisions can be traced
on the basis of the individual responses which have been estimated.
The analytical power of the Barnum-Squire model thus resides in its capacity to pursue
the impact of joint production and consumption decisions within the household into the
larger economic system. In other words it provides the basis for a general equilibrium
analysis of the peasant economy, in addition to the partial equilibria of the various
components in the individual household.
5.4. The Low Farm Household Model

Allan Low (1986) developed and applied a farm household model which differs in some
interesting ways from the other models. Again the root of this model is partly in the new
home economics model. Low’s model has different assumptions from the Barnum-
Squire model.
The conditions which concern Low are:
a. The existence of a labor market in which wage rates vary for different categories
of labor, and especially between men and women. This differs from the single
market wage rate assumed in the Barnum-Squire model.
b. An indigenous land tenure system which permits flexible access to land for farm
households according to their family size
c. Semi-subsistence farm households for which the farm-gate price of food differs
from the retail price at which food can be purchased back from the market. This
contrasts with the single food price at which food can be purchased back from
the market. This contrasts with the single food price assumed in the Barnum-
squire model.
d. The widespread occurrence of food-deficit farm households with hiring out of
family labor. This contrasts with the conditions informing the Barnum-squire
model of food –surplus farm households which, mainly, hire in more labor than
they hire out.
The first of these conditions implies that different household members have different
potential for earning wage income. In other words some members have a greater
comparative advantage in wage work than others.
The second condition means that the land input can be increased in parallel with the
labor input, thus deferring the onset of diminishing returns. Low assumes that the
marginal physical product of labor (MPPL) can be taken as constant over the relevant
range of economic analysis.
The third and fourth conditions mean that for food-deficit households the amount of
labor to commit to subsistence food production depends not on the farm-gate price of
output, but on the ratio of wages to the retail price of purchased food.

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Activity 5.2
 According to a food –deficit Low’s farm household model if the household
contains individuals of working age with the same productivity on farm but having
different wage rates in the labor market then how the family allocates the family
labor into on farm production and off farm wage work?
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The working of Low’s model for a food-deficit farm household is shown in figure 5.3.
This has real income on the vertical axis, and time on the horizontal axis, as in previous
graphs. For illustrative purpose we assume that the household contains three individuals
of working age, the labor times of which are given by the gaps A, B, and C along the
horizontal axis. These individuals each have the same productivity in farm subsistence
production, but they command different wage rates in the labor market.
The graph contains a total product curve (TPP) for subsistence output which is linear:
the marginal product of labor is constant and is the same for each household member.
The line OW traces out the rise in total wage income (or opportunity cost of labor)
which occurs as the labor time of each member is valued by the real wage that they
could earn in the labor market. The ‘real wage’, w/p, is given by the nominal wage rate
(w) divided by the retail price of food (P). This is because for the food-deficit household
what is relevant is the purchasing power of wages over the retail price of food.

Figure 5.3. The Low farm household model.
M’
W’
TPP
Real income Y
E
w
D
m
O
A B C
Labor time T
Corresponding to segmented line OW is the parallel opportunity cost of labor line, ww’,
which touches the TPP curve at point E. visual inspection of the graph confirms that
point E defines the profit maximizing level of labor input for this household( the gap
between TPP and OW is much the widest at this point). The implication is clear: only
those family members whose real opportunity cost of time, w/p, is lower than their MPP L
engage in work on the farm; family members, such as C, whose real opportunity cost of
time is higher than the MPPL on the farm should engage in off-farm wage work in order
to maximizes household income.
In terms of the graph what is relevant is the slope of the real wage line, w/p, compared to
the slope of the production function (MPP). Where w/p < MPP, then that household
member should engage in subsistence production on farm; where w/p > MPP, then the
household member engages in off-farm wage work.

The significance of using the retail prices of food as the deflator is revealed if one
considers the impact of a fall in retail food prices or a rise in wage rates on the division
of labor within the household. A fall in the retail prices of food, holding wage rates
constant, results in the opportunity wage cost line switching to mM’ in figure 5.3.
Household member B should now join C in off-farm work, leaving only member A in
subsistence production. The same result for an across- the-board rise in wages, holding
food prices constant. In this variant of the farm household model the production
behavior of the food-deficit household is determined by the purchasing power of wages
in terms of the retail price of food.

Summary
This chapter gives an introductory account of the new home economics, a branch of
microeconomic theory concerned with the links between time allocation and utility
maximization in the home. The new home economics provides the logical structure on
which many farm household models are based. The new home economics treats the
household as a production unit, in which the time of household members is combined
with purchased goods or services to produce items of final consumption. All units of
time, whether in housework, wage work, or leisure, are valued at their opportunity cost
in terms of the market wage. The Barnum-Squire farm household model contains three
goals in the household utility function - home time, own food consumption; market
purchase - giving three pairs of trade-offs between goals. An example of its predictions
is that a rise in the market wage causes a fall in total farm output, a rise in farm work
time by the family, a decline in hired labor use, and a rise in the proportion of output
consumed at home. A particular strength of this model is its capacity to generate general
equilibrium analysis of the wider peasant economy from the outcome of peasant
decisions in output and input markets. A possible weakness of the model is its
dependence on an assumption of competitive markets for the applicability of its results.
The farm household model put forward by Low to explain farm output stagnation in
southern Africa is summarized. This model has different market wage rates for different
household members, such that those members of whom W > MVP L do off-farm wage
work, while those members for whom W < MVP L stay on the farm. Wage rates are
measured in real terms, i.e, in terms of their purchasing power over retail food. Thus the
proportion of household labor working outside agriculture is a function both of money
wage levels and the consumer price of food.

Checklist
√
I can: Yes No
1. Define a farm household model
2. Explain the essence of new home economics model
3. List the assumptions of the new home economics model
4. Identify the production and consumption equilibrium

Point of new home economics model
5. List the assumptions of Barnum-Square model
6. Explain the essence of the Low farm household model
7. Compare and contrast the new home economics and the Low
farm household model


1. the main features of the new home economics model can be
A. the household, not the individual (unless the two coincide), is the
relevant unit of analyzing utility maximization
B. utility is not only, or even generally, derived directly from market
commodities, it is obtained from the objectives of final consumption
C. the household maximizes utility, not subject to a simple budget
constraint, but subject to its production function, a total time constraint,
and a money income constraint
D. all of the above
2. Which of the following is/are true about new home economics model?
A. Consumption and production equilibrium points are always the same
B. The equilibrium of the household in production of Z-goods is given at point,
where the average physical product of home work equals the real wage
C. Graph of new home economics model satisfies both the time constraint and
money income constraints
D. B and C
3. One of the following is not the assumption of Barnum-Square model, which
one?
A. Land available to farm household is fixed
B. There exists a market for labor so that farm households are able to hire in and
hire out labor
C. Uncertainty and behavior towards risk are considered

4. In the Low farm household model, the conditions which concern Low are:
A. The existence of labor market in which wage rate vary for different
categories of labor
B. An indigenous land tenure system which permits flexible access to land
C. Occurrence of food-deficit farm household with hiring out of family labor
D. All of the above
5. In Barnum-Squire Farm Household model a rise in the market wage rate causes:
A. A fall in output and corresponding fall in full income
B. A rise in farm work by the household, and a decline in the use of hired labor
C. An increase in home consumption, and a fall in market sales
D. All of the above
6. All are assumptions of Low farm household model except
A. Existence of labor market
B. Land available to the farm household is fixed
C. Occurrence of food deficit with hiring out of family labor
D. Different market price of food
7. According to Low farm household model, a household member is supposed to
work on farm if
A. his real wage is greater than his marginal physical product
B. his real wage is less than his marginal physical product of labor
C. his real wage is equal to his marginal physical product of labor
D. his engagement does not depend on his wage and marginal physical
product
1. In the new home economics model the household has a utility function
which represents its preference ordering between rages of final
characteristics of home produced goods and services.
2. A rise in the market price of output increases in-home consumption

3. The increase in wage-price ratio represents a reduction in the relative cost of

time as perceived by the household
4. Any changes in agricultural policy will affect not only production, but also
consumption and labor supply of farm households.
5. In Barnum-Squire agricultural household models, the equilibrium levels of
production and consumption are determined at different levels of labor time.

CHAPTER SIX
6. The Sharecropping Peasant
6.1. Introduction
There are different forms of land tenancies in most part of the world, including our
country Ethiopia. These forms of land tenancies are: sharecropping, fixed rent and
capitalist or commercial farm. This chapter is about one of the most widely used form of
land tenancy called sharecropping. Sharecropping is a form of land tenancy in which the
payment for the use of land, the rent, is a percentage of the total physical output obtained
in the crop season. In this chapter the economics efficiency of sharecropping can be
analyzed using the tenant model and landowner model. In the tenant model the share
tenant is taken to be a profit maximiser in a competitive market subject to the output
share being fixed in advance. In the land owner model the landowner is a profit
maximiser who can vary the amount of land at his disposal, decide the number and size
of land parcels distributed amongst share tenants, decide the rent share, and stipulate in
the share contract the amount of tenant labor input which is required. In this chapter we
discuss the reasons for engagement in sharecropping and policy intervention in the form
of land reform, legal control on crop shares and interest rates, subsidized credit schemes
and others.
There are activities and questions and finally self assessment questions for your better
understanding of the contents of the chapter.
Objectives:
After studying this chapter, you will be able to:
 Identify forms of land tenancy in Ethiopia
 Define sharecropping
 Analyze the economics efficiency of sharecropping using the tenant and
landowner model
 Identify reasons for peasants to engage in the sharecropping
 Suggest possible policy intervention when sharecropping is inefficient

6.2. Peasants as Share Tenants

Sharecropping is a form of land tenancy in which the payment for the use of land, the
rent, is a percentage of the total physical output obtained in the crop season. Since this
proportion is fixed in advance of the crop season, an important feature of sharecropping
is that the absolute amount of rent varies with the level of harvest. Sharecropping differs
from other types of land tenancies because the other types of land tenancies are based
on fixed annual rents, whether in cash or in kind. As a form of livelihood based on
access to land sharecropping also contrasts with (a) traditional land rights, (b) freehold
land ownership, and (c) agricultural wage laboring. Sharecropping has occurred widely
in history in many different parts of the world, and remains prevalent today especially in
Africa, South and South-East Asia
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Activity 6.1
 List and explain different forms of land tenancies that you know in Ethiopia in
general and in your locality in particular
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Distance learner! The economic decision making of the sharecropping peasant differs in
significant ways from the theories examined so far. Sharecropping perforce involves
interaction between households which differ in their command over land and other
resources. At its simplest this interaction concerns land and is between households which
possess land (the landowner) and those which do not (the landless share tenants). At its
most complex it is an interaction with multiple levels of contractual obligation between
households involving land, credit, consumption loans, input prices, access to markets
and so on. In all cases it shifts the emphasis from the isolated decision making of the
individual household to the nature of economic relationships between households. And
in doing so it serves to highlight the wider village, community, or class dimensions of
peasant production instead of downplaying them as in other microeconomic theories of
peasant behavior.

Sharecropping tends to be regarded as an interesting theoretical puzzle. The puzzle of

sharecropping resides in the incapability of ordinary economic analysis to explain certain
aspects of its existence as an institution, namely:
a) The fairly strong grounds for suspecting that it may be less efficient and less
open to innovation than other kinds of farm tenancies;
b) Its historical persistence and its coexistence, often in the same location, with cash
tenancy and capitalist farming
c) Customary crop shares between landowner and tenant (i.e fifty-fifty) which
cannot be explained by optimizing criteria alone.
The exploitation view of sharecropping stems from the way it concentrates economic
power in the hands of landowners, and the control this gives them over the livelihood of
tenants and landless workers.
The complexity in practice of sharecropping contracts needs to be stressed because its
theoretical treatment inevitably involves simplification.
a. Even in its simplest form it involves simultaneous transactions in two input
markets, land and labor (the labor of the tenant household work on the land
belonging to the landowner)
b. Sharecropping contracts are routinely a great deal more wide ranging than this
and may involve consumption loans, credit for production, labor service by
members of the tenant household for the landowner, cost sharing for variable
inputs, and innumerable other special arrangements.
c. Sharecropping does not always imply a clear cut distinction between a class that
owns land and a class that is landless. More typical is for land ownership to be
variably distributed in the peasant community, for some owners of small parcels
of land to sharecrop other land, even for complicated chains of tenancy and
cross-tenancy to exist between households with varying command over land and
other resources.
This chapter sets out the main components of the analysis of sharecropping and
interlocked factor markets. It covers (a) the basic microeconomic models of

sharecropping in a competitive environment, (b) the pursuit of the rationale of

sharecropping into dimensions of risk aversion, bargaining theory, and market
imperfections, (c) the analysis of interlocked factor markets.
6.3. Economic Analysis of Sharecropping

We begin by considering the simplest possible models of sharecropping, those which
restrict the share contract to a transaction in the use of land (and thus, implicitly, labor
too) and which assume a competitive environment. There are two opposing competitive
models of sharecropping, one which views production behavior from the point of view
of the tenant, and the other from the point of view of the landowner
? If the tenant is to make all the decision to maximize profit, do you think that the tenant
supplies enough labor power which maximize the profit of the farm?
_______________________________________________________________________
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_______________________________________________________________________
6.3.1. The Tenant Model

In this approach the share tenant is taken to be a profit maximiser in a competitive
market subject to the output share being fixed in advance. It is convenient to refer to the
share of the output going to the landowner as S, and the share going to the tenants as (1-
S). Thus if the shares were 60 percent and 40 percent then S would equal 0.60 and (1-S)
would equal 0.40(1-0.6). The economic position of the share tenant is shown in figure
6.1. The farm has a total output response to the input of tenant family labor as shown by
the total product curve (TVP). However, the tenant only receives a proportion, (1-S), of
the total product. Thus as perceived from the point of view of the tenant’s economic
interest, the relevant output response to labor is given by (1-S)TVP.

Given a competitive market wage which represents the opportunity cost or total cost
(TC) of labor time to the tenant family, the profit maximizing position with respect to
the labor input can be examined. It is rational for the tenant to maximize with respect to
(1-S)TVP by operating at pint A with labor input L 1 because he wants to maximize his
profit with respect to (1-S)MVP . However, this gives a lower total profit (EC=TVP -
TC) and lower output (Y1) than the profit (BD= TVP – TC) and output (Y2) which could
have been obtained by maximizing on TV (labor input L 2). Therefore, the use of the
variable input (L1), labor, is sub-optimal and sharecropping is inefficient.
The same result is demonstrated even more clearly in the graph of the marginal product
curves which correspond to the total products of figure 6.1. The marginal product curves
are shown in figure 6.2 as MVP and (1-S)MVP. The tenant maximizes at point A, with
labor input L1, where (1-S)MVP = w, the market wage. At this point the total MVP of
labor at point E is higher than the market wage, w, and, once again, sharecropping is
inefficient.
There are a number of aspects of this inefficiency model of sharecropping which are
worth drawing out more fully, and these are set out below. For some of them it is helpful
for the reader to appreciate that the area under a marginal value product curve, like, for
example, the area OHEL1 in figure 6.2, represents the total product in value terms (or
gross income) corresponding to the amount of input specified (the area under the curve
is the sum of the MVPs over every successive unit of input, and it therefore equals the
TVP). Thus different segments of this total area represent income flow either to
landowner or to tenants.
a. The analysis rests on an assumption that the tenant is free to choose the level of
labor input supplied; there is no control by the landlord over the labor time
committed to production
b. The same result obviously occurs for all variable inputs the use of which is left to
decision of the tenant, since in each case the production function for the tenant is
the share (1-S) of the output response to any variable input.

Figure 6.1: Sharecropping –the tenant model

Total output Y (Birr)
B
Y2
TVP
Y1 E
TC
A
(1-S)TVP
D
c. The economic waste of sharecropping

C (to the economy as a whole) is represented
by the area AEB in figure 6.2, which is the net income foregone due to the sub-
optimal level of input use at L1. This loss is incurred by the landowner, not by the
tenant, since it lies entirely within the landowner’s share (S) of the total product.
O L2
L1
d. By the same token as the tenant equates (1-S)MVP to the price of any variable
Labor input L
factor of production under his control, so the tenant would use land, if made
available, up to the point where the marginal product of land were zero. This is
because, as perceived by the tenant in this model, land has a zero price( the
landowner’s share, S, does not enter the decision making of the tenant as a price
for land, but instead as a prior deduction from output which reduces the average
and marginal products of all inputs)

e. In this model the tenant obtains a higher income and the landowner a lower
income, than would be the case if the landowner used wage labor or leased out
the land for fixed cash rent. This is indicated by the area FGA in figure 6.2,
which, for the tenant, is an income above that which he could obtain as a wage
worker (OFAL1) and, for the landowner, is a subtraction from the total profit,
FHEA, which could have accrued by using wage labor instead of share tenants to
farm the land. Alternatively the landowner could create a cash tenancy at a rent
level which would leave the tenant at the same income level as a wage worker.
Figure 6.2: Marginal product of labor of tenant model

Marginal value product (birr)
MVP (Farm)
H E
(1-S) MVP
G
w A B w’
F
6.3.2. The Landowner Model

In this model the landowner is a profit maximiser who can vary the amount of land at
O
his disposal, decide L1 size
the number and L2 of land parcels distributed amongst share
tenants, decide the rent share, andLabor

stipulate in the share contract the amount of tenant
input L
labor input which is required. The only constraint on the landowner is the market
wage: the tenancy contract must permit the tenant to obtain at least the same income

as could be obtained by working as a wage labor. Otherwise, no tenants will offer

themselves as sharecroppers.
As set up in this way an entirely different conclusion about the efficiency of
sharecropping is reached. Since the landowner now sets the labor input of the tenant,
profit maximization ensures that this occurs where the MVP of labor equals the wage
i.e at a labor input of L2 in figure 6.1 and 6.2. Further, the landowner will adjust the
number of tenancies, tenancies size, and share rate so that the implicit rent per unit
land is equal to the marginal product of land. With both these conditions satisfied
sharecropping become efficient.
In effect this model turns the landowner into a capitalist farmer. The income
distribution resulting from the share tenancy is the same as if the landowner managed
the land and hired in labor at the market wage. Gone is the advantage of
sharecropping to tenants over wage labor implied by the extra income FGA in figure
6.2
This result depends crucially on the assumed capacity of the landowner to vary the
size and number of tenancies, to vary the share rate, and to stipulate the labor input
of the tenant. These assumptions are not considered very satisfactory:
a. They seem to place the landowner in the position of a monopolist who can
offer all-or –nothing choices to prospective tenants, and this contradicts the
intention of the model to demonstrate the neoclassical competitively of
sharecropping
b. It is thought unlikely that the individual landowner could use the share
proportion as available in seeking efficient land use, because crop shares are
subject either to custom or to competition between land owners (in which an
individual land owners would be a price taker ) which make them fixed in
practice.
c. The notion that the land owner can stipulate the labor intensity of the tenant
is open to doubt. It assumes a zero enforcement cost to monitoring the labor
process on the tenant farm.

Activity 6.2
As we have seen in the previous tenant model that sharecropping is
 inefficient.
Is/are there any possibilities that the land owner can make the tenant to
supply his labor up to the point where the over all profit of the farm can be
maximized?
________________________________________________________________
However, in favor of the efficiency model is the consideration that under

sharecropping motivation of work effort is more secure than for wage labor. The
share tenant is at list self-motivated up to the efficiency point on the
proportionate production function, whereas the wage worker requires constant
supervision.
Moreover, efficiency for all other variable inputs can be achieved through the
device of cost sharing i.e. if the landowner contributes to the cost of purchased
inputs in the same proportion as the crop share then efforts by the profit
maximizing tenant to equate his share of MVP to his share to the input price will
result in the efficient use of variable inputs. This is thought to be a lower cost
way of monitoring input use than direct supervision.
According to the tenant model share cropping is inefficient, if so why people
engage in sharecropping? This is mainly for risk sharing. If it is fixed rent all the
risk of crop failure and other risks are assumed by the tenant. If it is capitalist
farm the risks are borne to the land owner. However, in share cropping the land
owner and the tenant share the risk in proportion to the share of crop yield in that
crop season.
________________________________________________________________
Activity 6.3
 In sharecropping it is the tenant that makes decisions on resource
allocation
and we know that according to the tenant model sharecropping is inefficient.

You as a professional, what possible policy interventions do you suggest?
6.4. Policy Aspects

The policy conclusions which are drawn from theories of the sharecropping
peasant evidently depend rather heavily on the positions taken with respect to (a)
its efficiency or in efficiency as an organizational form of farm production, and
(b) its impact on income distribution between landowners and tenants. Give that
sharecropping is intimately connected with the unequal distribution of land
ownership much of the policy emphasis in this area is on land reform. This and
other aspects of sharecropping are summarized briefly here as follows:
Land Reform
Land reform as major instrument of policy follows both from the inefficiently
theory of peasant decision making under sharecropping, and from concern over
its impact on income distribution. Indeed if the inefficiency argument is even
partially accepted, then land reform can be seen to promote both efficiency and
equity goals at the same time.
Land reform is unlike most policy interventions which seek to alter the
economic environment within which peasant production takes place. This is
because it centers on property ownership and related issues of social status and
economic power of an order quite different from typical market interventions’
by government. For one thing property owners usually predominate in the
structures of political power in most countries, and are the least likely class to
change the underlying basis of their own status. For another land reform is not a
marginal or graded shift in relative prices or access to resources; it involves a
major, once-for-all, change in the land ownership structure of a country.
For these reasons, and other, land reform has always proved an extremely
difficult proposition, has seldom occurred except in conditions of severe social
unrest or revolution, and usually fails in its objectives if it is only partial or
restricted in scope. The evidence from countries where major land reforms have

been carried out shows that it does greatly accelerate the transition of peasant
agriculture either in to capital farms or in to commercial family farms.
Legal Control on Crop Shares and Interest Rates

These are interventions designed to evade the political difficulty of full scale
land form, while at the same time attempting to give tenant sharecroppers some
protection against what are considered to be excessive crop shares and usurious
interest rates. Evidence as their efficacy is mixed, but a major drawback is the
ease with which they can be avoided or offset within the context of interlocked
factor markets. If a ceiling is placed on the landowner’s crop share, then the
interest rate on credit can be used as a substitute for surplus extraction; if a
ceiling is placed on interest rates, then variations is the cost of input, or in labor
service, or in countless other devices can be used to offset the control.
Subsidized Credit Schemes and Others

The provision of alternative, low cost, credit to tenants via state credit schemes
is anther way of attempting to alter the balance of advantage in favor of tenants.
The same is true of targeted inputs and similar devices. The problem with these
is their high cost of administration, the risk of default on loans, and the
impossibility in practice of controlling the final distribution of inputs. They may
have some improving effect on the situation of poor tenant farm families, but
one cannot help feeling that where sharecropping is perceived as a serious
barrier to improving the welfare of poor people bolder policy initiatives than
these are required.
The conclusion concerning policy responses to the unequal economic power of
landowners under sharecropping is that only land reform has any prospect of
improving the welfare of tenants. Partial reforms are likely only to intensify the
use by landowners of interlocked markets to evade them; and tenant credit
subsidies end up as subsidization of the welfare of landowners leaving tenant
welfare unchanged.


Summary
There are different forms of land tenancies in most part of the world, including our
country Ethiopia. These forms of land tenancies are: sharecropping, fixed rent and
capitalist or commercial farm. Sharecropping is a form of land tenancy in which the
payment for the use of land, the rent, is a percentage of the total physical output obtained
in the crop season. Since this proportion is fixed in advance of the crop season an
important feature of sharecropping is that the absolute amount of rent varies with the
level of harvest. The economics efficiency of sharecropping can be analysis using the
tenant model and landowner model. In the tenant model the share tenant is taken to be a
profit maximiser in a competitive market subject to the output share being fixed in
advance. In the land owner model the landowner is a profit maximiser who can vary the
amount of land at his disposal, decide the number and size of land parcels distributed
amongst share tenants, decide the rent share, and stipulate in the share contract the
amount of tenant labor input which is required.
In the economic analysis of sharecropping using the tenant model since the landowner
has no any control over the labor power supplied by the tenant, share cropping is
inefficient. This requires policy intervention in the form of land reform, legal control on
crop shares and interest rates, subsidized credit schemes and others.
Even though sharecropping is inefficient people engage in share cropping to minimize
risk, especially risk of crop failure. If the land tenancy is fixed rent the risk is assumed
by the tenant. If it is capitalist farm or commercial farm the risk is born by the land
lower. In the case of sharecropping the tenant and the landowner share the risk in
proportion to the share of physical output at the end of crop reason.

Checklist
√
I can: Yes No
1. Define sharecropping
2. Explain the difference of sharecropping from other form
of land tenancies
3. List assumptions of the tenant model
4. Assess the efficiency of sharecropping using both tenant
model and landowner model
5. List and explain the reasons for engagement in sharecropping

6. Identify policy intervention to make sharecropping efficient


Direction: For the following multiple choice questions choose the best answer
1. The potential range of transactions which might be contained either formally or
informally in a sharecropping contact are
A. The terms of consumption loans from the landlord to the tenant
B. The sale or cost share of farm inputs between the landowner and the tenant
C. The terms of production loans from the land lord to the tenant
D. The access to land via the crop share rent
E. All of the above
F. None of the above
2. Which of the following is not true about sharecropping models
A. According to the tenant model, sharecropping is inefficient because there is
undersupply of labor by the tenant
B. According to the land owner model sharecropping is efficient but the
assumptions seems unsatisfactory
C. In the case of fixed rent the risk is entirely born by tenant
D. people engage in sharecropping to avoid risk
3. Sharecropping differs from other type of farm tenancy in that

A. The land owner and the tenant have equal access to land
B. The absolute amount of the rent is known before the harvesting time
C. The use of land, the rent, is a percentage of the total physical output obtained
D. The land owner has control over the labor supply by the tenant
4. Given the model where R is the rent, F is the fixed rent, S is the
share of the landowner and Y is the physical output produced. Which of the
following shows the possible values of S and F in the share tenancy model
A. S=0 and F=1000

B. S=0.4 and F= -500

C. S=0.3 and F= 100
D. S=1 and F=0
5. One of the reasons for engagement in sharecropping is/are
A. To minimize risk of crop failure
B. To use land more efficiently
C. To control the labor power supplied by the share tenant
D. To avoid risk of crop failure
6. Possible policy intervention could be suggested in the sharecropping is/are
A. land reform
B. Subsidized credit schemes
C. Legal control on crop shares and interest rates
D. All of the above

1. Sharecropping is different from other forms of land tenancy in that the

absolute amount of the rent is known before the harvesting time
2. According to the tenant model sharecropping is inefficient because there is
under supply of labor by the tenant
3. Sharecropping is the most common type of land tenancy when the land
owner and the tenant have equal access to land.
4. One of the reasons for engagement in sharecropping is to share risk in case
of crop failure and other natural calamities
5. In sharecropping if the tenant is to determine the amount of labor power
supply in the production process there is net social welfare loss

CHAPTER SEVEN
7. Agriculture and International Trade
7.1. Introduction
Distance learner! In this chapter we will see agriculture and international trade. As you
all know, the main source of foreign exchange earning to less developed countries is
trade in agricultural goods. Trade in agriculture goods can play a significant role in
promoting economic development of less developed countries. We also see main
features of trade in agricultural goods such as, commodity concentration in trade,
geographical or market concentration and fluctuation of primary commodity prices.
It is generally acknowledged that some trade policies followed in the developed
countries (DCs) are not really conducive to the growth of exports of agricultural goods
from LDCs. We shall demonstrate in this chapter the impact of import levy instruments
of commercial policy which have been successfully used by the DCs to keep out imports
of agricultural goods from the LDCs. This has the effect of a tax on imports.
Objectives:
 Identify role of trade in agricultural goods in promoting economic development
 List main features of trade in agricultural goods
 Assess the income and price elasticity of agricultural products
 Assess impacts of trade policies in developed countries on agricultural products
trade in less developed countries

7.2. An Overview of Agriculture and International Trade

Trade in agriculture goods can play a significant role in promoting economic
development of LDCs. First, export of agricultural goods can pay for imports of capital
goods, technology, manufactured products and other essential commodities for a
sustained economic growth of developing countries. It is important to stress that exports
of agricultural goods from LDCs like Thailand and Malaysia have helped them
considerably to earn valuable foreign exchange for their industrialization and economic
growth.
Second, many LDCs have a comparative advantage in the production of agricultural
goods. Given a trade regime which is relatively free from control and regulations, LDCs
can use their comparative advantage in producing agricultural goods to raise their
standard of living. Indeed, in an export-led growth model of trade, it would be to the
advantage of many LDCs to specialize in the production of those goods where they have
a comparative advantage and to export the surplus production. Such a policy will lead to
the use of trade as an engine of growth apart from ensuring a rational allocation of
resources.
Third, even when developing countries successfully raise their standard of living, trade
in agricultural goods could still remain an important policy for a number of key
industries. Witness the case of Canada, New Zealand, Ireland, Denmark and even the
United States of America – in these rich countries, agriculture still performs a very
important role as a major export industry for stimulating economic growth.
_______________________________________________________________________
Activity 7.1
 Do you think that trade in agricultural products is free from different trade
restriction policies?
_______________________________________________________________________
Fourth, a growth of agricultural trade where LDCs can play an increasingly major role
could also be of considerable advantage to the developed counties. As the income in the
LDCs grows with a rise in their exports of agricultural goods, there will be a

corresponding rise of the demand for industrial goods and different types of services in
these countries which would be imported from the developed counties. In effect, the
market for developed countries in the LDCs will expand and trade in agricultural goods
will be of mutual benefit to both developed and LDCs. However, we are assuming a
trade regime which is free from all types of controls and regulations. In practice,
developed countries try to protect their agricultural sector by the imposition of different
types of controls for keeping out imports. Such controls usually take the form of quotas
whereby only a fixed amount of goods from LDCs are allowed to be imported. It may be
pointed out that LDCs also use tariffs, quotas and other exchange control regulations to
protect their “infant” industries from foreign competition. Some argue that the
impositions of these controls like tariff and quotas work against the principles of free
trade which is supposed to enhance economic welfare by providing goods at the cheapest
price.
7.3. Main Features of Trade in Agricultural Goods
Distance learner! List and explain main features or characteristics of less developed
?
countries trade in agricultural products
(You can use the space left below to write your response)

_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Good! Here are some of the features or characteristics of trade in agricultural goods in
addition to the characteristics you mentioned above.
Most LDCs trade in a large number of agricultural products which have the following
important characteristics.

7.3.1. Commodity Concentration in Trade

This feature implies that a large number of LDCs tend to export a limited number of
agricultural goods. For instance, Brazil tends to depend considerably on exporting
coffee, in the case of Ghana; the major export is cocoa; while Zambia’s chief export is
copper. Bangladesh and India depend substantially on the export of jute; India, Sri Lanka
and Kenya depend considerably on the export of tea; rubber is one of the few major
exportable for Malaysia; Argentina and Thailand depend very much upon export of food
grains. In other words, trade is heavily dependent upon the export of a few major
agricultural products.
7.3.2. Geographic or Market Concentration in Trade

Geographic or market concentration implies that most of the major exportable are
usually sold in a few markets of the industrialized countries. Examples are the sale of
tea, coffee, jute, cocoa and rubber in the markets of Europe, North America, Australia
and Japan. Such a geographic concentration has the implication that the economic
fortunes of the LDCs are strongly related to the rise or fall of the domestic and economic
activities of some industrialized countries.
7.3.3. Fluctuation in Primary Commodity Prices

It has been argued that the degree of fluctuation in trading of agricultural and primary
goods is significantly high or at least higher than fluctuations in prices of manufactured
goods which are traded in the world market. The figures for Brazilian coffee illustrate
the point: a monthly fluctuation in prices in the New York trading market is very
considerable. Many other agricultural goods which are exported by the LDCs show
similar fluctuations. Given such fluctuations, it is easy to understand why export
earnings (i.e price × quantity of export) to LDCs will also fluctuate under certain
assumptions.
The point has been made that such fluctuations in export earnings are detrimental to the
economic growth of LDCs. The theory is quite easy to illustrate. Assume that the
producers of primary goods are generally risk-averse. If risk can be approximated by an

index of instability of export earnings, then a high degree of instability in such earnings
will induce producers to withdraw resources from the production of such goods and,
under such a circumstance, output and employment will fall.
Primary commodity prices may also fluctuate in the export market due to demand
factors, two of which deserves special emphasis are:
i. The income elasticity of the demand for agricultural products is usually less than
unity. This implies that 10 percent rise in the level of income will raise the
demand for the product by less than 10 percent. Hence with economic growth
and a rise in per capita income, the rise in the demand for agricultural products
will tend to decline in proportional terms. This will have an adverse impact on
the export earnings of the LDCs.
ii. The price elasticity of the demand for agricultural product is usually less than
unity. Thus, an increase in supply of agricultural products in the international
market will reduce the price. But the additional demand generated by a decline in
price of agricultural exports will bring less revenue than before due to price
inelasticity of products. Once again, the LDCs will be hard hit if their combined
effort to expand production brings down the price by such an extent that total
earnings will actually fall.
7.4. Trade Policies in Developed Countries and their Impact on

Agricultural Trade
________________________________________________________
Activity 7.2
 How do you explain the impact of trade policies on agricultural

products
trade? Do these polices promote or hinder trade in agricultural products
_________________________________________________________________
It is generally acknowledged that some trade policies followed in the developed

countries (DCs) are not really conducive to the growth of exports of agricultural goods

from LDCs. We shall demonstrate here the impact of two main instruments of
commercial policy which have been successfully used by the DCs to keep out imports of
agricultural goods from the LDCs. The first instrument that has been generally used in
the DCs is an import levy. This has the effect of a tax on imports. The other commercial
policy has been export subsidy.
Consider first the case of an import levy. Figure7.1 illustrates the point of taxing imports
very clearly. On the vertical axis, price level (= P) is measured and quantity (= Q)
demanded and supplied is measured along the horizontal axis. The domestic demand is
shown by Dd and the domestic supply is given by Sd. The world price of the product is
given by OPw. At this price, domestic supply is given by OS w and the domestic demand
is ODw. Under the import levy scheme (as it has been used by the Common Agricultural
Policy (CAP) within the European Economic Community- EEC) a lower limit price is
given by OPL. Let us say, no country within the EEC will be allowed to import
agricultural goods at a price below OPL form the LDCs.
Figure 7.1: Welfare cost of an import levy
Sd
Price
PL H
J
A C
B D Sw
Pw G
T N
Dd
O
Sw SL DL Dw Quantity

Within the EEC as a result consumers are forced to pay OP L as the domestic market
price. Notice that when the domestic price rises from OP W ( the world price) to OPL(the
market price), PLPW is the amount of levy that has been imposed on the amount of
import(=SWDW) within the domestic market. The size of this levy will actually depend
upon the farm price policies of the EEC countries.
The impact of such a levy is easy to illustrate. Domestic supply rises from OS W to OSL
and domestic demand falls from ODW to ODL. The decline in the balance of trade deficit
is shown by SLDL instead of SWDW. This may be regarded as the balance of payment
effect of import levy which is now successful in keeping out the imports of primary
goods from LDCs. Production effect with the EEC is clearly observed as output rises by
SWSL.
However, the welfare cost of such an import levy is mainly borne by the consumers.
This is shown by the reduction of consumer surplus by the area P WGHPL. It is not a cost
for the community as a whole because what the consumers have lost as a group is partly
gained by the producer as a transfer payment or producer surplus gain (area A). The
governments also gain at the expense of consumers in tax revenue equal to the area C
(i.e, tax rate PLPW amount of import i.e. HJTN).

Summary
Trade in agriculture goods can play a significant role in promoting economic
development of LDCs. Export of agricultural goods can pay for imports of capital goods,
technology, manufactured products and other essential commodities for a sustained
economic growth of developing countries.
Many LDCs have a comparative advantage in the production of agricultural goods.
LDCs can use their comparative advantage in producing agricultural goods to raise their
standard of living. Even when developing countries successfully raise their standard of
living, trade in agricultural goods could still remain an important policy for a number of
key industries.
Growth of agricultural trade where LDCs can play an increasingly major role could also
be of considerable advantage to the developed counties. As the income in the LDCs
grows with a rise in their exports of agricultural goods, there will be a corresponding rise
of the demand for industrial goods and different types of services in these countries. In
effect, the market for developed countries in the LDCs will expand and trade in
agricultural goods will be of mutual benefit to both developed and LDCs. However, in
practice, developed countries try to protect their agricultural sector by the imposition of
different types of controls for keeping out imports from LDCs.
Most LDCs trade in a large number of agricultural goods which have the following
important characteristics: (a) Commodity Concentration in Trade. This feature implies
that a large number of LDCs tend to export a limited number of agricultural goods. For
instance, Brazil tends to depend considerably on exporting coffee, in the case of Ghana;
the major export is cocoa.(b) geographic or market concentration in Trade. This implies
that most of the major exportable are usually sold in a few markets of the industrialized
countries. Examples are the sale of tea, coffee, jute, and cocoa, rubber in the markets of
Europe, North America, Australia and Japan. (c) Fluctuation in Primary Commodity
Prices. It has been argued that the degree of fluctuations in trading of agricultural and
primary goods is significantly high or at least higher than fluctuations in prices of
manufactured goods which are traded in the world market.

It is generally acknowledged that some trade policies, such as import levy, followed in
the developed countries (DCs) are not really conducive to the growth of exports of
agricultural goods from LDCs.

Checklist
√
I can: Yes No
1. Identify role of trade in agricultural goods in
promoting economic development
2. List main features of trade in agricultural goods
3. Assess the income and price elasticity of agricultural
products
4. Assess impact of trade policies in developed countries on
agricultural products trade in less developed countries

SELF ASSESSMENT QUESSTION

1. Which of the following is not true about trade in agricultural products
A. In less developed countries export of agricultural goods can pay for imposts
of
capital goods
B. Even when developing counties successfully raises their standard of living,
trade in agricultural good could still remain an important policy for a number
of key industries
C. Agricultural goods are both income and price elastic
2. The main export of less developed countries is

A. agricultural products
B. primary products
C. manufactured goods
D. services
E. A and B
3. Which of the following is true about less developed countries agricultural goods
export?
A. agricultural goods are price elastic
B. agricultural goods are income elastic
C. agricultural product production is seasonal
D. none of the above
4. Most less developed countries mainly exports agricultural products to developed
nations. This is because
A. LDCs have comparative advantages in the production of agricultural products
B. Agricultural products are main source of foreign exchange earning

C. agricultural products are income and price elastics

D. there are many markets for products of developing nations
E. A and B
5. Main instruments of commercial policies which have been successfully used by

the DCs to keep out imports of agricultural goods from the LDCs is/are
A. Import levy
B. Import subsidy
C. Quota
D. A and B
Part II: True or False Type questions

1. Trade in agricultural goods can play a significant role in promoting

economic development of less developed countries
2. Many less developed countries have a comparative advantages in the
production of agricultural products
3. Growth of agricultural trade where LDCs can play an increasingly major
role could also be of considerable advantage to the developed counties.
4. When developing countries successfully raises their standard of living ,
trade in agricultural would not be an important policy for development of
key industries
5. In international trade, geographic or market concentration implies that
most of the major exportable are usually sold in a few markets

Part III. Discussion Question

For the following questions give your answer briefly
1. Many less developed counties have comparative advantages in the
production of agricultural goods. Explain this concept.
2. Discuss the price elasticity and income elasticity of agricultural products
of less developed countries in the international market.
3. List agricultural or primary products exports of our country Ethiopia
4. Discuss some of trade policies used by developed counties to reduce
imports of agricultural products from developing countries

Answers to selected self assessment questions

CHAPTER ONE
Part I: Multiple choice questions
1. A 5. E
2. E 6. D
3. E 7. A
4. D 8. B
1. T 4. T
2. T 5. F
3. F 6. T
CHAPTER TWO
Part I: Multiple choice questions
1. E 5. C 9. A
2. E 6. C 10.A
3. B 7. A 11.D
4. B 8. A
1. T 4. F
2. T 5. F
3. T
Part III: workout problems
4. a) 40kg of nitrogen
b) Input elasticity (E) = 0.46
c) Profit = 10031.25

5. the best enterprise combination is production of only 300units of

banana and no production of orange.
CHAPTER THREE
Part I: multiple choice questions
1. D 5. C 9. E
2. D 6. A 10.B
3. D 7. B
4. E 8. B
Part II: true or false type items
1. T 4. F
2. T 5. T
3. T
Part III: workout problems
4. growth rate of per capita consumption is 0.25 or 25%
5. a) equilibrium level of supply of wheat is 150 units
b) since policy impose price less than the price that market
determine ,
the intervention negatively affect the producers. The producers
supply only 125 units
c) in the market shortage of wheat exists and therefore, government
has options in favor of the consumers, i.e import to cover the
shortage
CHAPTER FOUR
1. A 3. A 5. C
2. D 4. C 6. C


1. T 4. T
2. F 5. T
3. F
CHAPTER FIVE
1. D 5. D
2. C 6. B
3. C 7. B
4. D
1. T 4. T
2. F 5. T
3. F
CHAPTER SIX
1. E 4. A
2. D 5. A
3. C 6. D
1. F 4. T
2. T 5. T
3. F
CHAPTER SEVEN
1. C 2. E

3. C 5. A
4. E
1. T 4. F
2. T 5. T
3. T

References
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Agrculutrale Economics

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Agrculutrale Economics

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AGRICULTURAL ECONOMICS MODULE

1. The Role of Agriculture in Economic Development

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1.2. Rural livelihood diversification

In line with the sustainable livelihoods framework, a livelihood is defined as “the

Less developed countries agriculture is nature dependent. When ever there is

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1.3 Contribution of Agriculture

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Food Market Linkage

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Raw Material Contribution

Foreign Exchange Contribution

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Food Supplies and Inflation

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1.4 Linkage Effect of Agriculture (Backward and Forward linkages)

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Figure1.1: Forward and backward linkage effect of agriculture

Output sold to other

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SELF ASSESSMENT QUESTIONS

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C. Total linkage effect

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2.2. Theoretical Foundation: Neo-Classical Theory of Farm Production

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b. The varying combination of two or more inputs required to produce a specified

2.2.1. Production Function (Physical Relationship between Inputs and Output)

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0 25 50 75 100 125 150

0 25 50 75 100 125 150

Fertilizer X1 (kg) MPP

In general, the production function in economics describes the technical or physical

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We know from Microeconomics I course that

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Economic Optimum Level of Resources Use

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0 25 50 75 100 125 150

E Marginal factor cost (MFC)

0 25 50 75 100 125 150

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Example: Consider the following production function

Where Y is the output and X is the variable input

Therefore, output maximizing level of input is 50 units of X

c. Find the level of X maximizing net return when

Profit maximizing level of input use is 37.5 units of X

2.2.2. Factor Combination (Factor-Factor Relationship)

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Y= quantity of a given output

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Optimum Combination of Inputs

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Figure 2.4: Optimum combination of inputs

………. This is the isocost line and is the slope of the

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Where Y= output, X1 and X2 are inputs