Farm Management, Production and Resource Economics 2(1+1)

Lecture 03:

ECONOMIC PRINCIPLES APPLIED TO FARM MANAGEMENT

INPUT-OUTPUT RELATIONSHIP/ FACTOR-PRODUCT RELATIONSHIP:

The goal of this relationship is the optimization of resources. This relationship is explained
by the law of diminishing returns.

The factor-product relationship is confined to a single variable input and output.

Y = f (X1 | X2, X3, ……….Xn )

Where, Y = Output from a particular enterprise

X1 = Variable resource
X2, X3, ……….Xn = Fixed resources
| (Vertical bar) = It separates variable resource from fixed resources.

Total Physical Product (TPP):

The total amount of output obtained by using different units of inputs, measuring in physical
units like quintals, kgs, etc.

TPP = Y

Average Physical Product (APP):

The average amount of output produced by each corresponding unit of input. It is obtained by
dividing the total output at a given level by the number of units of input applied at the
corresponding level. APP reflects the efficiency of the variable input (technical efficiency).

APP = Total physical product/ Input level = Y/ X

Marginal Physical Product (MPP):

The additional quantity of output, added by an additional unit of input. The change in output
as a result of change in the variable input. It is calculated as

MPP = Change in total physical product / change in input level = ∆Y/ ∆X

Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
Elasticity of Production (Ep):

It is defined as percentage change in output as a result of percentage change in input.

Ep= Percentage change in output/ Percentage change in input

The elasticity of production can be defined in terms of the relationship between MPP and
APP.

(∆Y/ Y) (∆Y/ ∆X)

Ep = =
(∆X/ X) (Y/ X)

We know that, ∆Y/ ∆X = MPP and Y/ X = 1/APP

Therefore, Ep = MPP/ APP

Law of Variable Proportions:

It explains the input-output relationship and guides the producer in making one of the
operational management decisions i.e., how much to produce?

This law helps in determination of optimum input to use and optimum output to produce.

It is a fundamental economic law, applicable to any production activity.

 The law is known as the law of variable proportions because-

The proportion among factors of production varies as one of the productive resources is
changed keeping the other factors of production constant.

 Three stages of production function:

The classical production function can be divided into three stages or zones or regions.

Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
Stage I:

It starts from the origin and ends at the point where, MPP = APP. In this stage, MPP ˃ APP
as a result of which APP is increasing. The MPP attains the maximum at the point of
inflection. (Inflection point is the point at which MPP is maximum. It is also the point at
which TPP curve reverses its shape from convex to concave). Thereafter it begins to decline.
TPP increases at an increasing rate till the inflection point and thereafter it increases at
decreasing rate.

Ep is more than one throughout the stage I of production and Ep is one at the end of the stage.

Stage II:

It is found from the point of equality of MPP and APP and ends where MPP is zero, at which
input use level TPP is maximum. In this stage, MPP is less than APP. However, both MPP
and APP exhibit declining trend. Average productivity derived from each individual unit of

Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
the variable resource is on the decline in this stage, though it is at its peak at the beginning of
stage II.TPP increases at a decreasing rate as MPP is declining.

Ep is less than one throughout stage II. Ep is zero at the end of this stage.

Stage III:

The starting point of stage III is the end of stage II, at which MPP is zero. In this stage MPP
is negative. APP continuously declines and TPP which is at its maximum at the end of stage
II, begins to decline.

Ep is less than zero.

 Rational and Irrational stages of production:

Of the three stages, stage I and stage III are irrational, while stage II is rational.

In stage I since the average productivity (technical efficiency) of variable resource keeps on
increasing, it is not judicious to stop the application of the variable resource. Fixed factor
which is kept as idle can be withdrawn and we can reorganize the resources. This
reorganization leads to the production of more output. Since it is possible to produce more
output from less quantity of resources through reorganization of fixed and variable resources,
this stage is called irrational stage.

In stage III, the technical efficiency of variable resource (APP) and fixed resource (TPP)
declines. The additional productivity of variable resource (MPP) becomes negative. Given
the productivities of variable and fixed resources, no rational producer attempts to operate in
this stage, as any attempt to continue production brings him colossal loss in the form of
additional costs of variable resource and reduction in total output. Such a situation is called
weak disposability of input. Since stage III offers the opportunity of reorganization of fixed
and variable resources, it is called an irrational stage.

In stage II, the point of optimality, either in the use of input or in the production of output,
lies. The boundaries of this stage are the points, at which the technical efficiency of variable
resource is maximum and the technical efficiency of fixed resource is maximum. At the
beginning of stage II, technical efficiency of variable resource (APP) is maximum. At the end
of stage II, technical efficiency of fixed resource (TPP) is maximum at the point of

Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
congestion. Since, there is no possibility of recombining fixed and variable resources, stage II
is a rational stage or optimal stage.

 The law is known as the law of diminishing returns because-

Reasons for Increasing, Decreasing and Negative Returns:

In stage I, fixed resources are abundant relative to variable resource. The technical efficiency
of variable resource is increasing as indicated by increasing APP. Also the technical
efficiency of fixed resource is increasing as reflected by increasing TPP. Under this situation
application of more quantities of variable resource makes to unutilized fixed resource
efficient leading to increasing returns.

As more quantities of variable resource are applied soon we reach the point of maximum
MPP. Beyond this point, any further increase in the use of variable resource yields less
additional output (decreasing returns). This happens as more quantity of variable resource has
to accommodate with less quantity of fixed resources.

Production in general is the integrated effort of fixed and variable resources. Since the
production of variable resource becomes too large to the very limited fixed resources, the
balance which is supposed to exist between fixed resources and variable resource gets
disturbed, thereby leading to the negative returns, in the third stage.

 The law in general applies to the field of agriculture, but its operation can be
postponed under the following conditions:

i. Improved Technology:

Technology components like high yielding varieties of seeds, irrigation, fertilizers,

and integrated pest management practices would help in increasing the returns.

ii. New soils:

When virgin soils are brought under plough, they give more and more yield, as their
productivity is higher.

iii. Scarcity of Capital:

Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
Scarcity of capital limits the farmers in applying sufficient quantities of variable resource
leading to the prevalence of increasing returns. This situation is found in stage I.

Reasons for the Operations of the Law of Diminishing Returns in Agriculture:

i. Excessive dependence on agriculture: A farmer, however good he is in managing

the farm may not get the expected yields as he has little control over weather. A
bad weather is just enough to fulfil his expectations.

ii. Less scope for division of labour: There is no possibility of division of labour in
farming as the farmer himself performs the role of labour, manager and capitalist,
therefore, the advantage of division of labour is not a possibility. Therefore, the
law of diminishing returns sets in quickly in farming.

iii. Less scope for mechanization: Though mechanization of the farms enhances the
productivity, the small size of holdings stands against using the machines for
various farm operations. Under this limitation, the farmer fails to derive the
advantage of mechanization.

iv. Cultivation of inferior lands: To meet food requirements of the teeming millions of
population, even inferior lands are brought under plough, the productivity of
which in general is low.

v. Continuous cultivation: Continuous cultivation of land drains out the fertility status
of the soil, thereby leading to low productivity. It is a fact that no farmer can
afford to keep the land fallow for some period, to allow the land build up its
fertility status.

Law of Variable Proportions or Law of Diminishing Returns or Principle of Added

Costs and Added Returns

The law of diminishing returns is a basic natural law affecting many phases of management
of a farm business. The factor product relationship or the amount of resources that should be
used (optimum input) and consequently the amount of product that should be produced
(optimum output) is directly related to the operation of law of diminishing returns. This law
derives its name from the fact that as successive units of variable resource are used in
Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
combination with a collection of fixed resources, the resulting addition to the total product
will become successively smaller.

Most Profitable level of production

(a) How much input to use (Optimum input to use).

The determination of optimum input to use: An important use of information derived from
a production function is in determining how much of the variable input to use. Given a goal
of maximizing profit, the farmer must select from all possible input levels, the one which will
result in the greatest profit. To determine the optimum input to use, we apply two marginal
concepts viz:

Marginal Value Product and Marginal Factor Cost.

Marginal Value Product (MVP): It is the additional income received from using an
additional unit of input. It is calculated by using the following equation.

Marginal Value Product =Change in Total Value Product/Change in Input level

MVP =∆Y. Py/∆X

∆ = Change
Y =Output
Py = Price/unit of output

Marginal Input Cost (MIC) or Marginal Factor Cost (MFC): It is defined as the additional
cost associated with the use of an additional unit of input.

Marginal Factor Cost =Change in Total Input Cost/ Change in Input level

MFC or MIC =∆X Px/∆X

Therefore, ∆X .Px /∆X = Px

X = input Quantity
Px = Price per unit of input

MFC is constant and equal to the price per unit of input. This conclusion holds provided the
input price does not change with the quantity of input purchased.

Decision Rules:
Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
1. If MVP is greater than MIC, additional profit can be made by using more input.

2. If MVP is less than MIC, more profit can be made by using less input.

3. Profit maximizing or optimum input level is at the point where MVP=MFC

(∆Y/∆X). Py = Px ∆Y/∆X = Px/ Py

Determination of Optimum output to produce: (An example)

In the above table, it is clear that MR is greater than MC up to the output level 62 units. At
the output level of 68 units, the MR=MC. This is the optimum output to be produced. If we
produce 72 units of output, additional revenue from additional output is less than the
additional cost of producing output. Therefore profit decline.

Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University
Dr. Arunima Konar Lecture: 03 Farm Management, Production & Resource Economics
Assistant Professor, Agril. Economics
Sister Nivedita University