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Theme 2: Production decisions

**Production function analysis
**

Planning is the managerial task dealing with:

purposeful deliberation on the future objectives of a business or a section thereof; the means and activities involved therein; the problems that may be experienced; and the formulation of the most suitable plan of action for the effective attainment of those objectives.

**Questions which should be asked in the planning process:
**

What are the objectives? What must be done to achieve them? Why are specific actions necessary? Who must take action? Where should action take place? What means will be necessary; and How should action be undertaken to achieve the best results?

Detailed planning is important, because farming is subject to numerous risks and uncertainty. Risk: Average outcome is known, whilst individual outcomes varies according to subjective or objective known deviations. There is adequate information concerning the possible results. Both the alternative outcomes and the probability of occurrence are known.

Example: the average rainfall in an area is known, as well as the deviations from one season to the next. Through record keeping, it can be determined what the impact on the crop will be given deviations in rainfall. Thus, given forecasts of rainfall the farmer can get a good indication of the risks he/she will have to face in the coming season.

Uncertainty: Average outcome may be known, but the variation of individual outcomes is unknown. There is incomplete or insufficient knowledge about the alternative outcomes and their probability of occurrence.

Example: El Niño has an impact on weather patterns. In South Africa we know that the eastern areas are usually the hardest hit by means of droughts. What is not known is how severe the drought will be and which specific areas will be hardest hit.

Planning….

To carry out the function of planning, certain procedures and methods are necessary to guide decision makers. Knowledge of production economics provides the manager with a set of principles and rules for decision making.

**Principles of production economics
**

The principles comprise of a set of rules which ensure that the choice or decision will achieve maximum profit. The rules are: Collecting physical and biological data, and processing the data into usable information; Collecting price data and processing this into usable information; Applying the rules relevant to economic decisionmaking in order to maximise profit.

**The concept of a production function
**

A production function portrays an inputoutput relationship Describes the rate at which resources are transformed into products There exist numerous input-output relationship due to different soil types, technologies, rainfall, etc Any given input-output relationship specifies the quantity and qualities of resources needed to produce a particular product

Symbolically, a production function can be written as follows: Y=ƒ(X1, X2, X3, ...., Xn) where Y = output X1 - Xn = different inputs used to produce the output i.e. for each combination of inputs, there will be a unique amount of output. This notation does not specify which inputs are variable and which are fixed.

Example of a fixed input is land or dairy cow, since they only have a certain capacity to transform variable inputs into outputs These inputs are called technical units Y=ƒ(X1, X2, X3, ...., Xn-1| Xn) where the vertical line indicates difference between variable and fixed inputs

To see what is output response to one variable is, Input, the notation is as follows: Y=ƒ(X1| X2, X3, ....,Xn) In this notation the level of the other inputs is assumed constant.

Production economics is a study of the economic principles to be used when making management decisions. These decisions must guide future production.

ASSUMPTIONS:

1. Perfect certainty Past input/output relationships must be used as a planning device if they represent or approximate the following years production function This is rather unrealistic since future outcomes are unknown This introduces risk and uncertainty To avoid these complexities it is assumed that the farmer knows the eventual outcome of the production process at the beginning of the production period

2. Level of technology

Products can be produced in many different ways The assumption is that the farm manager uses the most efficient process available to him, i.e. the one that results in the most products from a given amount of input.

**3. Length of time period
**

Very short run - time period so short that all resources are fixed Short run - time period of such length that at least one resource can be varied while other resources are fixed Long run - time period of such length that all resources can be varied i.e. in the long run, farmers may be able to change usage of inputs, but in the short run, they may not.

Production relationships

Relationships between inputs and output can take three general forms: 1)Constant productivity (returns) Constant productivity exists when each unit of variable input added to the fixed factor(s) increases output by the same amount.

Y

0

X1

This is a linear relationship i.e. Y= α +β X1 where α = intercept β = slope (coefficient)

Example: Production function (constant returns) Y = 25 + 0,5 X1 This means that the intercept is 25 units i.e. if no X1 is used 25 units of Y will be produced. The coefficient indicates that if 2 units of X1 are used, the output (Y) will increase with 1 unit.

2) Diminishing productivity (returns) This is when each additional unit of the variable input adds less to the total output than the previous unit.

Y

0

X1

3)

Increasing productivity (returns)

This is when each additional unit of the variable input adds more and more to the total product than the previous one

Y

0

X1

An example of increasing returns is the use of irrigation water in a low rainfall area.

The classical production function

**The classical production function exhibits both increasing and decreasing marginal productivity.
**

Y

X1 This production function can be continuous (A) or discrete (B).

0

A production function is continuous if all the inputs such as fertilizer etc. are perfectly divisible. Inputs such as tractors are not perfectly divisible and are called discrete. (You do not get 1½ tractor) If you use perfectly divisible inputs the output is also perfectly divisible

**The concept of marginality
**

The principle of marginality explains what the effect of a change will be. The manager wants to know what the effect is on production if one or more of the factors of production were to change. Marginal refers to a change in one factor as a result of a change in another factor i.e. it measures the additional change in output (Y) if there is a change in the input (X1, ...., Xn). The change in output or input is indicated by the Greek letter delta - ∆

The production function provides the basic data which could be used to reach further conclusions with respect to production. Total product (TP) = Y (Output) Average product (AP) = TP(Y) ÷ Input level (X) Marginal product (MP) = ∆ TP(Y) ÷ ∆ Input level (X)

The Average Product (or average physical product) The AP measures the average rate at which an input is transformed into a product The AP measures the efficiency of the variable input used in the production process APX1= Y = ƒ(X1|X2, ..., Xn) X1 = X1

The Marginal Product (or marginal physical product) The MP is the change in output resulting from a unit increment or unit change in variable input i.e. it measures the amount that total output increases or decreases as input increases/decreases MPX1 = ∆ Y = ∆ ƒ(X1|X2, ..., Xn) ∆ X1 ∆ X1

Example:

Input level (X) Nitrogen (kg/ha) 10 20 30 40 50 60 70 80 90 100 110 120 Total product Average (Y) product (AP) Wheat yield (kg/ha) 400 910 1350 1710 1960 2110 2190 2235 2250 2250 2230 2200 Marginal product (MP)

Kg wheat per Kg wheat per kg kg nitrogen nitrogen 40 45.5 45 42.8 39.2 35.2 31.3 27.9 25 22.5 20.3 18.3 51 44 36 25 15 8 5 2 0 -2 -3

Therefore for input level of 40kg N per ha: AP=Y ÷X =1710 ÷ 40= 42,8kg wheat per kg N MP= ∆ Y ÷ ∆ X= (1710-1350) ÷ (40-30)=360 ÷ 10 = 36kg wheat per kg N

Output (Wheat kg/ha)

Phase 1 Phase 2

C

Phase 3

TP B

A 0

Output (Wheat kg/ha)

Input level (N kg/ha) Phase 1 Phase 2 Phase 3

MP D E F 0

Input level (N kg/ha)

AP

**A typical production function in agriculture
**

Phase 1: TP increases at an increasing rate until point A, then it increases at a decreasing rate to point B This is also reflected by MP which increases to point D and then decreases to point E The AP increases to point E, here the AP reaches the maximum and is equal to MP Note: A=D and B=E

**Production in phase 1 is irrational because:
**

The AP constantly increases, since the MP curve lies above AP This implies that the additional production achieved through the application of additional N is higher than the AP, which causes the new AP to increase If objective = profit maximization you will not produce in phase 1, since by increasing N the AP increases, i.e. productivity increases

Phase 2: The TP curve increases at a decreasing rate from point B until it reaches a maximum at point C (rate of increase is zero) The MP and the AP decrease throughout The MP lies below the AP and MP=0 at point F Note: C = F

Phase 2 includes an area between Max AP and Max TP This is known as the rational production area

Phase 3: The TP starts to decline from point C This means the MP curve from point F is negative Production in this phase is irrational

**Law of diminishing returns /productivity
**

Definition: The law of diminishing marginal returns states that, as additional units of a variable input are applied in combination with one or more fixed inputs, the marginal returns will eventually start to decrease

ALSO, If increasing amounts of one input are added to a production process while all other inputs are held constant, the amount of output added per unit of variable input will eventually decrease This law specifically refers to the marginal product This phenomena is responsible for the typical form of the production function found in agriculture Important since phase 2 can only take place while marginal returns decreases

Elasticity of production

The elasticity of production is a concept that measures the degree of responsiveness between output and input Elasticity of production (ε p) is defined as:

εp =

∆X ∆X X ∆Y MP ÷ = × = Y X Y ∆X AP

**Stage 1 = Stage 2 = Stage 3 =
**

MP > AP ⇒ ε p > 1 MP < AP ⇒ 0 < ε p < 1 MP < 0 ⇒ε p < 0

Thus where MP = AP the ε p = 1 (First boundary) and where MP = 0 the ε p = 0 (Secondary boundary) Relevant production interval for a variable input is that interval wherein 0 ≤ ε p≤ 1

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