CHAPTER THREE

ECONOMICS OF AGRICULTURAL PRODUCTION

3.1. Introduction
• Microeconomics provides few basic principles, laws and relationships applicable to
agricultural production and resource use.
• The following table summarizes these fundamental relationships in agricultural
production.
  Principles of Economics Explaining Management decision
1 Principles of Diminishing Factor-Product How much to produce?
Returns or Increasing costs relationship [optimal level of resource use]
2 Principle of substitution or Factor-Factor How to produce? [Least-cost
least cost combination relationship method]
3 Principle of opportunity cost Product–Product What to produce? [Enterprise
or equi-marginal returns relationship Selection]
3.2. Physical and Economic Relationships of Agricultural production
Production in agriculture can be defined as the process of combining resources
(labor, fertilizer, mechanical implements….) in the creation of agricultural
products.
Producing a ton of wheat, for example requires in addition to suitable climatic
conditions, some amount of arable land, seed, fertilizer, equipment such as
ploughs, and human labor.
From this, we can understand that production varies in a systematic way with
the level of input usage, and economists call this relationship as production
function, which mathematically can be expressed as: Q = f (x1, x2,…,xn)
Where, Q = quantity of specific product
x1,…, xn = quantities of n inputs used in the production process
The function purely states that output is related to the levels of input usage.
The production function is purely physical concept:
it depicts maximum output in physical terms for each combination of specified
input in physical terms.
It relates to a given state of technology.
The technical aspects of production are discussed in terms of:
1. Factor- product relationships
2. Factor- Factor relationships
3. Product - product relationship
If it is assumed that all inputs except one (fertilizer denoted as x1) are held fixed,
the relationship between output and single variable factor can be denoted as:
Q = f (x1 / x2,…, xn )
The above relationship is represented by Total Physical Product (TPP) curve in
the following figure.
For inputs like fertilizer, irrigation water, weedicides, etc., one would expect some
level of output even if there were zero application of input and the graph starts
at some level above the horizontal axis.
For other inputs like seed, labor or land, a zero input would cause zero output
and production function begin at the origin of the graph.
The relationship states that as more of fertilizer (x1) is applied, output (Q)
increases until maximum, associated with input usage (x’’1) is reached.
Further application of fertilizer will only serve to reduce total output.
Three aspects of factor-product relationship will be of interest:
i) Marginal physical product (MPP)
ii) Average physical product (APP)
iii)Input elasticity (partial elasticity of production)
I. Marginal Physical Product (MPP) of the variable input
production function is constructed keeping other resources such as land, labor, and
production technology constant (varying only quantity of fertilizer).
Under such conditions though output grows with successive increases in fertilizer
application, the amount by which it grows changes because of existence of fixed
quantities of resources.
• The concept, which measures the quantity of additional output obtained for each
successive additional input is called the Marginal Physical Product (MPP).
It is defined as the change in output resulting from a small change in the variable
input expressed per unit of the input; alternatively, it is the slope of the total
product curve at any point.
For a discrete change: MPPx1 = where, ∆ signifies “change in”
For an infinitesimal change: MPPx1 = where, d signifies “derivative of” dx1

The slope of the TPP curve, i.e. MPP first increases and is maximum (the
slope of TPP is at greatest) at the point of inflection of the curve (x’1), it is
zero at the point of maximum TPP (x’’1) and becomes negative at input
levels beyond x’’1.
•II.  Average Physical Product (APP) of the variable input
It is a very important measure of productivity of factors of production
It is defined as total product divided by the total amount of the variable input
(fertilizer) used in production.

The APP is the slope of the line from the origin to the relevant point on the TPP
curve (A) at input level x01, where APPx1 = MPPx1, i.e., the slope of the TP curve
equals to the slope of a line from the origin at x01.
•III.
  Input elasticity
It is defined as the percentage change of output resulting from a given percentage
change in the variable input.
The relationship between E, MPP and APP can be summarized as:
 The area of diminishing marginal returns on production function occurs
When MPP< APP, but it is not negative, i.e., 0< E< 1.
 E > 1 and E < 0 define areas of production function in which it would not be
economically logical for the farmer to operate.
- The first case (E>1) is because output grows more than proportionately
with any increase in input, which means the farmer could always gain by
using more of the input.
- The second case (E<0) is because output decreased as a consequence of
using more input and the farmer clearly does better by reducing input use.
When summarized, discussion on physical relationship of factors and products,
all production functions must satisfy two conditions to make economic
justification acceptable:
a. MPP should be positive and declining, i.e. equation should have a positive first
derivative [dQ/dx > 0]
b. Its equation should have a negative second derivative [d2Q /dx2< 0], i.e. the
response of output to increasing level of input must be rising but at a
decreasing rate.
Notice that the TPP, MPP and APP curves have been divided into three stages.
Stage 1 is defined to be that in which APP of x1 is rising, and MPP is above
APP. With each additional units of fertilizer, more is not utilized efficiently.
In stage 2 both APP and MPP of x1 are falling but are positive
In stage 3 MPP of x1 is actually negative. In this stage additional units of
fertilizer reduce total product i.e. the marginal product of fertilizer is
negative. The fixed inputs are overloaded and the producer’s interest
would be better served by using less fertilizer (moving back out of stage 3).
 It would therefore be predicted that optimum position in terms of
variable input usage will lie somewhere in stage 2.
•  3.4. Economic Optimum level of resource use
The most efficient level of variable input depends on relationship between price of input and
price of output.
Then in deciding economically optimal usage of single variable input, the farmer requires
three pieces of information:
I. the MPPx1, which indicates contribution of variable input to total output;
II. the price per unit of final product (Py);
III.the price per unit of variable input (Px1).
Economic Optimum will be attained where value of marginal product of variable input is
equated to its price (price of variable input):
• VMPx1 = Px1; or =
• Where VMP = MPP * Py
At particular level of input usage associated with optimal condition, the
farmer is said to be in equilibrium (no incentive to alter production plan).
 When VMPx1 > Px1, an additional unit of the input would yield more to
the producer in terms of extra revenue than it would cost, thus more profit
would be obtained if an extra unit were employed
 When VMPx1 < Px1, the last unit of the input employed contribute less to
revenue than it added to cost, hence less of the input should be used.
 3.4. Factor-Factor relationship(production with 2 variable inputs)
Do you think that farmers use only one variable productive resource in one
season?

3.4.1.The physical interaction between inputs

Typically, in a given production period, there would be more than one variable
factor of production.

For example, in production of wheat, fertilizer, seed, and labor services may be
variable, while land and mechanical implements may remain fixed.
Assuming two variable inputs, the production function is defined as:
Q = f (x1, x2 / x3…xn)
This relationship will be illustrated by an isoquant map (or iso-product curve).
It is a contour line or locus of different combination of two inputs, which yield the same
level of output.

Qty of x1

X10
A

Q = 15
X1 1 B
Q = 10

Qty of x2
X20 X21

From the above figure one can easily understand that both the input combination at point A and
that at point B can produce ten units of output.
• In moving from A to B, the amount of x1 decreased from x10 to x11 and that of x2
increased from x20 to x21, i.e., x2 substitute for x1.
The rate at which one input substitutes for another at any point on the isoquant is
called Marginal Rate of Substitution (MRS) and it can be measured as the
slope of the isoquant curve.
Numerically,
- MRS of x2 for   
MRS is negative since more usage of one input is associated with less of
another, i.e., the isoquant is downward sloping.
However, the negative sign is often omitted.
Isoquants are convex to the origin.
This means that MRS tends to diminish as more of one factor is used to replace
the other.
The Diminishing Marginal Rate of Substitution (DMRS) results from the principle
of Diminishing Marginal Returns (DMR) which states as substitution proceeds it
requires more and more of input x2, to replace a single unit of x1 in order to
maintain the same level of output.
There are different rates of substitution between inputs:
I. Decreasing Rate of Substitution, the input being increased substitutes for
successively smaller amount of the input being replaced.
.
MRS of x2 for x1 at A is greater than at B
II. Constant Rate of Substitution, the amount of x2 required to replace a unit of x1 remains
the same.
MRS is constant
 III. Complementary Substitutes, there are no substitution possibilities since the inputs
must be used in fixed proportions.
•.
• However, the MRS as a measure of the degree of substitutability of inputs has a
serious defect in that it depends on the units of measurements of the inputs.
A better measure is provided by the elasticity of substitution () which is defined
as:-

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

The numerator is the percentage change in input, the input ratio, or factor
intensity
 3.5. Economic Optimum Level of Resource Combination
To determine appropriate level of input use when there are two variable factors
of production, a producer must know the rates at which input are exchanged in
the market [their relative prices] as well as the rates at which they can be
exchanged in production [their MRS].
To illustrate the former, we introduce isocost line, which is the locus of all
combinations of two variable inputs, which the producer can purchase with a given
cost outlay.
• The slope of the isocost line is the ratio of input prices =
The least cost combination of the two inputs occurs at a point of tangency
between isocost line (C0) and an isoquant line (Q).

At this point the slope of the isocost line is equal to the slope of isoquant.
• 
 At point A, MRS of x2 for

 Mathematical implications, in summary, on the factor-factor relationships can be

looked as:

Y = f (X1, X2), and

Inverse ratios of MPP = MRS

• = = = MRSx1,x2

The inverse ratio of MPP of each input equals the inverse ratios of their prices.
Therefore,

• by cross-multiplying
 3.6. The Product-Product Relationship (Enterprise choice or physical
interaction between outputs)
most farmers have a range of alternative crops they could grow for a given
availability of input.
As an example we can take the following:
Growing two different successive crops with short growing seasons on the same
land.
Utilizing different kind of land for the crops most suitable to the different soils.
The practice of mixed cropping which permits a fixed labor resource to
cultivate simultaneously several different crops.
It is assumed that the producer can produce two products, Wheat and Maize, each
output being produced by a set of n inputs.
•  Production function for wheat and maize can be specified as:


A Production Possibility Frontier (PPF) or [transformation curve] can illustrate

the production options, which are technically feasible for the above two production
functions.
This curve is the locus of combination of outputs [wheat and maize], which can be
produced with a set of given inputs and assuming a particular state of technology
•.
Qty of W0
PPF

C b

Qtity of M0
•The
  slope of the PPF represents the Marginal Rate of Transformation (MRT) of
Maize for wheat.

It is the amount of Maize on the horizontal axis (dy 2) which can be gained by
giving up one unit of wheat on the vertical axis (dy 1).
In other words, MRT measures the increase in y 2 (Maize) which results from a small
decrease in y1(wheat) .
It should be noted that an efficient farmer would chose to operate at some point
on PPF.
A point inside PPF would mean an inefficient use of resources, since with the same
level of inputs, more of at least one of product could be forthcoming specially in the
ab segment of the curve.
Economic Choice of Enterprises
Iso-revenue lines are different combination of outputs (wheat and maize)
which yield a given levels of total revenue.
The slope of the Iso- revenue lines equals the inverse ratio of output
prices.
The slope is negative because for total revenue to remain constant
increased income from one output is associated with decreased income
from the other.
The optimum combination of enterprise occurs at the point of tangency
of an iso- revenue line with PPF, since any iso-revenue lines to the left of
this point would represent lower returns.
Therefore, the optimal allocation point is at: W*. Pw + M*. Pw = 1500 birr
•In. General
Taking Y1 = f(X1) the single variable input, x, has two
Y2 = f(X1) MPPs, one for each function
dy 1 dy 2
MPP (y1) = dx 1
and MPP (y2) = dx1
MPPy 1 dy 1 dx1 dy 1
The MRT of output y1 into output y2 is MRT12 that is equal to MPPy 2
= dx 1
∗ dy 2 = dy 2

The MRT equals the ratio of MPP s for a given resource between the two enterprises.

P (y2)
MRT12 =
P (y1)

MPPy 1 P (y2)
Therefore at the optimum point, MPPy 2
= P (y1)

= MPP (y1)*P(y1) = MPP(y2) *P(y2)

MVP (y1 )= MVP (y2)

When the above mathematical applications are summarized, the optimum choice
of enterprise occurs when the Marginal Value Product (MVP) per unit of a
variable resource is equal in both enterprises.
This is called the principle of Equal-Marginal Returns.
It says that a variable input should be transformed from one enterprise to another
up to the point where the MVP of each unit of the input is equal for both
enterprises.
The two concepts mostly associated with the economic choice of enterprises are
Opportunity cost and Comparative advantage
A. Opportunity Cost: Opportunity cost of any resource may be defined as the maximum income
that the resource could have obtained in an alternative use. For example, if farmland could earn
more by turning into a holiday resort then the opportunity cost of continuing to use it in farming is
the income, which could have been obtained by leasing it to a hotel resort.
B. Comparative Advantage: It refers to the physical resources best suited to the production of
different crops/livestock which exist in different locations e.g. at the level of a single farm which
has land of difference qualities, it makes sense to grow alternative crops on the land economically
best suited to each crop.
Both on-farm and off-farm sector comparative advantage may change over time due to:
a)Change in technology (new variety, equipment, etc.)
b)Land improvement (drainage, irrigation, etc.)
c)Change in relative input costs or output prices in different location
d)Changes in transport cost (opening of new roads)
e)Development of substitute outputs (synthetic fibers)
•.

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