Introduction To Production and Resource Use

Introduction to
Production and
Resource Use
Chapter 6
Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,
Penson, Capps, Rosson, and Woodward Upper Saddle River, NJ 07458. • All Rights Reserved.
Topics of Discussion
Conditions of perfect competition
Classification of productive inputs
Important production relationships
(Assume one variable input in this chapter)
Assessing short run business costs
Economics of short run production
decisions

2 Penson, Capps, Rosson, and Woodward Upper Saddle River, NJ 07458. • All Rights Reserved.
Conditions for Perfect Competition
Homogeneous products
 i.e., Corn grain, mined low-sulfur coal
No barriers to entry or exit

 No regulatory barriers
 No extremely high fixed costs
Large number of sellers

 How large is large?
Perfect information
Information cost is relatively small
3 No one firm has access to information that
Introduction to Agricultural Economics, 5th ed
Penson, Capps, Rosson, and Woodward Page 86
© 2010 Pearson Higher Education,
Upper Saddle River, NJ 07458. • All Rights Reserved.
Classification of Inputs
Economists view the production process
as one where a variety of inputs are
combined to produce a single or multiple
outputs
 Cheese plant example
 Many inputs: Labor, stainless steel cheese vats,
raw milk, energy, starter cultures, cutting and
wrapping tables, water, etc.
 Multiple outputs: Cheese, dry whey, whey
protein concentrates are produced by the plant
4
Penson, Capps, Rosson, and Woodward Pages 86-87
Land: includes renewable (forests) and
non-renewable (minerals) resources
Labor: all owner and hired labor
services, excluding management
Capital: Manufactured goods such as
fuel, chemicals, tractors and buildings
that may have an extended lifetime
Management: Makes production
decisions designed to achieve specific
economic goals
5
Penson, Capps, Rosson, and Woodward Pages 86-87
Inputs can also be classified depending
on whether amount of input used changes
with production level
 Fixed inputs: The amount of input used
does not change with output level
 Up to a point the size of milking parlor does not
change with ↑ milk production/cow or for initial
↑ in herd size
 Variable Inputs: The amount of input used
changes directly with the level of output
 Usually the amount of labor supplied is a
variable input (i.e., car assembly plant that ↑ the
speed of assembly line to ↑ production/hour
Pages 86-87
Production Function
“given the level of”
Output = f(labor | capital, land,

and management)
Start with
one variable Assume remaining inputs
input fixed at current levels
f(•) is general functional notation

 Could be any functional form
7
Penson, Capps, Rosson, and Woodward Page 88
Production Function
Point Labor (hr) Output We can graph the
A 10 1.0 relationship between
B 16 3.0 output and amount of
C 20 4.8 labor used
D 22 6.5  Known as the Total
Physical Product (TPP)
E 26 8.1
curve
F 32 9.6  Purely a physical
G 40 10.8 relationship, no
H 50 11.6 economics involved
I 62 12.0  X lbs of fertilizer/acre
J 76 11.7 generates a yield of Y
Page 89
Total Physical Product (TPP) Curve
Maximum Output
Decreasing output
Data from previous table
Variable input
Page 89
Other Physical Relationships
The following derivations of the TPP curve
play an important role in decision-making
 Marginal Physical Product (MPP) =
 Average Physical Product (APP) =
Page 90
Production Function
MPP MPP = Change
Labor Output ∆Labor ∆Output in output as you
Point [5] = [4]
[1] [2] [3] [4] change input use
÷ [3]
A 10 1.0 ----- ----- -----
B 16 3.0 6 2 0.33
C 20 4.8 4 1.8 0.45 ↑MPP
D 22 6.5 2 1.7 0.85
E 26 8.1 4 1.6 0.40
F 32 9.6 6 1.5 0.25
G 40 10.8 8 1.2 0.15 ↓MPP
H 50 11.6 10 0.8 0.08
I 62 12.0 12 0.4 0.02
J 76 11.7 14 -0.3 -0.02
Page 89
Introduction to Agricultural Economics, 5 ed
th © 2010 Pearson Higher Education,
4.8
 MPP = 1.8/4.0 = .45
Output Output ↑ from 3.0 to 4.8
units = 1.8
3 Labor ↑ from 16 to 20
units = 4.0
Input
Page 89
Law of Diminishing
Marginal Returns
Pertains to what happens to the MPP with
increased use of a single variable input
If there are other inputs their level of use is not
changed
Diminishing Marginal Returns

The MPP ↑ with initial use of a variable input
At some point, MPP reaches a maximum with
greater input use
Eventually MPP ↓ as input use continues to ↑
Page 93
Production Function
MPP
Labor Output ∆Labor ∆Output
Point [5] = [4] ∆MPP
[1] [2] [3] [4]
÷ [3]
A 10 1.0 ----- ----- -----

B 16 3.0 6 2 0.33
C 20 4.8 4 1.8 0.45
D 22 6.5 2 1.7 0.85
E 26 8.1 4 1.6 0.40
F 32 9.6 6 1.5 0.25
G 40 10.8 8 1.2 0.15
H 50 11.6 10 0.8 0.08
I 62 12.0 12 0.4 0.02
J 76
th 11.7 14 0.3 -0.02 © 2010 Pearson Higher Education,
Plotting the MPP Curve
Change from A to B on
the production function Change in output
→ a MPP of 0.33 associated with a
change in inputs
15
Penson, Capps, Rosson, and Woodward
Page 91
Q of MPP = Slope of the line

Output
tangent at a point
A
(A) on the
∆Q* TPP curve
= ∆Q*/∆I*
Q of
0 Input
∆I*
Page 91
Q of
Output At A, MPP = ∆Q/∆I
A
= 0/∆I* = 0
TPP is at a maximum
when MPP = 0
Q of
0 Input
∆I*
Page 91
Production Function
APP
Labor Output ∆Labor ∆Output
Point [6] = [2] ÷
[1] [2] [3] [4]
[1]
Average Physical
A 10 1.0 ----- ----- 0.10 ----- Product (APP) =
B 16 3.0 6 2 0.19 Amount of
output ÷ amount
C 20 4.8 4 1.8 0.24 of inputs used
D 22 6.5 2 1.7 0.30 = Output/unit of
input used
E 26 8.1 4 1.6 0.31
F 32 9.6 6 1.5 0.30
G 40 10.8 8 1.2 0.27
H 50 11.6 10 0.8 0.23
I 62 12.0 12 0.4 0.19
J 76 11.7 14 0.3 0.15
Page 89
Output
APP = .31 (= 8÷26)

with labor use = 26
Input
Page 89
Plotting the APP Curve
Output divided APP = output level

by labor use at divided by level of
B (3 ÷ 16) =0.19 input use
Page 91
Plotting the APP Curve
Q of
Output
B APP = Q*/I*
= Slope of the line from
the origin to the point
on the TPP curve
A At I**, APP is at a maximum,
as line OB is just tangent
Q* to the TPP curve
0 Q of
I* Input
I**
Page 91
Relationship Between APP and MPP
Q of
Output APP is at a maximum at
MPP input level where APP = MPP
APP*
APP
Q of
0 Input
I*
Page 91
Definition of the Three Stages of Production
Stage I: MPP > APP

APP is ↑
APP is increasing in Stage I

Page 91
Stage II: MPP < APP

MPP > 0
Page 91
Stage III: MPP < 0
Page 91
The Three Stages of Production
Q of
Output
MPP
APP
Stage III
Q of
0 Input
Stage I Stage II
 Stage II starts at input use where APP is
at a maximum (pt A)
 Stage II ends at input where MPP = 0 (or
TPP is atEconomics,
a maximum)
Page 91
Introduction to Agricultural 5 ed
Why are using the amount of input in
Q of Stage I and Stage III of production
Output irrational from the producer’s
perspective?
MPP
APP
Stage III
Q of
0 Input
Stage I Stage II
Page 91
Q of
Can increase output by using
Output
less inputs: →More output and
less cost
MPP
APP
Stage III
Q of
0 Input
Stage I Stage II
Average productivity is increasing as more

inputs are being used so why stop if the
average return is greater than cost?
Page 91
Q of
Output
MPP
APP
Stage III
Q of
0 Input
Stage I Stage II
The producer’s economic question:

What level of input amount contained in
IntroductionStage IIEconomics,
should 5 ed the I use to maximize profits?
Page 91
to Agricultural th © 2010 Pearson Higher Education,
Economic Dimension
To answer the above question
We need to account for the price of the
product being produced
We also need to account for the cost of
the inputs used to produce the above
product

Key Cost Relationships
 The following cost concepts play key
roles in determining where in Stage II a
producer will want to produce
 Total Variable Cost (TVC) = the total value
of costs that change with the level of output
(e.g. energy costs, labor costs, material
costs, etc.)
 Total Fixed Cost (TFC) = total value of costs
that do not changed with the level of output
(e.g. property taxes)
 Total Costs (TC) = the sum of total variable
and fixed costs
 TC = TVC + TFC
Page 94-96
 The following cost concepts play key roles in
determining where in Stage II a producer
will want to produce
 Marginal Cost (MC) =  total cost of
production ÷  output produced as output level
changes
=  variable cost of production ÷  output
produced given that total fixed costs by
definition do not change with output =
∆TC/∆Q = ∆TVC/∆Q
 Average Variable Cost (AVC) = total variable
cost of production ÷ total amount of output
produced = TVC/Q
Page 94-96
 The following cost concepts play key roles
in determining where in Stage II a
producer will want to produce
 Average Fixed Cost (AFC) = total fixed
cost of production ÷ total amount of
output produced = TFC/Q
 Average Total Cost (ATC) = total cost of
production ÷ total amount of output
produced = TC/Q = AVC + ATC
Page 94-96
From TPP
curve on
page 113
Page 94
Fixed costs are
$100 no matter
the level of
production
Page 94
Total fixed costs (Col. 2)
÷ by total output (Col. 1)
Page 94
Costs that vary
with level of
production
37 Penson, Capps, Rosson, and Woodward Page 94
Total variable
cost (Col. 4) ÷
by total output
(Col. 1)
Total Fixed
Cost (Col. 2) +
Total Variable
Cost (Col.4)
Page 94
Change in Total Cost
(Col. 4 or 6) associated
with a change in output
(Col. 1)
[Total Cost (Col. 6) ÷ by Total
Output (Col. (1)] or [Avg. Variable
Cost + Avg. Fixed Cost]
Page 94
Let’s Graph the Above
Cost Items Contained
in the Previous Table

Table 6.3 Cost Relationships
70
MC = min(ATC) and
MC ATC min(AVC)
60
AVC AFC Vertical distance between
ATC and AVC = AFC
50
40
Cost ($)
30
20
AFC
10
0
3.0 4.8 6.5 8.1 9.6 10.8 11.6
Input Use
Introduction to Agricultural Economics, 5th ed Page 95
Key Revenue Concepts
 The following revenue concepts play key roles in
determining where in Stage II a producer will
want to produce
Total Revenue (TR) =Multiplication of total
amount of output produced by the sale price ($)
Average Revenue (AR) = Total revenue ÷ total
amount of output produced ($/unit of output) =
TR/Q
Marginal Revenue (MR) = ∆ total revenue ÷ ∆
total amount of output produced = ∆TR ÷ ∆Q
 How much revenue is generated by one additional
unit of output?
 Under
Introduction to Agricultural perfect
Economics,
th
5 ed competition, it is the per unit© 2010
price
Pearson Higher Education,
Now let’s assume this
firm can sell its
product for $45/unit

Key Revenue Concepts
Remember we are assuming perfect competition

 The firm takes price as given
 Price (Col. 2) = MR (Col. 7)
46  What
Introduction
is the AR value?
to Agricultural Economics, 5 ed
th

Page 98
Profit Maximization
With perfect competition, where would the

firm maximize profit in the above example?
Let’s see this in
graphical form

Profit Maximization
70
Profit maximizing
MC ATC
60 Output where MR=MC
AVC MR
P=MR=AR
50
$45
40
30
20
10
11.2
0
49 1Introduction 3and Woodward 4.8
to Agricultural Economics, 5 ed
Penson, Capps, Rosson,
th
6.5 8.1 9.6 Page 9911.6
10.8
Profit Maximization
The previous graph indicated that

Profit is maximized at 11.2 units of output
MR ($45) equals MC ($45) at 11.2 units of output
Profit maximizing output occurs between points G and H
50
Introduction
At 11.2 units
to Agricultural of output
Economics,
th

5 ed profit would be $190.40. Let’s do © 2010the
Pearsonmath….
Higher Education,
Profit at Price of $45?
$
MC
Revenue = $45  11.2 = $504.00
P =45
ATC
Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
28
Since P = MR = AR
AVC
Average profit = $45 – $28 = $17
Profit = $17  11.2 = $190.40
11.2 Q

$
Revenue = $45  11.2 = $504.00

MC
P =45 Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
$190.40 ATC
Since P = MR = AR
28
AVC Average profit = $45 – $28 = $17
Profit = $17  11.2 = $190.40
11.2 Q

P=MR=AR
Zero economic profit if price

falls to PBE
Firm would only produce output
OBE where AR (MR) ≥ ATC Page 99
Revenue = $28  10.3 = $288.40
Total cost = $28  10.3 = $288.40
$ Profit = $288.40 – $288.40 = $0
MC
45
Since P = MR = AR
ATC
Average profit = $28 – $28 = $0
P=28 Profit = $0  10.3 = $0 (break even)
AVC
10.3 11.2 Q

P=MR=AR
Firm can just cover

variable cost if price
falls to PSD.
Firm would shut down
if price falls below PSD Page 99
Revenue = $18  8.6 = $154.80
$ Total cost = $28  8.6 = $240.80
MC Profit = $154.80 – $240.80 = –$86
45
Since P = MR = AR
ATC
Average profit = $18 – $28 = –$10
28
Profit = –$10  8.6 = –$86 (Loss)
AVC
P=18
8.6 10.3 11.2 Q

Revenue = $10  7.0 = $70.00
$
Total cost = $30  7.0 = $210.00
Profit = $70.00 – $210.00 = – $140.00
MC
45
Since P = MR = AR
30 ATC Average profit = $10 – $30 = –$20
28 Profit = –$20  7.0 = –$140
AVC
19
Average variable cost = $19
P=10 Variable costs = $19  7.0 = $133.00
Revenue – variable costs = –$63
7.0 8.6 10.3 11.2 Q Not covering variable costs!!!!!!

The Firm’s Supply Curve
Profit Maximizing Output Levels
$
MC
45
ATC
AVC
28
18
10
Q
7.0 8.6 10.3 11.2

We know that so long as P (= MR) > AVC
some of the fixed costs can be covered
Better economic position then shutting down
altogether, WHY?
We know that when P (= MR)=MC, the
firm maximizes profit
Portion of MC curve defined by output
level that generates the minimum AVC is
referred to as the firm’s supply curve

Page 99
$
MC Firm Supply Curve
45
ATC
AVC
28
18
Q
8.6 10.3 11.2

Now let’s look at the
demand for a single
input: Labor

Key Input Relationships
The following input-related derivations play
key roles in determining amount of variable
input to use to maximize profits
Marginal Value Product (MVP) =
MPP × Product Price
 MPP → ∆Output ÷ ∆Input Use
 Product Price → ∆Revenue ÷ ∆Output
 MVP → ∆Revenue ÷ ∆Input Use
(Additional output value generated by
the last increment in input use)
Marginal Input Cost (MIC) = wage rate,
rental rate, seed cost, etc.
Page 100 © 2010 Pearson Higher Education,
D
MVP=MPP x Output Price
Wage rate is
B
C
E
labor’s MIC
F
5 G
H I
J

 Profit maximizing input use rule
 Use a variable input up to the
point where
 Value received from another
D
unit of input (MVP)
 Equals cost of another unit of
input (MIC)
 → MVP=MIC
C
B E
F
G
5
I
H
J

D
The area below the green lined
MVP curve and above the red
lined MIC curve represents
cumulative net benefit
C
B E
F
G
5
I
H
J

MVP = MPP × $45 Page 100
Profit are maximized where MVP = MIC Page 100
Introduction to or where
Agricultural Economics,MVP
th
5 ed =$5 and MIC = $5 © 2010 Pearson Higher Education,
– =
Marginal net benefit (Col. 5) = MVP (Col. 3) – labor

MIC (Col. 4) = Value of additional output from last
Page 100
68 unit of input net of the cost of that input
th

The cumulative net benefit (Col. 6) of input use
= the sum of successive marginal net benefits (Col. 5)
= Introduction
the grey area
to Agricultural in 5previous
Economics,
th
ed graph. Page
© 2010 Pearson Higher100
Education,
For example…
$25.10 = $9.85 + $15.25
$58.35 =Agricultural
Introduction to $25.10 + 5$33.25
Economics, ed
th
Page 100
– =
Cumulative net benefit is maximized Page 100

71 where MVP=MIC at $5
If you stopped at point E on the MVP curve,
for example, you would be foregoing all of the
potential profit lying to the right of that point
D
up to where MVP=MIC.
B E
F
G
5
I
H
J

D
If you use labor beyond the
point where MVP =MIC, you
begin incurring losses as the
return to another unit of
labor is < $5.00, its per unit
C
cost
B E
F
G
5
I
H

A Final Thought
One final relationship needs to be made. The level
of profit-maximizing output (OMAX) in the graph on
page 99 where MR = MC corresponds directly with
the variable input level (LMAX) in the graph on page
101 where MVP = MIC.
Going back to the production function on page 88,

this means that:
OMAX = f(LMAX | capital, land and management)

In Summary…
Features of perfect competition
Factors of production (Land, Labor,
Capital and Management)
Key decision rule: Profit maximized at
output MR=MC
Key decision rule: Profit maximized
where MVP=MIC

Chapter 7 focuses on the choice
of inputs to use and products to
produce….


Introduction To Production and Resource Use

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Introduction To Production and Resource Use

Uploaded by

Copyright:

Available Formats

Introduction to

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

No barriers to entry or exit

Large number of sellers

Output = f(labor | capital, land,

f(•) is general functional notation

Data from previous table

 Marginal Physical Product (MPP) =

 Average Physical Product (APP) =

Diminishing Marginal Returns

A 10 1.0 ----- ----- -----

Data from previous table

Q of MPP = Slope of the line

Data from previous table

APP = .31 (= 8÷26)

Output divided APP = output level

Data from previous table

Stage I: MPP > APP

APP is increasing in Stage I

Stage II: MPP < APP

Stage III: MPP < 0

Average productivity is increasing as more

The producer’s economic question:

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Remember we are assuming perfect competition

Penson, Capps, Rosson, and Woodward

With perfect competition, where would the

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

The previous graph indicated that

Penson, Capps, Rosson, and Woodward

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Revenue = $45  11.2 = $504.00

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Zero economic profit if price

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Firm can just cover

8.6 10.3 11.2 Q

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed Page 101

Introduction to Agricultural Economics, 5th ed Page 101

Marginal net benefit (Col. 5) = MVP (Col. 3) – labor

Penson, Capps, Rosson, and Woodward

Cumulative net benefit is maximized Page 100

Introduction to Agricultural Economics, 5th ed Page 101

Introduction to Agricultural Economics, 5th ed Page 101

Going back to the production function on page 88,

OMAX = f(LMAX | capital, land and management)

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

Introduction to Agricultural Economics, 5th ed © 2010 Pearson Higher Education,

You might also like