KENYATTA UNIVERSITY

SCHOOL OF AGRICULTURE AND ENTERPRISE DEVELOPMENT

DEPARTMENT OF AGRIBUSINESS MANAGEMENT AND TRADE
COURSE OUTLINE FOR KBT 203: AGRICULTURAL PRODUCTION ECONOMICS
(Second Year, Second Semester 2013/14)

LECTURER: Name: Patrick Mugo

Email: [email protected]
Consulting Hours: Working hours
Telephone: 0723525319

COURSE GOALS/OBJECTIVES
1. Develop a better understanding of applied microeconomic theory of the firm
2. Improve understanding and use of simple algebra and graphical analytical skills to applied economic
theory in agricultural production
3. To understand the various agricultural production interrelationships
4. Enhance the importance of agricultural production in the economy

RECOMMENDED REFERENCES
1) Heady, Earl O, 1964, Economics of Agricultural Production and Resource Use:, Prentice Hall of India,
Private Limited, New Delhi
2) Debertin, D.L. 2002. Agricultural Production Economics Second Edition.
3) Samuelson, Paul A. Foundations of Economic Analysis. New York: Atheneum, 1970 (Originally
published in 1947).
4) Smith, Adam. 1937. The Wealth of Nations, Edwin Cannan ed. New York: The Modern Library, 1937
(Originally written in 1776).
5) Jhingan, M.L (2006). Microeconomic Theory. Vrinda Publications Ltd. Delhi.
6) Colman, D and Trevor, Y. 1989. Principles of Agricultural Economics: Markets and Prices in Less
developed Countries. Cambridge University Press.

TEACHING METHODOLOGIES AND EQUIPMENT

 Teaching methodologies will be lectures, class exercises and group assignments.
 Students are required to have calculators and necessary stationery.

EXAMINATIONS
 All students will be required to attend scheduled lectures and sit all CATs as well as Final Examination
 The University examination regulations will apply.
 All Students will be expected to take written examinations in this unit.
 The Final examination will constitute 70% of the total marks while the course work assessment tests
(CATS) will constitute 30%.

TENTATIVE OUTLINE OF WEEKLY CLASS SCHEDULE

Week 1: Nature and Characteristics of Agricultural Production

 The Field of Agriculture
 Agricultural Production
 Agricultural Economics defined
Week 2&3: Production Theory
 Production and Production Function
 Production in Short run
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  Production in Long run
Week 4: Principles and Concepts in Production Analysis
 Law of Diminishing Marginal Returns
 Equi-marginal Principle, Physical product and Elasticity of Production
 Value Product and Factor Costs
Week 5: Analysis of Production Function and CAT I
 Factor-Product relationships
 Factor-Factor relationships
 Product-Product relationships
Week 6: Relationships among Inputs and Products
 Relationship among Inputs
 Relationship among Products
Week 7: Theory of Cost
 Cost Function
 Types of Costs
 Short run Total and Per Unit Cost Schedules
 Long run Cost Input Relationships
 Break even Analysis
 Economic Optimization
Week 8: Theory of Revenue
 Revenue
 Profit Analysis
Week 9: Risk and uncertainty in Agriculture
 The Farm Environment
 Sources of Risk and Uncertainty
 Risk Aversion
 Methods of Reducing Risk and Uncertainty
Week 10: Revision and CAT II.

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 LECTURE 1: NATURE AND CHARACTERISTICS OF AGRICULTURAL PRODUCTION

THE FIELD OF AGRICULTURE

Agriculture is a word derived from two Latin words "ager" and "cultura" meaning "field cultivation”. But
the meaning has been expanded with time, thus agriculture is "the art and science of cultivation of crops and
rearing of animals for man's use. Agriculture is both a field of study (applied science) and a practice and the
process is incomplete until the crop or animal so-produced gets to the hands of the ultimate consumer.
Agriculture as an Art
As an art or practice, agriculture can be broadly classified into:
1. Crop Production - This encompasses all activities relating to land preparation; planting; fertilizer
application; weeding, pests and diseases control or prevention and harvesting of crops.
2. Animal Production - This involves all activities relating to construction of animal houses, feeding,
watering, disease and pest control, and harvesting. Fishery Production which involves pond
construction, feeding, disease and pest control harvesting etc.
3. Marketing - Relates to all activities that transpire from the point of initial production to the ultimate
consumer. This include processing, that is, changing the form of the produce to a more acceptable form
to the consumer; transportation, packaging, buying and selling, etc.
4. Financing - Involves sourcing funds for the production of both crops and animals either through
personal savings, friends or relatives, co-operatives, Banks, etc.
5. Support Services - like engineers making machines that make work easier and more efficient, scientists
producing improved technologies, extension agents and government making inputs needed available to
the farmer as at when needed, etc.
Agriculture as a Science
As a field of study, agricultural science can be broadly: Crop Science, Plant Science or Agronomy: This
study area involves breeding of new seed varieties, developing better technology relating to cultural or
agronomic practices, adaptation of new crops to other areas other than their area of origin; developing varieties
resistant to pests, diseases, weeds and drought; developing small scale irrigation technologies compatible with
the farming systems of the farmers etc. Areas of specialization include: Irrigation Agronomy, Weed Science,
Genetics, Crop breeding, etc.

AGRICULTURAL PRODUCTION
Agriculture is a basic industry supplying the primary needs of man, hence is of special significant and no
nation can afford to neglect it, if required agriculture needs even to be protected.
Agricultural production is characterized by a high degree of uncertainty, being a biological activity it is
subject to the vagaries of nature. A large number of physical factors like soil, temperature, precipitation,
evaporation, latitude, altitude and accessibility serve as limiting factors in man‟s effort to improve agriculture.
In addition to these are the risks of innumerable crop pests and diseases. However, technological progress has
placed more and more power in the hands of man to overcome some of these limitations.
The limited area of land poses a restriction on efforts to expand agricultural production, unlike
manufacturing industries. In the majority of manufacturing and industrial undertakings fresh injection of capital
leads to increased returns. In agriculture however, the application of the law of diminishing returns is more
pronounced than in any industry.
Other industries can adjust their production at short notice in response to the changing pattern of demand.
This is not possible in agriculture once a crop is planted; the plant is in no position to alter the course of
production. A favourable prevailing price may attract the farmer to devote more resources to particular
enterprises but when prices deteriorate, the farmer cannot alter the course of production until the following
season. Due to agriculture‟s inability to make quick adjustments n supplies as a response to changes in market
demand, agriculture faces greater price risks.
Agriculture is a seasonal activity with production being realized at specific periods during the year. The
turnover is therefore low. This also creates problems of transport, marketing and credit, etc during peak periods.
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 In addition, farm products are bulky and perishable. This creates a need for storage, processing and
refrigeration. To overcome the perishability of some of these products, processing is necessary. The bulkiness
of some agricultural products, like fruit and vegetables, which contain high moisture content, causes these
products to have a low value per unit weight.
Due to the seasonal nature of production, production resources are at certain times stretched to the limit
while at other times the resources are unemployed.
Farmers produce largely identical products which compete against one another in the market.
The demand for agricultural produce like cereals and milk is more common or less inelastic.
There are however, other produces like fruits, vegetables, sugar, and, meat which may have a high elasticity
of demand in ill fed and underdeveloped areas. But as compared with industrial products, the demand for most
products is less elastic.
Agricultural products are generally joint products. Straw and wheat, sawdust with timber, beef and hides.
Efforts are being made to put these by-products to economic use. Organizing producers, even on regional basis
is difficult because production is in small and scattered units measured in terms of capital and income.
Economies of large scale production and division of labour are not practicable in agriculture to the same extent
as in industries.

AGRICULTURAL PRODUCTION ECONOMICS

Agricultural production economics is a field of specialization within the subject of agricultural economics. It
is concerned with the choice of production patterns and resource use in order to maximize the objective function
of farmers, their families, the society or the nation within a framework of limited resources. Production
economics is concerned with two broad categories of decisions in the production process.
1) How to organize resources in order to maximize the production of a single commodity? i.e., Choice
making among various alternative ways of using resources.
2) What combination of different commodities to produce?

Goals of Production Economics

1) To provide guidance to individual farmers in using their resources most efficiently.
2) To facilitate the most efficient use of resources from the stand point of economy

Definition: Agricultural Production Economics is an applied field of science wherein the principles of choice
are applied to the use of capital, labour, land and management resources in the farming industry.

Subject matter of Agricultural Production Economics

With a view to optimizing the use of farm resources on an individual farm level and to rationalize the use of
resources from a national angle, production economics involves analysis of relationships and principles of
rational decisions. Production Economics is concerned with productivity i.e. use and incomes from productive
inputs (land, labour, capital and management). As a study of resource productivity, it deals with
a. Resource use efficiency
b. Resource combination
c. Resource allocation
d. Resource management
e. Resource administration
The subject matter of Production Economics includes such topics as methods or techniques of production,
combination of enterprises, size of the farm, return to scale, leasing, production possibilities, farming efficiency,
soil conservation, use of credit and capital, risks and uncertainty which effect decision making.
Any agricultural problem that falls under the scope of resource allocation and marginal productivity analysis
is the subject matter of the production economics. The production economist is therefore, concerned with any
phenomena which have a bearing on economic efficiency in the use of agricultural resources.

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Objectives of Agricultural Production Economics
The main objectives of Agricultural production economics are:
1) To determine and define the conditions which provide for optimum use of resources.
2) To determine the extent to which the existing use of resources deviates from the optimum use.
3) To analyze the factors or forces which are responsible for the existing production pattern and resource
use and
4) To explain means and methods for changing existing use of resources to the optimum level.
Some major concerns in agricultural production economics include the following.

1. Goals and objectives of the farm manager

Agricultural economists often assume that the objective of any farm manager is that of maximizing
profits, a measurement of which is the difference between returns from the sale of crops and livestock less
the costs of producing these commodities. However, individual farmers have unique goals. One farmer
might be more interested in obtaining ownership of the largest farm in the county. Another might have as
his or her goal that of owning the best set of farm machinery. Still another might be interested in minimizing
his or her debt load.
The goals and objectives of a farm manager are closely intertwined with a person's psychological makeup,
and the goals selected by a particular person may have very little to do with profit maximization.
Nonetheless, most economic models used for representing the behavior of farm managers assume that the
manager is interested in maximizing profits, or at minimum is interested in maximizing revenue subject to
constraints imposed by the availability of resources.

2. Choice of outputs to be produced

A farm manager faces an array of options with regard to what to produce given available land, labor,
machinery, and equipment. The manager must not only decide how much of each particular commodity to
be produced, but also how available resources are to be allocated among alternative commodities. The
farmer might be interested in maximizing profits but may have other goals as well. Often other constraints
enter. For example, the government may permit the farmer to grow only a certain number of acres of a
particular commodity. The farmer may have a particular knowledge of, or preference for, a certain
commodity. The farmland may be better suited for certain types of crops or livestock than for other types.

3. Allocation of resources among outputs

Once decisions have been made with regard to what commodity or commodities are to be produced, the
farmer must decide how his or her available resources are to be allocated among outputs. A simple question
to be answered is which field is to be used for the production of each crop, but the questions quickly become
far more complex. The amount of farm labor and machinery on each farm is limited. Labor and machinery
time must be allocated to each crop and livestock activity, consistent with the farmer's overall objective. The
greatest share of this text is devoted to dealing with issues underlying the problems faced by farm managers
in the allocation of resources or inputs across alternative outputs or enterprises.

4. Assumption of risk and uncertainty

Models in production economics frequently assume that the manager knows with certainty the
applicable production function (for example, the yield that would result for a crop if a particular amount of
fertilizer were applied) and the prices both for inputs to be purchased and outputs to be sold. However, in
agriculture, the assumption of knowledge with respect to the production function is almost never met.
Weather is, of course, the key variable, but nature presents other challenges. Cattle develop diseases and die,
and crops are affected by insects and disease. Most farmers would scoff at economic theory that assumes
that a production function is known with certainty.
Although farmers may be fully aware of the prices they must pay for inputs such as fuel, fertilizer, and
seed at the time each input is purchased, they are almost never aware at the beginning of the production
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 season of prices that will prevail when outputs are sold. Price uncertainty is a result of the biological lag
facing the producer of nearly any agricultural commodity, and production in agriculture takes time.
Economists have often made a simplifying assumption that production takes place instantaneously that
inputs are, upon acquisition, immediately and magically transformed into outputs. The transformation does
not instantaneously take place in agricultural production. Production of most crops takes several months.
The time may be measured in years from when a calf is conceived to when the fattened steer is placed on
the market. Hence farmers must make production decisions with less than perfect knowledge with regard to
the price at which the product will sell when it is actually placed on the market.

5. The competitive economic environment in which the farm firm operates

Economists often cite farming as the closest real World example of the traditional model of pure
competition. But the competitive environment under which a farmer operates depends heavily on the
particular commodity being produced.

THE ASSUMPTIONS OF PURE COMPETITION

Economists often use the theory of pure competition as a basic model for explaining the behavior of firms in
an industry. At this point, it is useful to review the assumptions of the classical economic model of pure
competition and assess the degree to which these assumptions might apply to farming in the Kenya. The model
of pure competition assumes the following.

a) A large number of buyers and sellers in the industry exist.

Few would feel that there are not a large number of sellers in farming. Provision figures indicates that there
are about 5 million farms in Kenya, but, but farm numbers are far fewer for selected agricultural commodities.
Only a few farms supply the entire nation's wheat needs, for example.
The assumption of a large number of buyers may be met to a degree at a local livestock auction market or at
a Wakulima market in Nairobi, but many agricultural products move in markets in which only a comparatively
few buyers exist. The tobacco producer may face only buyers from the two or three major cigarette
manufacturers, and prices are determined in an environment that is not very competitive. In the livestock sector,
Pig and broiler production has been dominated in recent years by only a few major producers. Production of
Beef in Kenya is often closer to a purely competitive environment in which a large number of farm firms take
prices generated by overall supply and demand for Beef cattle. However, there are a relatively small number of
buyers for beef cattle, which again means that the model of pure competition does not strictly apply.

b) The firm can sell as much as it wants at the going market price, and no single firm is large enough to
influence the price for the commodity being produced
For many agricultural commodities, the farmer can sell as much as he or she wants at the market price.
Farmers are price takers, not price setters, in the production of commodities such as wheat, maize, beef, and
pork. However, for certain commodities, the sparcity of farms means that the producers might exert a degree of
control over the price obtained.

c) The product is homogeneous

The homogeneity assumption implies that the product produced by all firms in the industry is identical. As a
result, there is no need for advertising, for there is nothing to distinguish the output of one firm from another.
For the most part, this assumption is true in farming. There is little to distinguish one producer's number 2
maize; from another's number 2 maize. For a few commodities, there have been some attempts at product
differentiation! for example, branded chicken by the individual broiler producer.

d) There is free entry and exit, and thus free mobility of resources (inputs or factors of production) exists
both in and out of farming

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 The free-mobility assumption is currently seldom met in agriculture. At one time it may have been possible
for a farmer to begin with very little money and a lot of ambition. Nowadays, a normal farm may very well be a
business with a million shillings investment. It is difficult to see how free entry and exit can exist in an industry
that may require an individual firm to have a million shillings in startup capital. Inflation over the past decade
has drastically increased the startup capital requirements for farming, with resultant impacts on the mobility of
resources.
Free mobility of resources in linked to an absence of artificial restraints, such as government involvement.
There exist a number of artificial restraints in farming. The government has been and continues to be involved
in influencing production decisions with respect to nearly every major agricultural commodity and numerous
minor commodities as well. Agricultural cooperatives have had a significant impact on production levels for
commodities such as milk and coffee.
Grain production in the Kenya is often heavily influenced by the presence of government programs. The
maize and wheat programs are major examples. Though liberalized the prices for the maize subsector are
occasionally regulated by the government. In milk production, the government has largely determined the prices
to be received by dairy farmers before liberalization.

e) All variables of concern to the producer and the consumer are known with certainty
Some economists distinguish between pure competition and perfect competition. These economists argue
that pure competition can exist even if all variables are not known with certainty to the producer and consumer.
However, perfect competition will exist only if the producer knows not only the prices for which outputs will be
sold, but also the prices for inputs. Moreover, with perfect competition, the consumer has complete knowledge
with respect to prices.
Most important, with perfect competition the producer is assumed to have complete knowledge of the
production process or function that transforms inputs or resources into outputs or commodities. Nature is
assumed not to vary from year to year. Of course, this assumption is violated in agriculture. The vagaries of
nature enter into nearly everything a farmer does, and influence not only output levels, but the quantity of inputs
used as well.

Why Retain the Purely Competitive Model?

As has been indicated, the assumptions of the purely competitive model are not very closely met by farming
in Kenya. The next logical question is: Why retain it? The answer to this question is simple. Despite its
weaknesses, the purely competitive model comes closer to representing farming than any other comprehensive
model of economic behavior. An individual farm is clearly not a monopoly if a monopoly is thought of as being
a model in which a single firm is the industry. Nor, for most commodities, do farmers constitute an oligopoly, if
an oligopoly is defined as a model in which only a few firms exist in a competitive environment where price
and output decisions by one firm a strongly affected by the price and output decisions of other firms. Nor does
farming usually meet the basic assumption of monopolistic competition, where slight differences in product
prices can be maintained over the long term because individual producers are somewhat successful in slightly
differentiating their product from products made by a rival firm.
In summary, the purely competitive model has been retained as the basic model for application within
agricultural production economics to farming because it comes closer than any of the remaining models of
competitive behavior. This does not mean that other models of competitive behavior are unimportant in the
remainder of the lecture. Rather, reliance will be placed on the purely competitive model as the starting point
for much of our analysis, with modifications made as needed to meet the particular features of the problem.

Summary on the basic concepts of economics and principles

Man uses limited resources to meet seemingly endless competing needs. In the process of defining this,
you were told that economics study is concerned with this paradigm and that economics has two main branches
namely microeconomics and macroeconomics. You were also told that while micro deals with the price

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mechanism which operates with the help of the forces of demand and supply. These forces help to determine the
equilibrium price at the household and at the individual firm levels.
Macroeconomics on the other hand, basically concerned with issues such as at the national income, output and
employment which are determined by aggregate demand and supply in the economy.

Several assumptions are made in production economics;

1) Technology is assumed to be constant; the manager selects the most efficient known technology and
does not change it during production period.
2) Production functions are drawn as smooth well behaved curves. Inputs are assumed to be homogenous,
equal in quality, easily divisible and mobile. The same assumptions of homogeneity and perfect
divisibility are also applied to products.
3) Perfect certainty assumption. This removes price and yield uncertainty.
4) Time discounting is excluded. So production for all practical purposes is considered to be instantaneous.
5) The goals of the manager are important. Our assumption is that the manager is motivated by profits and
is rationally seeking to maximize profits.
6) Purely competitive market. Each farmer‟s production is insignificant to the whole; therefore the farmer‟s
entry or exit from the market cannot influence prices of inputs and outputs.

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 LECTURE 2: PRODUCTION THEORY

INTRODUCTION
Production is important because of the fact that all economic activities depend on it. For consumption to
take place, goods and services must be produced. Without production goods and services will not be produced
Production is the process involved in transforming a number of inputs into a product. In terms of
satisfaction derived, production can be termed creation of utility.
Inputs are also called resources or factors of production. However, the use of these terms is not permanent
because what is a product to one person may be an input to another person. For example, a farmer may produce
maize using land, labour, capital (hoes and cutlasses) and his managerial skills as factors of production. On the
other hand, a poultry farmer sees the maize as one of the inputs in producing eggs or chicken as outputs.
A positive relationship exists among these inputs and the output such that the greater availability of any
of these factors will lead to a greater potential for producing output. In addition, all factors are assumed to be
essential for production to take place. The functional relationship f (.) represents a certain level of technology
and know-how that presently exists, for conversion these input such that any technological improvements can
also lead to the production of greater levels of output. Egg production process requires at least two inputs, feeds
and pullets in addition to other fixed input like water, housing etc .in every case, production can only take place
with at least two inputs.

FACTORS OF PRODUCTION
A factor of production can be defined as that good and service which is required for production. A factor
is indispensable for production because without it no production will be possible. The factors can be grouped
broadly into four categories though the line of demarcation between some of them is not very clear.

Natural resources - This includes land, water, climate and soil conditions. These are necessary for agricultural
production and without them agriculture is impossible. Land is obviously the most important natural resources
for agricultural purposes and is often defined economically to include all materials and forces that supplied by
nature for use in the production of goods and services. In other words, land include all the other natural
resources e.g. water, forest, soil, climate, etc.
Labour - Labour can defined as all human efforts made in the process of transforming inputs to output. Labour
is always used in combination with other factors to produce outputs. The labour may be skilled or unskilled,
family, hired or exchange. Labour is measured agriculturally per day, i.e., Man-day. For accounting purposes,
children labour is rated 0.5 unit of adult while woman and old men (over 60 years) are rated 0.75 units of adult.
But this practice may not be totally acceptable in today‟s situation.
Capital - Capital can be called means of production or intermediate Production. It represents resources
produced by past human efforts. Capitals include long-term investment seen as buildings, machinery as well as
equipment, implements such as tractors and their implements.
Seeds, fertilizers, as well as cash (at hand) are all capital. Capital may also include tree crops, breeding stock (of
animals), dairy cattle, and bullocks (used in land preparation) as well as bullock plough. Some capital items
normally loose value with years, the annual loss in momentary term is called depreciation or capital term called
appreciation or capital gain or accumulation.
Management or Entrepreneurship - This is a qualitative input as against others, which are quantitative. It is
the effective harnessing of the other factors of production for maximum profit. Thus it involves planning,
decision making, supervision, evaluation and general co-ordination of all activities on the farm.

PRODUCTION FUNCTION CONCEPT

Production is a process whereby inputs are transformed into outputs. The firm‟s output of products
depends upon the quantities of inputs used in production. This relationship between input and output can be
characterized by a production function. A production function describes the technical relationship that
transforms inputs (resources) into outputs (commodities).
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 A production function provides information concerning the quantity of output that may be expected
when particular inputs are combined in a specified manner. The chemical, physical and biological properties of
inputs determine the kind and amount of outputs which will be received from particular combination of inputs.
There are many possible combinations of inputs and not all production functions are known. It is the job of
research and experimentation to discover the production functions which are chemically, physically and
biologically possible. Once of the production functions have been discovered, they provide very useful
information for making decisions by farmers and other producers. No one controls the production function, but
an individual has to choose between alternative production functions.
One of the simplest production decisions involves questions concerning the effects of varying the
quantity of one input on the amount of output produced.

Let Y represent output

F – is a function of output or depends in
Let X1 – represent an input used in production of Y
Y=f (X1) is the production function i.e. the amount of Y produced depends upon the amount of X1 used.

In order for this function to be useful to decision makers, information, the types of inputs used must be known,
and the particular quantities of it used to produce particular quantities of products. The producer needs to know
the quantitative relation between inputs and outputs.
The production function is the basis for production function analysis, in seeking to answer the following
questions:
 What is efficient production?
 How is the most profitable amount of input determined?
 How will farm production respond to a change in price of output?
 What enterprise combinations will maximize profits?

Production Economics and Decision Making

Production economics is the application of the principles of micro-economics in agriculture. The logic of
production economics provides a framework for decision making on the farm. Based on the theory of the firm,
the study of the principles of production economics should clarify the concepts of costs, output response to
inputs, and the use of resources to maximize profits and/or minimize costs. These principles are extremely
useful to the farm manager seeking profit and efficiency.
A production function can be expressed in different ways:
a) Tabular - Listing inputs and the resulting outputs numerically in a table
b) Graphically
c) As an algebraic equation

Symbolically, a production function can be written

Y = f(X1, X2, X3, X4………., Xn)
Y= output e.g. maize yield
X1…..Xn = inputs used to produce Y
e.g. X1 = Fertilizer, X2= Soil structure, X3 = Plant population, X4 = Labour
Y=f (X1, X2, X3, X4…........., Xn)
The input-output relationships are generally derived using data from biological experiments or from farm
records.
Assumptions:
1. Since production functions are to be used to guide future production, the manager needs to know the
production function for the coming season. Along with this, the farmer needs to know the cost of inputs
and prices of outputs at the end of the production period. This assumption is known as the Perfect
Certainty Assumption.
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 2. Usually, a product can be produced in many different ways. A common 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. The method of production is assumed to be the most efficient level of
technology/state of the art for the duration of production.
3. The production function depicts the output resulting from the production process during a given time
period. Normally, it refers to the production season. Fixed and variable resources are used to classify
the length of the production 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 is varied while others are fixed.
Long run period – time period of such length that all resources are variable.
4. Inputs and outputs are perfectly divisible hence production functions are drawn as smooth curves.
5. Inputs and outputs are homogeneous and of equal market value.
6. Production is considered to be instantaneous, no time discounting is considered.
7. The manager is motivated by profits and is rationally seeking to maximize profits.

Types of Production Functions:

a) Continuous Production Function: This is obtained for those inputs which can be split up into smaller
units. All those inputs which are measurable give raise to continuous production function. Example:
Fertilizers, Seeds, Plant protection chemicals, Manures, Feeds etc
b) Discontinuous or discrete Production Function: Such a function is obtained for resources or work
units which are used or done in whole numbers. In other words, production function is discrete, where
inputs cannot be broken into smaller units. Alternately stated, discrete production is obtained for those
inputs which are counted. Example: Ploughing, Weeding, Irrigation etc.,
c) Short Run Production Function (SRPF): Production Function in which some inputs or resources are
fixed. Y= f (X1 | X2, X3,………….., Xn) e.g.: Law of Diminishing returns or Law of variable
proportions.
d) Long Run Production Function (LRPF): Production function which permits variation in all factors of
production. Y = f ((X1, X2, X3, ……………., Xn) E.g.: Returns to scale.

The production function can be expressed in three ways:

Tabular form: Production function can be expressed in the form of a table, where one column represents input,
while another indicates the corresponding total output of the product. The two columns constitute production
function.

Input (x) Output (y)

0 2
10 5
20 11
30 18
40 25

Graphical Form: The production function can also be illustrated in the form of a graph; where horizontal axis
(X axis) represents input and the vertical axis (Y axis) represents the output.

Algebraic Form: Algebraically production function can be expressed as Y= f(X). Where, Y represents
dependent variable, output (yield of crop, livestock enterprise) and X represents independent variable, input
(seeds, fertilizers, manure etc), f = denotes function of.
When more number of inputs is involved in the production of a product, the equation is represented as
Y=f(X1, X2, X3, X4 ……… Xn)
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In case of single variable production function, only one variable is allowed to vary, keeping others constant, can
be expressed as
Y=f(X1 | X2, X3 ………. Xn)
The vertical bar is used for separating the variable input from the fixed input. The equation denotes that the
output Y depends upon the variable input X1, with all other inputs held constant.
If more than one variable input is varied and few others are held constant, the relationship can be expressed as
Y=f(X1, X2 | X3, X4 …….. Xn)

Production function can also be expressed as;

Y= a + bX---------------------------- Linear production function
Where Y is dependent variable, a is constant, b is coefficient, X is independent variable
The constant a represents the amount of product obtained from the fixed factor if none of the variable input is
applied, while b is the amount of output produced for each unit of X (input) applied.

Production function depends on the following factors:

1) Quantities of inputs used.
2) Technical knowledge of the producer.
3) Possible processes in production
4) Size of the firm
5) Nature of firm‟s organization
6) Relative prices of factors of production.

Assumptions under the Short Run and the Long Run Functions
Production in the Short run
There are some assumptions about the production function. In order to better understand the technological
nature of production, we distinguish between short run production relationships where only one factor input
may vary (typically labour) in quantity holding the other factors of production constant (i.e., capital and/or
materials) and the long run where all factors of production may vary. The short run allow for the development
of a simple two variable model to understand the behavior between a single variable input and the
corresponding level of output. Thus we can write:
Y = f (L | K, M, R) or Y =f (L)
For example we could develop a short run model for agricultural production where the output is measures as
kilograms of grain and labour is the variable input. The fixed factor production includes the following: 1
plough, 1 tractor, (capital), 1 truck, 1 acre of land, 10 kilograms of seed grain. We might hypothesize the
production relationship to be as follows:

Input (L) Output (Y grain) MPL

0 0kg -
1 100 100
2 200 100
3 300 100
: : :
10 1000 100

In this example we find that each time we add more units of labour, output increases by 100kg. The third
column MPL defines this relationship. This column measures the marginal productivity of labour, that is, a
measure of the contribution of each additional unit of labour input to the level of output. In this case, we have a
situation of constant marginal productivity which is unrealistic with production in the short run.
Constant marginal productivity implies that as labour input increases, output always increases without bound.
This situation is difficult to imagine with limited capital and one acre of land.
12
A more realistic situation would be that of diminishing marginal productivity where increasing quantities of a
single input lead to less and less additional output. This property is just an acknowledgement that it is
impossible to produce an infinite level of output when some factors of production (machines or land) fixed in
quantity. Numerically, we can model diminishing marginal productivity as follows:

Input (L) Output (Y grain) MPL

0 0kg -
1 100 100
2 180 80
3 240 60
4 280 40
5 300 20
6 300 0

In this case, additional labour input results in additional output. However, the contribution of each additional
unit of labour is less than previous units such that the sixth unit of labour contributes nothing to output. With 5
or 6 workers, the available amount of land cannot support additional output.
A short run production relationship can be modeled as shown. In this example, labour is the variable factor
input and land, capital, and entrepreneurship are fixed in quantity. There is a positive relationship between
labour input and output levels. However, as additional labour is used, less and less additional output is
produced. The shape of this production function is consistent with the law of diminishing marginal productivity.
Production in the Long run
Production in the long run is distinguished from short run production in that all factor inputs may be used in
varying amounts. Though the long run is more of planning concept, it is important for economic analysis. Given
the production function:
X = f (L, K, M, R)
We find that one factor may be substituted to some degree, for another factor of production. For instance;
 Increasing the amount of capital or machinery „K‟, can replace some labour „L‟, but not all of the labour
in a production process.
 Increasing amounts of labour (greater care being taken in production to avoid waste) can reduce the need
for some material inputs „M‟.
In addition, where all factors or production are allowed to vary in quantity, proportional increases in all factors
of production may lead to unbounded increases in output.
As we begin to model production in the long run, we will simplify the production function somewhat as:
X = f (L, K),
Where, we assume that the extraction of raw materials or the development of land is accomplished with
combinations of labour and capital input. Entrepreneurship is embedded in the production technology used. This
allows for a two-dimensional representation of combinations of factor inputs required to produce chosen levels
of output.
It is possible to produce 100 units of output (Y = 100) with the following combinations of labour and capital.
L K
50 200 Capital Intensive Production
100 100 Equal Amounts
200 50 Labour Intensive Production

13
 LECTURE 3: PRINCIPLES AND CONCEPTS IN PRODUCTION ANALYSIS

LAW OF DIMINISHING MARGINAL RETURNS

The factor - product relationship or the amount of a resource that should be used and consequently the
amount of output that should be produced is directly related to the operation of law of diminishing returns.
This law explains how the amount of product obtained changes as the amount of one of the resources is
varied while the amount of other resources is fixed. It is also known as law of variable proportions or principle
of added costs and added returns.
Definitions:
 An increase in capital and labour applied in the cultivation of land, causes in general, less than
proportionate increase in the amount of produce raised, unless it happens to coincide with the
improvements in the arts of agriculture (Marshall)
 If the quantity of one of productive service is increased by equal increments, with the quantity of other
resource services held constant, the increments to total product may increase at first but will decrease
after certain point (Heady)
Limitations:
The law of diminishing returns fails to operate under certain situations. They are called limitations of the law of
diminishing returns.
1) Improved methods of cultivation
2) New soils and
3) Insufficient capital.

Why the law of diminishing returns operates in agriculture:

The law of diminishing returns is applicable not only to agriculture but also manufacturing industries. If the
industry is expanded too much, supervision will become difficult and the costs will go up. The law of
diminishing returns therefore set in. The only difference is that in agriculture it sets in earlier and in other
industries much later. There are several reasons for the operation of law of diminishing returns in agriculture.
The reasons are:
1) Excessive dependence on weather.
2) Limited scope for mechanization.
3) Limited scope for division of labour.
4) Agriculture uses larger proportion of land resource.
5) Soil gets exhausted due to continuous cultivation.
6) Cultivation is extended to inferior lands.

PRINCIPLES OF MAXIMUM PROFIT

This law states that to maximize profit, added increments of the variable inputs should continue until the value
of the resultant output is equal to the price of the inputs.

PRINCIPLE OF LIMITED RESOURCES (EQUI-MARGINAL PRINCIPLES)

The equi-marginal principle was originally associated with consumption theory and the law is called „the
law of equi-marginal utility‟. The law of equi-marginal utility states that a utility maximizing consumer
distributes his consumption expenditure between various goods and services him/her consumes in such a way
that the marginal utility derived from each unit of expenditure on various goods and services is the same. The
pattern of consumer‟s expenditure maximizes a consumer‟s total utility.
The law of equi-marginal principle has been applied to the allocation of resources between their
alternative uses with a view to maximizing profit in case a firm carries out more than one business activity. This
principle suggests that available resources (inputs) should be so allocated between the alternative options that
the marginal productivity gains (MP) from the various activities are equalized.

14
PHYSICAL PRODUCT
Total Physical Product (TPP) - This is the amount of product which results from different quantities of
variable input. Total product indicates the technical efficiency of fixed resources.

Average Physical Product (APP) - It is the ratio of total product to the quantity of input used in producing that
quantity of product.
APP= Y/X where Y is total product and X is total input.
Average product indicates the technical efficiency of variable input.

Marginal Physical Product (MPP) - The marginal physical product (MPP) refers to the change in output
associated with an incremental change in the use of an input. The incremental increase in input use is usually
taken to be 1 unit. Thus MPP is the change in output associated with a 1 unit increase in the input.
MPP = ΔY/ΔX
The MPP of input xi might be referred to as MPPxi. Notice that MPP, representing the incremental change in
TPP, can be either positive or negative.

ELASTICITY OF PRODUCTION (EP)

The term elasticity is used by economists when discussing relationships between two variables. Elasticity is
a number that represents the ratio of two percentages. Any elasticity is a pure number in that it has no units.
The elasticity of production is defined as the percentage change in output divided by the percentage change
in input, as the level of input use is changed.
Suppose that x represents some original level of input use that produces y units of output. The use of x is then
increased to some new amount called x1, which in turn produces y1 units of output. The elasticity of production
(Ep) is defined by the formula
Ep = (y1 - y)/y
(x1-x)/x
Where y, y1, x, and x1 are as defined previously.
The elasticity of production is one way of measuring how responsive the production function is to changes
in the use of the input. A large elasticity (for example, an elasticity of production greater than 1) implies that the
output responds strongly to increases in the use of the input. An elasticity of production of between zero and 1
suggests that output will increase as a result of the use of x, but the smaller the elasticity, the less the response in
terms of increased output. A negative elasticity of production implies that as the level of input use increases,
output will actually decline, not increase.
The elasticity of production can also be defined in terms of the relationship between MPP and APP. The
following relationships hold. First,
Ep = Percentage change in output/Percentage change in input.
Ep = ((change in output / initial output)*100) / ((change in input / initial input)*100)
i.e., ((ΔY/Y)*100)/ ((Δ X/X)*100)
= (Δ Y/Y) / (ΔX/X) = (Δ Y/Y)*(X/ΔX) = (ΔY/ΔX) * (X/Y)
By rearranging we have,
Ep = (ΔY/ΔX) * (X/Y) = (ΔY/ΔX)/(Y/X) = MPP/APP
The elasticity of production is the ratio of Marginal Physical Product to Average Physical Product.
Ep = 1, Constant Returns. Ep is one at MPP = APP (At the end of I stage)
Ep > 1, Increasing Returns (I Stage of Production)
Ep < 1, Diminishing returns (II Stage of Production)

Elasticities of Production for a Neoclassical Production Function

A unique series of elasticities of production exist for the neoclassical production function, as a result of the
relationships that exist between MPP and APP. These are illustrated and can be summarized as follows

15
VALUE PRODUCT
Total Value Product (TVP) - Expression of TPP in terms of monetary value, it is called Total Value Product.
TVP = TPP*Py or Y*Py

Average Value Product (AVP) - The expression of average physical product (APP) in monetary value.
AVP = APP*Py

Marginal Value Product (MVP) - When MPP is expressed in terms of monetary value, it is called Marginal
Value Product.
MVP = MPP*Py or (ΔY/Δ X)* PyΔ Y. Py /Δ X

FACTOR COST
Total Factor Cost (TFC) - This is the total money cost of the factors used in a production process. It is
obtained as;
TFC = ΣX1 .Px

Average Factor Cost (AFC) - This is the average cost of the factors or cost per unit of the factors in a
production process. It is given as
AFC = TFC/ X1

Marginal Factor Cost (MFC) - This is addition to total costs by using an extra unit of the variable input. It is
given as MFC= ΔTFC/ ΔX1 = Δ (Σ{X1 .Px})/ ΔX1

COMPARATIVE ADVANTAGE
The concept of comparative advantage simply is specialization of countries or regions in production of
goods in which it has comparative advantage and imports those in which it has comparative disadvantage. In
agriculture, the concept is very important because weather and soil conditions vary from place to place. If for
instance, it costs country A Kshs.30 to produce a kilogram crop X and KShs. 40 to produce crop Y while it
costs country B Kshs.50 to produce a kilogram crop X and Kshs.30 to produce crop Y country A has advantage
in producing crop X while country B has advantage in producing crop Y.
The principle encourages country A to concentrate in the production of X while country B concentrates on
Y and they in turn imports the other crop for which they are at disadvantage.

16
A farm firm should produce or engage in enterprises in which it has comparative advantage e.g. in producing
cattle, savannah, and region has comparative advantage over the other areas of country because: There is vast
grassland; Cattle move freely over a long distance without obstruction; There is adequate water supply; There is
less tsetse fly infestation, and the climate is favourable.

GROSS MARGIN AND FARM PROFIT

Gross margin of an enterprise is the difference between total value of products and the variable costs of
production. The gross margin of an enterprise measures the contribution of that enterprise to the farm‟s total
profit given the fixed costs on a farm, the larger the total gross margin from all enterprises on the farm, the
larger the profit. When the gross margins for each enterprise has been decided, they are all added together and
from this, the fixed cost (common costs) are deducted. What is left is farm profit.
Gross margin = Value of gross output - variable costs for each enterprise combination

GMi = VGOi – VCi for enterprise „i‟

Where VGO = Q.Pq and VC = X.Px

It is mostly used in cases where the fixed cost is negligible as in peasant farming.

17
 LECTURE 4: ANALYSIS OF PRODUCTION FUNCTION
INTRODUCTION
An agricultural production function is presented using graphical and tabular approaches. Algebraic examples of
simple production functions with one input and one output are developed. Key features of the neoclassical
production function are outlined. The relationship between factors of production or inputs and outputs
(production function) can be studied under three main analytical headings; factor-product, factor-factor and
product-product relationships.

FACTOR-PRODUCT RELATIONSHIP
This is a case of producing a product by using one variable factor. For example, a farmer may produce maize
using fertilizer as the variable factor. Although this type of relationship is very easy to analyse, it rarely occurs
in real life situation. That means the use of fertilizer varies with the quantity of maize produced. The
relationship can be represented technically as:
Q = f (X1|X2, X3, …, Xn) or Q = f(X1)
Where Q = quantity of output
X1 = quantity of variable input
X2, X3, …., Xn = fixed inputs.
Graphically, the relationship can be represented as;

Factor- Product Relationship

The above graph clearly demonstrates the law of diminishing returns, i.e. as more of the variable input is added
to the fixed factors, the quantity of output increases at a diminishing rate. Therefore, the job of the economist is
to determine the point of optimum production.
Because of diminishing returns, the above graph can be divided into three portions (the so-called stages of
production) based on the relationship between TPP, APP and MPP thus the Stages of Production

Three Regions of Production Function

The production function showing total, average and marginal product can be divided into three regions, stages
or zones in such a manner that one can locate the zone of production function in which the production decisions
are rational. The three stages are shown below.

18
First Stage or I Region or Zone 1:
 The first stages of production starts from the origin i.e., zero input level.
 In this zone, Marginal Physical Product is more than Average Physical Product and hence Average
Physical Product increases throughout this zone.
 Marginal Physical Product (MPP) is increasing up to the point of inflection and then declines.
 Since the marginal Physical Product increases up to the point of inflection, the Total Physical Product
(TPP) increases at increasing rate.
 After the point of inflection, the Total Physical Product increases at decreasing rate.
 Elasticity of production is greater than unity up to maximum Average Physical Product (APP).
 Elasticity of production is one at the end of the zone (MPP = APP).
 In this zone fixed resources are in abundant quantity relative to variable resources.
 The technical efficiency of variable resource is increasing throughout this zone as indicated by Average
Physical Product.
 The technical efficiency of fixed resource is also increasing as reflected by the increasing Total Physical
Product.
 Marginal Value Product is more than Marginal Factor Cost (MVP >MFC).
 Marginal revenue is more than marginal cost (MR > MC).
 This is irrational or sub- optimal zone of production.
 This zone ends at the point where MPP=APP or where APP is Maximum.

19
Second Stage or II Region or Zone II:
 The second zone starts from where the technical efficiency of variable resource is maximum i.e., APP is
Maximum (MPP=APP).
 In this zone Marginal Physical Product is less than Average Physical Product. Therefore, the APP
decreases throughout this zone.
 Marginal Physical Product is decreasing throughout this zone.
 As the MPP declines, the Total Physical Product increases but at decreasing rate.
 Elasticity of production is less than one between maximum APP and maximum TPP.
 Elasticity of production is zero at the end of this zone.
 In this zone variable resource is more relative to fixed factors.
 The technical efficiency of variable resource is declining as indicated by declining APP.
 The technical efficiency of fixed resource is increasing as reflected by increasing TPP.
 Marginal Value Product is equal to Marginal Factor Cost (MVP=MFC).
 Marginal Revenue is equal to Marginal Cost (MR= MC).
 This is rational zone of production in which the producer should operate to attain his objective of profit
maximization.
 This zone ends at the point where Total Physical Product is maximum or Marginal Physical Product is
zero.

Third Stage or III Region or Zone III:

 This zone starts from where the technical efficiency of fixed resource is maximum (TPP is Maximum).
 Average Physical Product is declining but remains positive.
 Marginal Physical Product becomes negative.
 The Total Physical Product declines at faster rate since MPP is negative.
 Elasticity of production is less than zero (Ep < 0).
 In this zone variable resource is in excess capacity.
 The technical efficiency of variable resource is decreasing as reflected by declining APP.
 The technical efficiency of fixed resource is also decreasing as indicated by declining TPP.
 Marginal Value Product is less than Marginal Factor Cost (MVP < MFC).
 Marginal Revenue is less than Marginal Cost (MR < MC).
 This zone is irrational or supra- optimal zone.
 Producer should never operate in this zone even if the resources are available at free of cost.
Three Regions of Production-Economic decisions
Stage I: It is called irrational zone of production. Any level of resource use falling in this region is
uneconomical. The technical efficiency of variable resource is increasing throughout the zone (APP is
increasing). Therefore, it is not reasonable to stop using an input when its efficiency is increasing. In this zone,
more products can be obtained from the same resource by reorganizing the combination of fixed and variable
inputs. For this reason, it is called irrational zone of production.
Stage II: It is rational zone of production. Within the boundaries of this region is the area of economic
relevance. Optimum point must be somewhere in this rational zone. It can, however, be located only when input
and output prices are known.
Stage III: It is also an area of irrational production. TPP is decreasing at increasing rate and MPP is negative.
Since the additional quantities of resource reduces the total output, it is not profitable zone even if the additional
quantities of resources are available at free of cost. In case if a farmer operates in this zone, he will incur double
loss. i.e.
1. Reduced Production
2. Unnecessary additional Cost of inputs.

20
FACTOR-FACTOR RELATIONSHIP
1. This relationship deals with the resource combination and resource substitution
2. It deals with the production efficiency of resources.
3. The rate at which the factors are transformed in to products is the study of this relationship.
4. Optimization of production and Cost minimization are the goals of this relationship.
5. This relationship is known as input-output relationship by farm management specialists and fertilizer
responsive curve by agronomists.
6. Factor-Product relationship guides the producer in making the decision „how much to produce?
7. This relationship helps the producer in the determination of optimum input to use and optimum output to
produce.
8. Price ratio is the choice indicator.
9. This relationship is explained by the law of diminishing returns.
10. Algebraically, this relationship can be expressed as
Y = f (X1 / X2, X3………………Xn)
In the production, inputs are substitutable. Capital can be substituted for labour and vice versa, grain can be
substituted for fodder and vice versa. The producer has to choose that input or inputs, practice or practices
which produce a given output with minimum cost. The producer aims at cost minimization i.e., choice of inputs
and their combinations.

Isoquants
The relationship between two factors and output cannot be presented with a two dimensional graph. This
involves three variables and can be presented in a three dimensional diagram giving a production surface.
An isoquant is a convenient method for compressing three dimensional picture of production into two
dimensions.
Definition:
An isoquant represents all possible combinations of two resources (X 1 and X2) physically capable of producing
the same quantity of output.
Isoquants are also known as isoproduct curves or equal product curves or product indifference curves.

Isoquant Map or Iso product Contour

If numbers of isoquants are drawn on one graph, it is known as isoquant map. Isoquant map indicates the shape
of production surface which in turn indicates the output response to the inputs.
Characteristics of Isoquants
1. Slope downwards from left to right or negatively sloped.
2. Convex to the origin.
21
 3. Nonintersecting
4. Isoquants lying above and to the right of another represents higher level of output.
5. The slope of isoquant denotes the marginal rate of technical substitution (MRTS).

Marginal Rate of Technical Substitution (MRTS)

It refers to the amount by which one resource is reduced as another resource is increased by one unit. Or the rate
of exchange between some units of X1 and X2 which are equally preferred
MRTSX1X2 = Δ X2/Δ X1
MRTS X2X1 = ΔX1/ΔX2

Marginal Rate of Technical Substitution = Number of units of replaced resource

Number of units of added resource
The slope of Isoquant indicates MRTS.
Substitutes: A range of input combinations which will produce a given level of output. When one factor is
reduced in quantity, a second factor must always be increased MRTS is always less than zero.
Perfect Substitutes: When two resources are completely interchangeable, they are called perfect substitutes.
The isoquants for perfect substitutes is negatively sloped straight lines.
The MRTS is constant. Examples: Family labour and hired labour, Farm produced and purchased seed etc.
Complements: Two resources which are used together are called complements. In the case of complements,
reduction in one factor cannot be replaced by an increase in another factor. MRTS is zero.
Perfect Complements: Two resources which are used together in fixed proportion are called perfect
complements. It means that only one exact combination of inputs will produce a particular level of output. The
isoquant in this case is of a right angle. Examples: Tractor and driver, Pair of bullocks and labourer

Types of factor substitution

The shape of isoquant and production surface will depend up on the manner in which the variable inputs are
combined to produce a particular level of output. There can be three such categories of input combinations.
They are:
1. Fixed Proportion combination of inputs - To produce a given level of output, inputs are combined
together in fixed proportion. Isoquants are „L‟ shaped. It is difficult to find examples of inputs which
combine only in fixed proportions in agriculture. An approximation to this situation is provided by
tractor and driver combination. To operate another tractor, normally we need another driver.

Fixed proportion Map

22
 2. Constant rate of Substitution - For each one unit gain in one factor, a constant quantity of another
factor must be sacrificed. When factors substitute at constant rate, isoquants are linear, negatively
sloped.

X1 X2 ΔX1 ΔX2 MRTS X1X2 =ΔX2/Δ X1

0 50 - - -
5 40 5 10 10/5=2
10 30 5 10 10/5=2
15 20 5 10 10/5=2
20 10 5 10 10/5=2
25 0 5 10 10/5=2

The above table shows that the six combinations of resources X 1 and X2 can be used in producing a given level
of output. As X1 input is increased from 0 to 5 units, 10 units of X2 are replaced. Similarly addition of another 5
units of X1 replaces another 10 units. The MRS of X1 for X2 is 2. That means if we want to obtain one unit of
X1, we have to forego 2 units of X2.
Example: family labour and hired labour. When inputs substitute at constant rate, it is economical to use only
one resource, and which one to use depends up on relative prices.

Constant rate of substitution

Algebraically, constant rate of factor substitution is expressed as

Δ 1X2/Δ 1X1 = Δ 2X2/Δ 2X1 = ……. = Δ nX2/Δ nX1

3. Decreasing Rate of substitution:

Decreasing rate of substitution means that every subsequent increase in the use of one factor, replaces less and
less of other factor. In other words, each one unit increase in one factor requires smaller and smaller sacrifice in
another factor.
Example: Capital and labour, concentrates and green fodder, organic and inorganic fertilizers etc.

23
 X1 X2 ΔX1 ΔX2 MRTS X1X2 =ΔX2/Δ X1
1 18 - - -
2 13 1 5 5/1=5
3 9 1 4 4/1=4
4 6 1 3 3/1=3
5 4 1 2 2/1=2

The MRS of X1 for X2 becomes smaller and smaller as X1 replaces X2. Isoquants are convex to the origin when
inputs substitute at decreasing rate.

Decreasing Rate of Substitution

Algebraically, decreasing rate of substitution is expressed as

Δ 1X2/Δ 1X1 > Δ 2X2/Δ 2X1 > ……. > Δ nX2/Δ nX1
Decreasing rate of factor substitution is more common in agricultural production.

Isocost lines and Ridgelines

Each combination of inputs has a cost associated with it. The cost is variable because the inputs considered are
variable. Denoting the total variable cost per unit of X 1 as PX1 and the cost per unit of X2 as PX2 the total
variable cost TVC is given by
TVC = PX1X1 + PX2X2
Just as production surfaces are characterized by isoquants, the total variable cost surfaces can be described
using isocost lines. An isocost line traces the set of points on the cost surface that are an equal distance above
the input base.
Isocost line determines all combinations of the two inputs that cost the same amount.
The equation of the isocost line can be found by solving the TVC equation for X 1 as an explicit function of X2.
PX1X1 = TVC - PX2X2

24
 X1 = TVC/ PX1 - PX2 / PX1X2
The two important aspects of the isocost line are its distance from the origin and its slope.
When prices do not change, each possible total variable cost has a different isocost line.
As total variable cost increases, the ration TVC / PX1 increases and the isocost line moves to a higher points on
the cost surface, located further from the origin.
Changes in the input price change the slope of the isocost line.
Characteristics of Isocost line:
1. As the total outlay increases, the isocost line moves farther away from the origin.
2. Isocost line is a straight line because input prices do not change with the quantity purchased.
3. The slope of isocost line indicates the ratio of factor prices.

The least Cost Criterion

There are innumerable possible combinations of factors which can be used to produce a particular level of
output.
The least cost criterion concept is needed to determine the combinations of inputs that will produce a given
output at a minimum of cost are available. The problem is to find out a combination of inputs which should cost
the least, a cost minimization problem. There are three methods to find out the least cost combination of inputs.
They are:
1) Simple Arithmetical calculations: - One possible way to determine the least cost combination is to
compute the cost of all possible combinations and then select the one with minimum cost. This method
is suitable where only a few combinations produce a particular level of output. The following table
contains seven combinations of inputs that produce 105 units of output;

Minimum cost combination of inputs for an output of 105 (P X1 =KShs. 180. PX2 = KShs. 270)
Units of X2 Units of X1 Cost of X2 Cost of X1 Total Variable Cost
2 9.0 KShs. 540 KShs 1,620 KShs. 2,160
3 6.0 810 1,080 1,890
4 5.0 1,080 900 1,980
5 4.4 1,350 792 2,142
6 4.1 1,620 738 2,358
7 4.0 1,890 720 2,610
8 4.1 2,160 738 2,898

2) Algebraic method:
a. Compute marginal rate of technical substitution (MRTS)
MRS = Number of units of replaced resource / Number of units of added resource
MRSX1X2 =ΔX2/ΔX1
MRSX2X1 =ΔX1/ΔX2
b. Compute Price Ratio (PR)
PR=Price per unit of added resource/Price per unit of replaced resource
PR=PX1/PX2 if MRSX1X2
Or
PR= PX2/PX1 if MRSX2X1
c. Workout least cost combination by equating MRS and PR
ΔX2/ΔX1= PX1/PX2 MRSX1X2
ΔX1/ΔX2= PX2/PX1 MRSX2X1
The same can be expressed as
ΔX2. PX2= Δ X1. PX1
Or
ΔX1. PX1= ΔX2. PX2
25
The least cost combination is obtained when Marginal Rate of substitution is equal to Price Ratio.
3) Graphical Method: - Since the slope of isoquant indicates MRTS and the slope of isocost line indicates
factor price ratio, minimum cost for given output will be indicated by the tangency of these isoclines.
For this purpose, isocost line and isoquant are drawn on the same graph for different levels of
production. The least cost combination will be at the point where isocost line is tangent to the isoquant
i.e., slope of isoquant=slope of isocost line i.e., MRS=PR

Isocost, Isoquant and Least cost Curves

The isoquant has an infinite number of points – only one will represent the cost minimizing combination. At
this point the following criterion called the least cost criterion will hold:
MRS of X2 for X1 = - PX2 / PX1
Because of definition of MRS, the criterion can be written
ΔX1 / ΔX2 = - PX2 / PX1
Thus the least cost combination of inputs occurs at the point where the isocost line is tangent to the isoquant,
given that the isoquant is convex to the origin.
Isoclines are lines or curves that pass though points of equal marginal rates of substitution on an isoquant map.
That is, particular isocline will pass through all isoquants at points where the isoquants have a specific slope.
There can be a number of possible output levels as shown in the figure and the least cost combination can be
found out for these various output levels.
A line or curve connecting the least cost combination of inputs for all output levels is called isocline

Isocost Map

The isocline passes through all the isoquants at points where they have the same slope.
Isoclines can be drawn at different sets of price ratio. All isoclines of course converge at the point of maximum
output. Though all the points on isocline represent least cost combination, only one point represents the
maximum profit output.

26
The expansion path too is an isocline. The expansion path traces out the least cost combination of inputs for
every possible output level. While all the points on an expansion path represent the least cost combinations,
only one point represents the maximum profit output.
The choice indicator of expansion path is the input price ration. On the expansion path the marginal rate of
substitution must be equal the input price ratio.
If resources are technical substitutes and the marginal rate of substitution is decreasing, any change in the
relative prices of the inputs also changes the expansion path. The changes in input prices shift the expansion
path to a new isocline that assumes the role of expansion path.
The economic implications of expansion path are:
1. If the expansion path is a straight line emanating from the origin, then the inputs will be used in the
same proportions at all output levels.
2. When the expansion path is curved, the proportion of the inputs that must be used to achieve the least
cost combination will vary among yield level.
Ridge lines or Border or Boundary lines
Ridge lines represent the points of maximum output from each input, given a fixed amount of another input.
Also they represent limits of substitution. Ridge lines reflect the limits of economic relevance, the boundaries
beyond which isoquant map ceases to have economic meaning. The portions of isoquants which lie between the
lines are suited for economic production (Where MPP of both inputs are positive but decreasing and isoquants
are negatively sloped). Portions of isoquants outside the ridge lines are not suitable for production in economic
terms (outside the ridge lines, MPP of both factors are negative and methods of production are inefficient).
Ridge lines represent special types of isocline which represent the limit of economic relevance, the boundaries
beyond which the isocline and isoquant maps cease to have economic meaning.
On the ridge line of X1, MPPX1 is zero; the tangent to the isoquant is vertical and has no definite slope. Ridge
lines represent the points of maximum output from each input, given a fixed amount of the other inputs.

Expansion path and Profit maximization

The expansion path traces out the least cost combination of inputs for every possible output level. The question
of which output level is the most profitable is answered by proceeding on the expansion path, that is, increasing
output until the value of the product added by increasing the two inputs along the expansion path is equal to the
combined cost of the added amounts of the two inputs.

Method of maximizing profit directly:

Profit = PY Y – PX1X1 – PX2 X2 - TFC
Maximize the function
∂ Profit / ∂X1 + PY ∂Y / ∂X1 – PX1 = 0
∂ Profit / ∂X2 + PY ∂Y / ∂X2 – PX2 = 0
The above equation can be written as
VMPX1 = PX1
VMPX2 = PX2
27
Thus the profit maximizing criterion requires that marginal earning of each input must be equal to its cost. This
must be true for both inputs simultaneously.

Cost curves and Profit maximization

Another method to estimating the profit maximization is through equating MC to P Y.
Computing costs for least cost combination of inputs (P X1 = and PX2 = 7)
Least Cost Combinations of X1 and X2 for Minimum total AVC MC
indicated outputs outlay for output
TVC
X1 X2 Y
0.00 0.00 0 0 - -
0.96 0.75 26 13.89 0.53 0.53
2.00 1.55 52 28.85 0.56 0.58
3.30 2.55 78 47.55 0.61 0.72
5.00 3.90 104 72.30 0.70 0.95
9.00 7.00 130 130.00 1.00 2.22

The expansion path is X1 = (9/7) X2

PRODUCT-PRODUCT RELATIONSHP
Product-Product relationship deals with resource allocation among competing enterprises.
The goal of Product-Product relationship is profit maximization. Under Product-Product relationship, inputs are
kept constant while products (outputs) are varied. This relationship guides the producer in deciding „What to
produce‟. This relationship is explained by the principle of product substitution and law of equimarginal returns.
This relationship is concerned with the determination of optimum combination of products (enterprises).The
choice indicators are substitution ratio and price ratio. Algebraically it is expressed as Y1=f

(Y2 Y3, ……. Yn) Or (Q1, Q2) = f (X1|X2, X3, …..,Xn) or X1 =f(Q1,Q2)

Where X1= variable inputs

X2, X3,…..,Xn =fixed inputs
Q1, Q2= products
Again we would have required a three-dimensional space to represent the above relationship graphically, but it
is instead represented in a two- dimensional space known as production possibility curve (PPC) as shown in the
figure below.

Production Possibility Curve

28
The above graph clearly depicts varying amounts of Q1 (wine) and Q2 (Cotton) produced with a fixed quantity
of X1(land). The slope of the curve is positive and is normally called MRPT (Marginal Rate of Product
Transformation) and it indicates the amount by which product one is increasing and two is decreasing at a fixed
level of the variable factor. It is given as

MRPT = ΔQ1/ ΔQ2

Where ΔQ1= change in product 1
ΔQ2 = change in product 2
The isorevenue line is superimposed on the PPC in other to determine the optimum point.
The revenue line is the line joining all combinations of the two products that earn the same revenue. The point
of tangency of the curve and the line is called revenue-maximizing point (RMP) and is the points of maximum
profit where the farmer should produce.
In this lecture, we have differentiated between the three relationships in production. These could be factor-
factor, factor-product or product-product relationships. There are three stages in the production process namely:
stage I, stage II and Stage III. While it pays the producer to keep increasing the quantity of variable inputs used
in this stage, the reverse is the case in stage III. Stage II is the stage of rational production.

SUMMARY
There are three stages in the production process. The stage of rational production is the stage
II. However, the point of production which maximizes the producer‟s objective is determined through the
imposition of price variable into the model. The producer could thus produce to either maximise revenue, profit
or minimize costs. This is achieved at the point of tangency between the isoquant and the isocost line. For the
revenue maximization, the iso-revenue line must be tangent to the production possibility curve.

29
 LECTURE 5: RELATIONSHIPS AMONG INPUTS AND PRODUCTS

RELATIONSHIP BETWEEN INPUTS

Inputs are technical substitutes such that it is possible for an increase in one input to lead to a decrease in the
other input while maintaining the level of output. They tend to compete with each other though. The marginal
rate of technical substitution for these inputs is negative. There are three types of substitution basically.
a) Constant rate of substitution - This occurs when the amount of input replaced by another input remain
unchanged with the addition of the other input. In other words, the isoquant remains unchanged with the
change in the input combination. This type of input are called constant substitutes.
b) Increasing rate of substitution - This is a situation when an increase in an input replaces larger amount
of input being substituted. Again we can say that the marginal rate of substituting input X1 for X2
increases as X1 is increased along the isoquant.
c) Decreasing Rate of Substitution - This occurs when the input being increased substitute for
successively smaller amount of the input being replaced. This is caused mainly by the law of
Diminishing returns. This implies that the rate at which X1 substitutes for X2 decreases as X1 is
increased along the isoquant curve.

RELATIONSHIP BETWEEN PRODUCTS

Products or enterprises compete for limited resources such as land, labour, capital and others. For cocoa and oil
palm could be competing for labour use on the farm. The decision maker must ensure that the resources are
allocated among these products lines in a manner that the goal of the firm is achieved. There are four types of
relationships which are likely among enterprises or products name: Competitive, complementary,
supplementary and joint relationships.
a) Competitive Products - Products or enterprises are competitive when in the use of resources on the
farm, when output can only be increased through the reduction in the products of the other enterprise.
Such products substitute for each other at an increasing rate. At times they can substitute for each other
at a decreasing or constant rate. Price, will determine which one to produce. Two varieties of a crop can
substitute at a constant rate. In that case on a parcel of land (limited resource), the ratio of reduction in
land for the production of one variety to an increase in land for the production of the other variety of the
same crop can substitute at constant rate.
What the farm manager does in such situation is to produce the one which commands higher price.
b) Complementary Products - Complementarity of products exists when an increase in the production of
one product through the transfer of more resource to its production leads to increase in the production of
the other product. This occurs more when one of the products supplies input(s) to the production of the
other. For example, production of legumes in crop rotation increases the nitrogen level in the soil for the
use of other crops. The legumes have nitrogen fixing bacteria in their root system (nodules) which fix
nitrogen in the soil thus increase the available nitrogen in the soil. Therefore any additional resource
committed to cultivating legumes can result in higher grain production in a legume/cereal mixture or in a
legume followed by cereal rotation regime. This advantage could be explored to some level on the farm
as the products could soon become competitive with time.
c) Supplementary Products - This type of relationship exits when the amount of one product can be
increased without any effect on the other products. In other words, they are independent of one another.
To produce cocoa and oil palm using labour and some implement can be said to be complementary. The
use of pressing machine for extracting oil does not affect the production of cocoa as it is not needed in
cocoa production. Like in the complementary situation, this could also become competitive at some time
in the production process. There are situations when this type of relationship could be taken advantage
of.
d) Joint Products - This is a situation when products results from the same production process. The
production of one implies the production of the other. They are a times produced in some ratios. The
production of palm oil and palm kernel for example is together as the same resources: land and oil palm
30
tree are involved. There are some varieties of the palm oil which produce more palm oil than kernel. So
the farmer could take the advantage of this type of scenario in deciding on what to produce. When the
demand for palm oil for example is on the increase and price is increasing, the farmer can decide to go
for the variety which yields more palm oil. Switching from variety however, may take time.

31
 LECTURE 6: THEORY OF COSTS

COST FUNCTION
The cost functions are derived functions. They are derived from the production function, which describes the
available efficient methods of production at any one time. Economic theory always distinguishes between long
run and short run costs. Thus the cost function is the technical relationship between the quantity of output and
the cost of producing the output, e.g.
Q =f(X1) production function
C =f (X1PX1) cost function
The above means the quantity of output is a function of the cost of the variable inputs provided all other factors
are fixed. The two functions above can be represented graphically thus:

Comparison of production and cost function

COST THEORY
Cost refers to the value of inputs used in production. The traditional theory distinguishes two types of costs in
terms of the short run and the long run periods. The short run is the period during which some factor(s) is fixed;
usually capital equipment and management are considered as fixed in the short run. The long run is the period
over which all factors become variable. Thus the firm‟s total costs are split into two groups: total fixed costs and
the total variable costs.
Costs are classified into two major categories.
a. Variable costs - These are costs that increase or decrease as output change e.g. labour hired, machine
use, seed, fertilizer, pesticides, and herbicide.
b. Fixed costs - These are incurred for the resources that do not change as output is changed. These costs
cannot be allocated to a particular enterprise on the farm e.g. depreciation on buildings and equipment,
land rent, interest charges, family labour, management, taxes, telephone and stationary charges.
32
 Total fixed costs are costs that remain the same for a given farm, no matter how much output varies
within the capacity of the operation.

Fixed and variable costs are further classified into total, average and marginal costs.
 Total Fixed Costs (TFC) - It is total costs on all fixed factors. These include interest payments on
borrowed capital, rental expenditures on leased plant and equipment, property taxes, cost of managerial
and administrative staff, etc.
 Total Variable costs (TVC) - On the other hand, are total obligations of the firm for all the variable
inputs that the firm uses. These include payments for raw materials, most labor costs, etc.
 Total Costs (TC) - Equal total fixed costs (TFC) plus total variable costs (TVC). That is,

TC = TFC + TVC
TYPES OF COST
Average Cost
From the total fixed, total variable and total cost functions, we can derive the corresponding per-unit (average
fixed, average variable, average total, and marginal) cost functions of the firm.

Average Fixed Cost (AFC) = TFC

Q

Average Variable Cost (AVC) = TVC

Q

Average Total Cost (ATC) = TC = TFC + TVC

Q Q Q

ATC = AFC + AVC

Marginal Cost
This is the addition to the cost due to the production of an additional unit of product.

Marginal Cost (MC) = ∆TC

∆Q

SHORT-RUN TOTAL AND PER-UNIT COST SCHEDULES

The table shows the hypothetical short-run total and per-unit cost schedules of a firm.
Quantity of Total Cost (TC) TFC TVC AVC AFC ATC MC=TC2-TC1
Output (X) X2-X1
0 60 60 0 - - - -
1 80 60 20 20 60 80 20
2 90 60 30 15 30 45 10
3 105 60 45 15 20 35 15
4 140 60 80 20 15 35 35
5 195 60 135 27 12 39 55

 The total fixed cost can be identified by considering the value of the total cost at the level of output
equal zero. Note that variable cost will always be equal to zero if no output is produced.
Therefore, TFC = KShs. 60 at all levels of output.
 By deducting the value of TFC from the TC we are able to derive the value of TVC at each level of
output. For example, at X = 3, TVC = TC – TFC (i.e. 105 – 60 = 45).
 These schedules are plotted below.
33
Short run cost curves
Cost (KShs)
TC

TVC

60 TFC

0 Output (X)
 The TFC is graphically denoted by a straight line parallel to the output axis since it does not vary with
the variation in the output between zero and a certain level of output.
 The TVC varies with the variation of output. When output is zero, TVC = 0. It starts from the origin and
has an inverse-S shape.
 The total cost curve (TC) has the same shape as the TVC curve, but it does not start from the origin.
Where it intersects the vertical axis depends on the value of the fixed cost.
 The TVC has an inverse-S shape. It shows that the TVC first increases at a decreasing rate and then at
an increasing rate with the increase in the total output. The pattern of change in the TVC stems directly
from the law of increasing and diminishing returns to the variable inputs.
 According to this law, at the initial stages of production with a given fixed input, additional variable
factor is productive so that output increases at an increasing rate.
 Taking total variable cost and dividing it by output would mean that average variable cost declines.
 At optimal combination of the fixed and variable factor, marginal productivity of additional variable
factor reaches its maximum, implying that average variable cost reaches its minimum.
 Beyond an optimal combination of the fixed and variable factor(s), increased employment of the
variable factor causes productivity of the variable factor(s) to decline and thus average variable costs to
rise. TVC increases at an increasing rate.

Short-Run Per-Unit Cost Curves

Cost per unit

(KShs) MC
ATC

35 AVC
AFC

15

0 3 4 Output (X)

34
  The AFC, which is given by the vertical distance between the ATC and the AVC, declines continuously
as output expands as the given total fixed costs are spread over more and more units of output.

Cost per Unit

AFC

0 Output (X)
Average Fixed Cost (AFC) Curve
 Graphically, AVC is the slope of a ray from the origin to the TVC curve. The ATC is equal to the slope
of a ray from the origin to the TC curve, while the MC is the slope of the TC or TVC curves.
 In the top panel, the ray from the origin and tangent to the TC and TVC at points A and B, respectively,
have the lowest slopes compared to all other lines from the origin. At point A, the ATC is at its
minimum. Similarly, the AVC is at its minimum at point B.
 Note that since the ray from the origin is tangent to the TC and the AVC, it implies that MC cuts both
AVC and ATC at their minimum.
 This brings us to the three important relationships between the average curves and the marginal cost
curves.
1) So long as the MC lies below the ATC curve, ATC must be declining.
2) When MC is above ATC, the ATC will be rising.
3) The MC cuts the ATC when ATC is at its minimum.
 The same relationship can be observed between MC and AVC.
 Also observe that the ATC and AVC curves do not reach their minimum at the same level of output.
ATC reaches its minimum after the AVC. In other words, the minimum point of the ATC occurs to the
right of the minimum point of the AVC. This is due to the fact that ATC includes AFC, and the latter
falls continuously with increases in output.
 After AVC has reached its lowest point and starts rising, its rise is over a certain range offset by the fall
in the AFC, so that ATC continues to fall. However, the rise in AVC eventually becomes greater than
the fall in the AFC so that the ATC starts increasing.

Explaining the U Shape of the AVC and MC curves

With labor as the only variable input, TVC for any output level (X) is given as;
TVC = wL
Where w is wage rate (which is assumed to be fixed),
L is the quantity of labor used.

Thus,
AVC = TVC = wL = w = w
X X X/L APL

35
From the theory of production, it was observed that the average product of labor (AP L) usually rises first,
reaches a maximum, and then falls. This implies, therefore, that the AVC curve first falls, reaches a minimum,
and then rises. Since the AVC curve is U-shaped, the ATC curve is also U-shaped.
Similarly, we can explain the U shape of the MC curve as follows:

MC = ∆TVC = ∆(wL) = w(∆L) = w = w

∆X ∆X ∆X ∆X/∆L MPL

Recall from the theory of production that the marginal product of labor (MP L) first rises, reaches a maximum,
and then falls. This means that MC curve first falls, reaches a minimum, and then rises. Thus, the rising portion
of the MC curve reflects the operation of the law of diminishing returns.

LONG-RUN COST-OUTPUT RELATIONS

Long-Run Average Cost (LAC) Curve
Cost (KShs)
SAC(K4)
LAC
SAC(K3)
SAC(K0)
C3 SAC(K1)
C2 SAC(K2)

C1

0 X0 X1 X2 X3 Output (X)

 In the long-run, planning period is long enough for a firm to be able to vary all factors of production it
uses. As a result, all costs become variable in the long run.
 To derive the long-run cost curves it is helpful to imagine that a long-run is composed of a series of
short-run production decisions. Each short-run alternative situation comprises a combination of a certain
quantity of a fixed input (e.g. capital) with various units of variable inputs.
 SAC (K1) is a short run average cost curve associated with K1 units of capital input.
 SAC (K0) is a short run average cost curve associated with a lower amount of capital.
 By joining the minimum points of the SAC curves we obtain the long-run average cost (LAC) curve.
The LAC curve is also known as „Envelope Curve‟ or planning Curve‟ because it covers various short-
run average cost curves.
 It shows the least possible cost per unit of producing various output using different sizes of plants
(capital). For instance, for the firm to produce X 2 units of output, it would be appropriate to employ K2
units of capital because it minimizes cost (SAC (K2) is at its minimum). The firm would pay a higher
cost if it tried to produce X2 with K1 units of capital.

BREAK-EVEN ANALYSIS
It has been implicitly assumed in the earlier analysis that minimization of cost or optimization of output is the
primary objective of the firm. However, in traditional theory of firm the objective of the firm is to maximize
profit, which does not necessarily coincide with the minimum cost.
The break-even analysis is an important analytical technique used to study the relationship between the total
costs, total revenue and the total profits and losses over the whole range of stipulated output. Firms can plan
their production better if they know the profitable and non-profitable ranges of production.

36
The break-even analysis under both linear and nonlinear revenue and cost conditions is described next.

Break-Even Point: Linear Cost and Revenue Functions

Assume a short-run linear cost function of the form;
TC = 100 + 10X
Where TFC = 100
TVC = 10X
Also assume a linear revenue function of the form;
TR = PX
= 15X
Break even chart of the firm would be as shown;

TC, TR

TR

Profit TC
Break even
A

100 Loss TFC

Profit Curve
Profit
0
Loss 20 Quantity (X)

-100

Break-even Analysis: Linear Functions

 The line TFC shows the total fixed cost at Kshs.100 for a certain level of output. Line TC, which is the
summation of TFC and TVC, must cut the vertical axis at Kshs.100.
 The line TR shows the total revenue (TR) obtained by multiplying P to quantity of output, X. It must
start at the origin since at X = 0, TR equals zero.
 The break-even level of output is obtained at the intersection of line TR and TC at point A. From the
diagram, the break-even level of output equals 20 units.
 The vertical distance between the TR and TC line represent the operating profits/losses. Below the
break-even level of output, TC exceeds TR, meaning that the firm suffers an operating loss (TR – TC <
0). Beyond X = 20, the firm enjoys an operating profit since (TR – TC > 0).
 Therefore, when plotting the profit curve, it must intersect the vertical axis at negative 100, since the
firm only incurs a fixed cost when it does not produce anything. The profit curve cuts the output axis at
X=20 since profit equal zero at the break-even point.

Algebraic Computation of the Break-even output

Given,
37
 TC = 100 + 10X
TR = PX
The break-even output is computed as follows:
TR = TC
15X = 100 + 10X
5X = 100
X = 20

Break-Even Point: Nonlinear Cost and Revenue Functions

The break-even analysis based on linear cost and revenue functions may give an impression that the whole
output beyond the break-even level is profitable. In real life, however, the cost and revenue functions may be
non-linear so that AVC and price vary with variation of output. The total cost (TC) may increase at an
increasing rate while the total revenue (TR) increases at a decreasing rate, hence, resulting to two break-even
points that limit the profitable range of output and determine the lower and upper limits of profitable output.

Break-even Analysis: Non-linear Functions

TR, TC
TC

D
TR
B

G TFC

0 X1 X2 OUTPUT (X)
∏
C’

D’
0 X1 X2 OUTPUT (X)
G’
∏

Points B and D are the lower and the upper break-even points, respectively. A firm producing more than 0X1
and less than 0X2 units will make profits.

ECONOMIC OPTIMIZATION/HOW MUCH TO PRODUCE

Identifying the optimum level of production – this refers to answering the question of “how much to produce
and how much input to use” for profit maximization. This involves incorporating input and output prices to our
physical production information.
We will need the following information
1) Production function data (input-output or factor-product data)
2) Work out and APP and MPP values
3) Market price for input X, Px
4) Market price for output Y, Py
5) Workout AVP values = APP.Py
6) Workout MVP values = MPP.Py
7) Work out MFC value (Marginal Factor Cost)

38
 Input (X) Output (Y) APP AVP(APP.Px) MPP VMP(MPP.Py) MFC
0 0 0 0
10 75 7.5 7.50 7.5 7.50 5
20 245 12.3 12.30 17 17.00 5
30 435 14.5 14.50 19 19.00 5
40 560 14 14.00 12.5 12.50 5
50 648 13 13.00 8.8 8.80 5
60 710 12.8 12.80 6.2 6.20 5
70 753 10.8 10.80 4.3 4.30 5
80 782 9.8 9.80 2.9 2.90 5
90 800 8.9 8.90 1.8 1.80 5
100 810 8.1 8.10 1 1.00 5
110 808 7.4 7.40 -0.2 -0.20 5

To confirm this in another way, we work out the TR values and TVC values for all input and output levels.
TR = Y.Py
TVC = X.Px
Then subtract TVC from TR to get net revenue. Find the level of output and input at which net value is at a
maximum.
Input TR (Y.Py) TVC (X.PX) NR
50 648 250 398
60 710 300 410
20 753 350 403

AVP (Average Value of Product) is the average value of output per unit of input at each level of use of input.
AVP = APP x Py

VMP (Value Marginal Product) is the value of additional output produced by each additional unit of input used
VMP = MPP x Py

MFC (Marginal Factor Cost)

 This measures costs at the margin, just as MVP measures output value at the margin. MFC is the amount
that is added to total cost when 1 more unit of input is used. MFC of an input is the price of 1 unit of that
input.
MFC = Px
 Profit maximization occurs where the VMP is equal to MFC or price of input X (Px). I.e. The optimum
occurs where one more unit of the variable input adds to revenue just what it adds to cost.
 From our data, the optimum occurs at 60 units input use and 710 output.
 Also by drawing the graph AVP, MVP and MFC versus inputs levels will also show the point of optimum
use where the VMP and MFC intersect.

Profit maximization
Profit = TVP – TC = TVP – TFC - TVC
Profit = PyY – Px,X – TFC
When an algebraic expression is available for the profit function, Y = f(x), then profit is expressed as a function
of the input X, as follows.
Profit = Py. f(x) – Px.X – TFC

To maximize this function with respect to the variable input, the 1st derivative would be to set to zero.
39
 LECTURE 7: THEORY OF REVENUE
REVENUE
This is the value of output obtained in a production process. It is given as;
R = f (Q, Pq)
Where Q = quantity of output
Pq = price of output

TYPES OF REVENUE
Total revenue - This is the total value of the output produced by the production process given by;
TR= Q.Pq

Average Revenue - This is the total revenue per unit of the output and it is given as;
AR = TR/Q = Q.Pq/Q=Pq

Marginal Revenue - Marginal revenue (MR) is defined as the change in the total revenue per unit change in
output.
MR= ∆TR/∆Q

PROFIT ANALYSIS
Profit is the total revenue less total cost. The function is represented as;
Π = TR-TC

PROFIT MAXIMIZATION
Whatever the structure within which the firm operates, the underlying assumption is that it wishes to maximize
profits. Profits (Π) are defined as the difference between total revenue (TR) and total cost (TC):
Π = TR-TC

Both total revenue and total cost depend upon the firm‟s output. If a firm is to maximize its profits it must
increase output for as long as each additional unit adds more to total revenue than it does to total cost, or for as
long as marginal revenue (MR) exceeds marginal cost (MC). By the same token a profit maximizing firm
should refrain from increasing output when the MC exceeds the MR. This implies, therefore, that firm
maximizes profit at the point at which MC equals MR.
The essential of this rule is presented mathematically by differentiating the equation with respect to output (Q).
dΠ = d(TR) - d(TC)
dQ dQ dQ

Since profits are maximized when:

dΠ = d(TR) - d(TC) = 0
dQ dQ dQ
Or, equivalently:
d(TR) = d(TC)
dQ dQ

The profit maximization condition implies:

MR = MC

Note however that this condition could also identify a profit maximizing position and so there is need to
consider the second order condition which for a maximum is given as;
dΠ2 = d(MR) - d(MC) < 0
dQ2 dQ dQ
40
 LECTURE 8: RISK AND UNCERTAINTY IN AGRICULTURE

THE FARMING ENVIRONMENT

Agriculture is basically affected by an unstable natural environment as well as by major economic
uncertainties. The biological nature of agricultural production and its exposure to elements pose special
problems in attempts to forecast yields. Yields are affected by extremes of weather, pests and diseases, against
which farmers have only limited control.
Most LDC agriculture is situated in the tropics where extremes of weather (rainfall, temperature and
wind) are greater than in temperate areas. The main economic effect of an unstable physical environment is
yield uncertainty. Complete crop failure can occur under extreme conditions of flood, or drought. Low yields or
complete crop failure poses serious consequences for the subsistence farm. For the semi-subsistence or
commercial farms intending to produce a marketed surplus the loss of money income due to crop failure or low
yields can have serious repercussions for the purchase of food and other necessities.
In view of the uncertainty of their natural environment, it is quite rational for farmers in traditional
agriculture to be risk-averse. A major source of economic uncertainty is price uncertainty. Agricultural market
prices are inherently unstable due to short term shift in aggregate demand and supply which farmers are
powerless to control. When the future is not known with certainty, the producer is faced with the problem of
determining the most profitable value of future returns from alternative uses of the resources.
The distribution of income over time is also important to the producer. Thus considering the available
alternatives producers are sometimes inclined to choose enterprises even though the average returns may be
lower than average return from other enterprises which have large year variation in net returns.

DEFINITIONS
Risk is a situation where all possible outcomes are known for a given management decision and the probability
associated with each possible outcome is also known. Risk refers to variability or outcomes which are
measurable in an empirical or quantitative manner. Risk is insurable.
Uncertainty exists when one or both of two situations exist for a management decision. Either, all possible
outcomes are unknown, the probability of the outcomes is unknown or neither the outcomes nor the
probabilities are known. Uncertainty refers to future events where the parameters of probability distribution
(mean yield or price, the variance, range or dispersion and the skew and kurtosis) cannot be determined
empirically. Uncertainty is not insurable.

SOURCES OF RISK AND UNCERTAINTY

The most common sources of risk are.
1. Production risk: Crop and livestock yields are not with certainty before harvest or final sale weather,
diseases, insects, weeds are examples of factors which cannot be accurately predicted and cause yield
variability. Even if the same quantity and quality of inputs are used every year, these and other factors will
cause yield variations which cannot be predicted at the time most input decision must be made. The yield
variations are examples of production risk. Input prices have tended to be less variable than output prices but
still represent another source of production risk. The cost of production per unit of output depends on both costs
and yield. Therefore, cost of production is highly variable as both input prices and yield vary.
2. Technological risk: Another source of production risk is new technology. Will the new technology perform
as expected? Will it actually reduce costs and increase yields? These questions must be answered before
adopting new technology.
3. Price or marketing risk: Variability of output prices is another source of risk.
Commodity prices vary from year to year and may have substantial seasonal variation within a year.
Commodity prices change for number of reasons which are beyond the control of individual farmer.
4. Financial risk: Financial risk is incurred when money is borrowed to finance the operation of farm business.
There is some chance that future income will not be sufficient to repay the debt. Changes may take place in the
interest rates, scale of finance, and ability of the business to generate income.
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RISK AVERSION
Most people have an aversion to risk if faced with a choice between the certainties of receiving
50/= or 50:50 chance of receiving 100/= or nothing, they would choose the former even though the EMV is the
same in each case.
In theory the avoidance of risk has a cost. In so far as profits are likely to be maximized in the long run
by always choosing the alternative with the highest EMU, some profits will be foregone if any other criterion is
used.
Agriculture economists have developed techniques of decision making that involve considerable cost in
terms of time and effort, if not money. Time and effort are involved in understanding these approaches,
collecting information, listing alternatives, predicting outcomes, estimating probabilities and evaluating the
financial outcomes.
In practice farmers are not concerned with finding the option or best possible choice of action. Instead
they have a certain limited objectives and suspiration levels, and any plan which satisfied these objectives will
be accepted.

DECISION MAKING UNDER RISK AND UNCERTAINITY

The financial outcome of a particular production decision cannot be predicted with complete accuracy because
1) The relevant production function will not be perfectly known
2) The quantities applied of some biological and climatic inputs lie outside the control of the decision
maker
3) Variation in prices paid for inputs and products
4) Yield uncertainty
5) Management performance
Therefore because of variation in the quantity of output and fluctuation in prices, no production decision has a
unique financial outcome.

RISK AND UNCERTAINTY

The assumption of perfect certainty in agricultural economic analysis is unrealistic.
Agricultural production decisions take place in an environment of uncertainty. Plans are made at one point in
time for a product which will be forthcoming at a future point in time.
Agriculture producers are faced with 2 types of eventualities or outcomes which have a bearing on plans for the
future.
Risk refers to variability of outcomes which are measurable in an empirical or quantitative manner. The
statistical probability of outcome can be established when
a) Samples large enough
b) The observations are repeated in the population
c) The observations are independent
Insurance companies can predict the statistical probability of fire losses, death etc with a degree of certainty
such that the phenomena under consideration can be classed as risk. Risk is insurable but uncertainty is not.
With uncertainty the probability of an outcome cannot be established in a quantitative sense.
Uncertainty is not insurable. Uncertainty includes all circumstances in which decisions must be made without
perfect knowledge i.e. climatic an origin and experience of weather patterns.
Uncertainty refers to cases where the probability of each outcome occurring are not accurately known.
Uncertainty includes all circumstances in which decisions must be made without perfect knowledge.

Farmers face 2 major types of imperfect knowledge

Yield uncertainty
Refers to the unpredictability of yields and arises from the variation in conditions of production beyond the
control of the farmer e.g. weather conditions and disease outbreak.
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This is absent in manufacturing and processing non-agricultural industries.
Price uncertainty – With regard to input and product prices
Prices to be realized by farmers range in accordance with actions of other producers, the degree of national
prosperity, changes in consumer tastes, weather variation etc. price instability or unpredictability is never quite
as great in other industries nor are they affected by weather-generated price variation. Monopolistic non-
agricultural industries have greater control of product and factor prices. Production of farm commodities
fluctuates more than would be the case if producers had complete control over the quantity of product produced
when the quantity of product in the market varies, price also changes. A change in demand and supply
conditions for inputs also alters the prices for inputs.

METHODS OF REDUCING RISK AND UNCERTAINTY

Selection of products with low variability
This involves selecting a greater number of „reliable‟ enterprises whose output has shown less variability in the
past. Farmers refer to enterprises with greater output fluctuations as „risky‟. In this way the farmer foregoes the
possibility of big gains but minimizes the possibility of large loses. Production methods and resource
combinations can also be selected which even though they do not result in maximum returns; they have the
effect of stabilizing income or minimizing the probability of variable returns.
Diversification: Selection of multiple products
It is employed as an uncertainty precaution where the immediate objective is not so much one of profit
maximization but one of stability of income. Diversification can be accomplished by increasing the amount of
resources so as to produce product A & B or the amount of resources can be held constant while part is shifted
to other products. The mixed farm is thought to provide more security than the specialist one because the
farmers believe that a bad year for one crop will be offset by a good year for another. It involves production of
several products at the same time. Through this, farmers spread the risk of loss over several commodities and
this reduces the risk of loss from the farm as a whole. Weather conditions which reduce the production of some
farm products will actually increase the production of others. Also prices of some farm commodities increase
when prices of other commodities decrease and vice versa. Due to this farmers are able to reduce the variability
in their incomes by producing several commodities.
Contract farming
Product price instability can be reduced through contract farming. Many processors of agricultural raw
materials like to know in advance how much of a commodity they will have for processing. In order to assure
themselves of the volume of product they desire, they often contract for the production of a specified amount to
be purchased at a guaranteed price.
Production on contract basis removes uncertainty as to price of the product at the time of sale. What lower
prices than would at the time. The risk of price changes is shared between the buyer and the producer.
Insurance
In the production of some products, farmers may insure against loss due to weather hazards and destruction
from insects and diseases. Insurers are able to accept the risk of loss, on individual farms because they spread
their will over a large number of farms. They are able to predict what percentage of farms, in aggregate, will
suffer damages. As a result of spreading their risk over a large number of products insurance Company are able
to absorb the risk of loss on individual farms. In purchasing insurance the farmer incur a cost.
Flexibility
Refers to the ease with which the organization of production can be changed. A flexible organization is one
where changes in production can be readily made so as to take advantage of improved knowledge in regard to
economic and technological changes. An example of flexibility is where some farmers decide to construct
buildings that have more than one use e.g. poultry buildings that can produce layers or broilers depending on
which is more profitable. Flexibility allows turning points in time or quick changes at lower cost.
Hedging: It is a technical procedure that involves trading in commodity futures contracts through a commodity
broker.

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