FARM MANAGEMENT.

 Apply economic principles and theories for optimum resource

allocation and utilization
 Identify various production relations in pursuit of optimal resources
combination that suites specific farm situation,
 Apply farm planning and budgeting techniques in farm management
decision-making
 Prepare farm plan and recommend on the feasible alternative activities.
 Apply management science and economics tools to solve farm related
problems,
 Analyze farm business investment opportunities for effective farm
planning,
 FARM MANAGEMENT.

 Apply economic principles and theories for optimum resource

allocation and utilization
 The outpouring of new technological information is making the farm
problems increasingly challenging and providing attractive opportunities
for maximizing profits.
 Hence, the application of economic principles to farming is essential for
the successful management of the farm business.
 Farm management deals with the business principles of farming from
the point of view of an individual farm.
 Some of the economic principles that help in rational farm management
decisions are discussed in this section.
 ECONOMIC PRINCIPLES APPLIED TO FARM MANAGEMENT.
(Chapter five production relation)
1. Law of variable proportions or Law of diminishing returns:
 It solves the problems of how much to produce ?
 It guides in the determination of optimum input to use and optimum
output to produce.
 It explains the one of the basic production relationships viz.,
factor-product relationship.
2. Cost Principle:
 It explains how losses can be minimized during the periods of
price adversity.
3. Principle of factor substitution:
 It solves the problem of ‘how to produce?.
 It guides in the determination of least cost combinations of
resources.
 It explains factor-factor relationship.
4. Principle of product substitution:
 It solves the problem of ‘what to produce?’.
 It guides in the determination of optimum combination of enterprises
(products).
 It explains Product-product relationship..
5. Principle of equi-marginal returns:
 It guides in the allocation of resources under conditions of
scarcity.
6. Time comparison principle:
 It guides in making investment decisions.
7. Principle of comparative advantage:
 It explains regional specialisation in the production of
commodities.
 1. The Law of Diminishing Returns/
Law of Variable Proportions/
Principle of Added Costs and Added Returns

• As quantity of one variable input is ↑ by equal amount

while the quantity of fixed input kept constant, TPP ↑ ↑ up
to (inflection pt), then ↑↓, maximum and ↓ beyound.

• Starts when MPPmax coincides with the point of inflexion

of the TPP curve.

• Guides the efficient allocation of resources.

 Cont…
 The law implies that;

 If fixed cost remain constant, it is only profitable to

increase the level of production if only the marginal
return is greater than the marginal cost.

 Thus, employ additional fertilizer as long as ;

 The added return is greater than the additional cost

of employing the fertilizer.
The F-P relationship or

1. the amount of resources that should be used

(optimum input) and;
2. the amount of product that should be produced
(optimum output)

 is directly related to the operation of law of

diminishing returns.
 Most Profitable level of production
(a) How much input to use (Optimum input to use)

 The farmer must select from all possible input levels,

which results in the greatest profit.

 To determine the optimum input to use;

 we apply two marginal concepts viz:

MVP and MIC/MFC

 Marginal Value Product (MVP)
• It is the additional income received from using an
additional unit of input.

MVP = ∆ TVP/∆ input level

MVP = ∆ Y. Py/ ∆ X

• Where, ∆ = Change; Y = Output and Py = Price/unit

 Marginal Input Cost (MIC) or
Marginal Factor Cost (MFC)
• The additional cost associated with the use of an additional
unit of input.

MFC = ∆ TIC/ ∆ Input level

MFC or MIC = ∆ X. Px/ ∆ X = Px

Where, X = input Quantity; and Px = Price per unit of input

• MFC is constant and equal to the price per unit of input.

• Provided the input price does not change (constant)

 Decision Rules
1. If MVP > MIC, additional profit can be made by using
more input.

2. If MVP < MIC, more profit can be made by using less

input.

3. Profit maximizing or optimum input level is at the

point where
MVP=MFC
 Determination of optimum input level –
Example Input price: Br12 per unit, Output price: Br 2 per
unit

Input level TPP MPP TVP (Rs) MVP (Rs) MIC (Rs)
X
0 0 -- -- -- --
1 12 12 24 24 12
2 30 18 60 36 12
3 44 14 88 28 12
4 54 10 108 20 12
5 62 8 124 16 12
6 68 6 136 12 12
7 72 4 144 8 12
8 74 2 148 4 12
9 72 -2 144 -4 12
10 68 -4 136 -8 12
 Form the above example;
 Maximum output will happen between input level 8
and 9.

 Here is the transition at which MPP becomes Zero.

 The profit maximizing point is the point at which

MVP=MFC=12

 After this point MVP starts to be <MFC

 (b) How much output to produce (Optimum output)

 To answer this question, we requires two new marginal concepts.

1. Marginal Revenue (MR): It is defined as the additional income
from selling additional unit of output.

Marginal Revenue = Change in TR/ Change in TPP

MR = ∆TR / ∆ Y
MR= ∆ Y.Py / ∆ Y
= Py
• Where, Y = output; and Py = price per unit of output

TR = TVP.

• MR is constant and equal to the price per unit of output.

 2) Marginal Cost (MC)

 It is defined as the additional cost incurred from

producing an additional unit of output.

Marginal Cost = ∆ TC / ∆ TPP

MC= ∆ X. P x/ ∆ Y

 Where, X= Quantity of input and Px= Price per unit

of input.
 Decision Rules:
1. If MR > MC, additional profit can be made by
producing more output.
2. If MR < MC, more profits can be made by producing
less output.
3. The profit maximizing output level is at the point where

MR=MC

∆Y. Py/∆Y=∆X. Px/∆Y

Py = ∆ X. Px/∆Y
∆ Y. Py = ∆ X. Px
 Determination of Optimum output to produce
(An example); Given: Input Price Br.2 per unit and output price Br.2
per unit
TPP MR (Br) MC (Br)
Input
TR (Br)
level
MPP
X
0 0 -- --
-
0 0 - - -
1 12 12 24 2.00 1.00
2 30 18 60 2.00 0.67
3 44 14 88 2.00 0.86
4 54 10 108 2.00 1.20
5 62 8 124 2.00 1.50
6 68 6 136 2.00 2.00
7 72 4 144 2.00 3.00
8 74 2 148 2.00 6.00
9 72 -2 144 2.00
10 68 -4 136 2.00
 In the above table
 MR is greater than MC up to the output level 62 units.

 At the output level of 68 units, the MR=MC.

 This is the optimum output to be produced.

 If we produce 72 units of output, additional revenue from

additional output is less than the additional cost of
producing output.

 Therefore profit decline.

 From the above graph
 If the farmer does not operate the farm the loss
would be Br 707 in the form of fixed costs.

 If farm is operated, gross income of Br 3150 exceeds

the VC (Br 2621) by Br 529.

 By this amount the loss of Br 707 on account of

FC gets reduced i.e., (Br 707-529 = Br 178).

 The loss would be reduced to Br 178 by operating

the farm.
 2. PRINCIPLE OF FACTOR SUBSTITUTION

 Explains one of the basic production relationships

viz., F-F r/ship.

 Guides in the determination of LCC of resources.

 It helps in making a management decision of how to

produce.
 Cont…
 Substitution of one input for another input occurs frequently in
agricultural production.

 E.g. one grain can be substituted for another or chemical fertilizers

for organic manure, machinery for labor, etc.

 The farmer must select that combination of inputs which will

produce a given amount of output for the least cost.

 The problem is to find the least cost combination of resources,

which maximize profit.
 p. Of input subs…..
Says that go on adding a resource so long as the
cost of resource being added is less than the
saving in cost from the resource being replaced.

If input X1 is being increased, and input X2 is

being replaced, increase the use of X1 so long as,
cost added is less than reduced cost (saved cost)
 Decision rules

1. If MRS > PR, costs can be reduced by using more

of added resource.

X 2 PX 1
 , increase use of X1
X1 PX 2
X1 PX 2
or  , increase use of X 2
X 2 PX 1
 Decision rules

2) If MRS < PR, costs can be reduced by using

more replaced resource.

X 2 PX 1
 , increase use of X 2
X1 PX 2
X1 PX 2
or  , increase use of X1
X 2 PX 1
 Decision rules
3) Least cost combination of resources is at the
point where MRS=PR

X 2 PX 1

X 1 PX 2
X 1 PX 2
or 
X 2 PX 1
Example: Selecting a Least-cost feed ratio :
(Price of grain: Br 4.40 per kg , price of hay : Br 3/- per kg)

Grains in Hay in kgs ΔX1 ΔX2 MRS PR

kgs (X1) (X2)
825 1350 - - - -
900 1130 75 220 2.93 1.47
975 935 75 195 2.60 1.47
1050 770 75 165 2.20 1.47
1125 630 75 140 1.87 1.47
1200 520 75 110 1.47 1.47
1275 440 75 80 1.07 1.47
The least cost combination of grain and hay is a combination of
1200 kgs of grain and 520 kgs of hay, as the SR =PR.
 3. PRINCIPLE OF PRODUCT SUBSTITUTION

 Explains the P-P relationship and helps in deciding the

optimum combination of products.

 Guides in making a decision of what to produce.

 Substitute one product for another product, if the

decrease in returns (from replaced product) is less than
the increase in returns (from added product)
 Decision rules
1. If MRPS < PR, profits can be increased by
producing more of added product.

Y2 PY 1
MRPSY 1,Y 2   , increase Y1
Y1 PY 2
Y1 PY 2
MRPSY 2,Y 1   , increase Y2
Y2 PY 1
 Decision Rule

2. If MRS > PR, profits can be increased by

producing more of replaced product.

Y2 PY 1
MRPSY 1,Y 2   , increase Y2
Y1 PY 2
Y1 PY 2
MRPSY 2 ,Y 1   , increase Y1
Y2 PY 1
 Decision Rule

3. Optimum combination of products is when

MRS=PR

Y2 PY 1
MRPSY 1,Y 2   , Or
Y1 PY 2
Y1 PY 2
MRPSY 2 ,Y 1  
Y2 PY 1
 Example : Selecting an optimum combination of enterprises
(PY1 = Br 280 per quintal; P Y2 = Br 400 per quintal)

Y1 Y2
(Quintals (Quintals Y1 MRS ↓ in ↑ in
Y2
) ) Y1, Y2 PR returns returns

0 60 - - - - - -
20 56 20 4 0.20 0.70 1600 5600
40 50 20 6 0.30 0.70 2400 5600
60 41 20 9 0.45 0.70 3600 5600
80 30 20 11 0.55 0.70 4400 5600
100 16 20 14 0.70 0.70 5600 5600
120 0 20 16 0.80 0.70 6400 5600
 From the above table

 Up to fifth combination MRS is less than PR.

 But at the sixth combination MRS = PR.

 Thus, the sixth combination which produces 100

quintals of Y1-corn and 16 quintals of Y2- wheat is the
optimum or profit maximizing combination.
 4. Cost Principle Or Minimum Loss Principle

 This principle guides the producers in the minimization

of losses.

 Costs are divided into fixed and variable costs.

 VC are important in determining whether to produce or not

.
 FC are important in making decisions on different
practices and different amounts of production.
 Cost in short run
The short run is a period of time for which two
conditions hold:

 The firm is operating under a fixed scale (fixed factor) of

production, and

 Firms can neither enter nor exit an industry.

 In the short run, all firms have costs that they must
bear regardless of their output.
 These kinds of costs are called fixed costs.
 Short-Run Fixed Cost (Total and Average) of a
Hypothetical Farm
(1) (2) (3)
q TFC AFC (TFC/q)
0 $1,000 $ --
1 1,000 1,000
2 1,000 500
3 1,000 333
4 1,000 250
5 1,000 200

 AFC falls as output rises; a

phenomenon sometimes
called spreading overhead.
 Variable Costs
 The total variable cost curve is a graph that shows
the relationship between total variable cost and the
level of a output.

 The total variable cost is

derived from production
requirements and input
prices.
 Derivation of Total Variable Cost Schedule
from Technology and Factor Prices
UNITS OF TOTAL VARIABLE
INPUT REQUIRED COST ASSUMING
USING (PRODUCTION FUNCTION) PK = $2, PL = $1
PRODUCT TECHNIQUE K L TVC = (K x PK) + (L x PL)

1 Units of A 4 4 (4 x $2) + (4 x $1) = $12

output B 2 6 (2 x $2) + (6 x $1) = $10

2 Units of A 7 6 (7 x $2) + (6 x $1) = $20

output B 4 10 (4 x $2) + (10 x $1) = $18

3 Units of A 9 6 (9 x $2) + (6 x $1) = $24

output B 6 14 (6 x $2) + (14 x $1) = $26

 The total variable cost curve shows the cost of

production using the best available technique at each
output level, given current factor prices.
The Shape of the Marginal Cost Curve in
the Short Run
Marginal costs ultimately increase with
output in the short run.
Graphing Total Variable Costs and
Marginal Costs
 Total variable costs always
increase with output. The
marginal cost curve shows
how total variable cost
changes with single unit
increases in total output.
 Below 100 units of output, TVC
increases at a decreasing rate. Beyond
100 units of output, TVC increases at
an increasing rate.
Relationship Between Average Variable Cost
and Marginal Cost
 When marginal cost is below
average cost, average cost is
declining.
 When marginal cost is above average
cost, average cost is increasing.

 Rising marginal cost intersects average

variable cost at the minimum point of
AVC.
 At 200 units of output, AVC is
minimum, and MC = AVC.
 Total Costs
 Adding TFC to TVC means
adding the same amount of
total fixed cost to every level
of total variable cost.

 Thus, the total cost curve

has the same shape as the
total variable cost curve; it is
simply higher by an amount
equal to TFC.
TC  TFC  TVC
Average Total Cost
• Average total cost (ATC) is
total cost divided by the
number of units of output
(q).

ATC  AFC  AVC

TC TFC TVC
ATC   
q q q

• Because AFC falls with output,

an ever-declining amount is
added to AVC.
Relationship Between Average Total Cost
and Marginal Cost
 If marginal cost is below
average total cost, average
total cost will decline toward
marginal cost.
 If marginal cost is above
average total cost, average
total cost will increase.
 Marginal cost intersects
average total cost and
average variable cost curves
at their minimum points.
Output Decisions: Revenues, Costs, and Profit
Maximization
 In the short run, a farm firm faces a demand curve that
is simply a horizontal line at the market equilibrium
price.
 Total Revenue (TR) and
Marginal Revenue (MR)
 Total revenue (TR) is the total amount that a firm
takes in from the sale of its output.

TR  P  q
 Marginal revenue (MR) is the additional revenue that a firm takes in
when it increases output by one additional unit.
 In perfect competition, P = MR.

 TR P(  q )
MR    P
q q
 Case 1
1) In the short run, the gross returns or TR must cover the TVC.

 i.e. Selling price must cover the AVC to continue

production in SR.
 MR = MC point may be at a level of output which may involve
loss instead of profit.

 Operating the farms when the price of product (MR) is less than
ATC, but greater than AVC (ATC>P>AVC)- common in
agriculture.

 Which explains the reason why the farmers keep farming

even when they run into losses.
 DECISION RULES
SHORT RUN:

1. If P selling > ATC minimum, profit is expected and is

maximized by producing where MR = MC.

2. If P selling < ATC minimum but > AVC minimum, a loss is

expected but the loss is less than TFC and is minimized by
producing where MR = MC.

3. If P selling < AVC minimum, a loss is expected but can be

minimized by not producing anything.
 The loss will be equal to TFC.
Profit-maximizing level of output
Economic Profits > 0

Economic profit
Economic loss (AVC<P< ATC)
Loss if shut down
If P < AVC, shut down
 The Short-Run Supply Curve

• At any market price, the marginal cost curve shows the output level that
maximizes profit.
 Case 2

In the long run, gross returns or TR must cover

TC. (P>ATC)

 i.e. Selling price must cover ATC to

continue production in LR.
 DECISION RULES
LONG RUN

• Production should continue in the LR when the P selling

> ATC minimum

• If P selling < ATC minimum, it result in continuous losses.

• Then, the fixed assets should be sold (Shut down) and you
have to invested money in more profitable
alternative.
 The following example illustrates the operation of cost principle.
Cost of cultivation of
(Br/ha)
groundnut
Total variable costs 2621.00
Total fixed costs 707.00
Total costs 3328.00
Yield (quintals) 9
Average variable cost 291
Average total cost 369.77
Selling price 430
Gross returns 3870
Net returns 542
Suppose the price declines to 350
Gross returns 3150
Net income -178
 From the above table
 If the price of groundnut per quintal is Br 430, for 9
quintals, farmer gets Br 3870 as gross income.

 The net income is Br. 542 (Br 3870 – Br 3328).

 Suppose the price decline to Br 350 per quintal, the net

income would be Br 178 (Br 3150 – Br 3870).

 Now the question is whether the farmer should

continue the production or not at the price of Br 350.
 5. Law of Equi-marginal Returns/ or
Principle of Limited Resources

 Says that returns from the limited resources will be

maximum if each unit of the resource should be used
where it brings greatest marginal returns.

 A limited input should be allocated among alternative

uses in such a way that the MVP of the last unit are
equal in all its uses.

 This law provides a guidelines for the rational

allocation of scare resources.
 5. LAW OF EQUI-MARGINAL RETURNS

• Since most of the farmers have limited resources, they must decide
how the limited input should be allocated or divided among
many possible uses or alternatives.

• Example;

1. You have to decide the best allocation of fertilizer;

among different crops (Teff, Barely, Wheat ect)

2. You have to decide the best allocation of Limited capital

to purchase (fertilizers, seeds, feed etc).
Example: A farmer has 3,000 Br and wants to grow
sugarcane, wheat and cotton.

To get maximum profits, what amount of money

must be spent on each enterprise
Amount MVP from
(Br.) Sugarcane (Br.) Wheat (Br.) Cotton (Br.)
500 800 (1) 750 650
(2) (6)
1000 700 (3) 650 (5) 560
1500 650(4) 580 550
2000 640 540 510
2500 630 520 505
3000 605 510 500
 From the table,
 The first Br 500 would be allocated to sugarcane as it has the
highest MVP.

 The second dose of Br 500 would be allocated to wheat as its MVP

is higher than that of cotton and sugarcane.

 The third would be used on sugarcane, the fourth, fifth and the
sixth on sugarcane, wheat and cotton respectively.

 Each successive Br of 500 is allocated to the crop which has

highest MVP remaining after previous allocation.

 The final allocation is Br 1500 on sugarcane, Br 1000 on wheat

and Br 500 on cotton.
 6. PRINCIPLE OF COMPARATIVE
ADVANTAGE
 Certain crops can be grown in only limited areas because
of specific soil and climatic requirements.

 Farmers in Jimma zone specialize in COFFEE

production while farmers in FICHE area specialize in
TEFF production.

 Regional speciation in the production of agricultural

commodities and other products can be explained by the
principle of comparative advantage.
 P. Comparative adv….
 While crops and livestock products can be raised over a
broad geographical area;
 the yields,
 production costs,
 profits may be different in each area.

 It is relative yields, costs, and profits which are important for

the application of this principle.

 Thus, ‘an Individuals or regions should specialize in the

production of those commodities for which their
resources give them a relative or comparative advantage.
 Specialization
• Involves the production of one type of product (specialize in
poultry only, diary only etc.

• The farmer may likely be more efficient in his operations

and techniques of the business.

• It’s drawback is that it involves risks because once the business

fails; there is no other way of producing other products.

• Failure can occur as a result of pest and disease outbreak etc.

 7. Time Comparison Principle
• Many farm decisions involve time.

• E.g. a farmer has to decide between a cereal crop pn. harvested

after 4 months or cash crops pn. Harvested after 3 years.

• Thus, you have to make decisions whether to invest money

today or tomorrow through;

1. Compounding method or ;
2. Discounting method
 Future value of a present sum:
 The future value of money refers to the value of an investment
in the future.

 It assumes that investment will earn interest which is reinvested

at the end of each time period.

 Compounding: is the procedure of determining the future

value of present sum.

FV  P 1  i 
• FV of present sum:
n

FV = Future value; P = the present sum; i = the interest rate; n = no of yr.

 Example:
Assume you have invested Br. 100 in a savings account which
earns 8% interest compounded annually and would like to know
the FV of this investment after 3 years.

Value at the
Value at beginning
Year Rate of Interest end of the year
of year (Br.)
interest earned (Br.) (Br.)
1 100 8% 8.00 108.00
2 108 8% 8.64 116.64
3 116.64 8% 9.33 125.97

 A present sum of Br 100 has a future value of Br 125.97

when invested at 8 per cent interest for 3 years.

 Interest is compounded when accumulated interest also

earns future interest.
 Present value of future sum:
 PV of future sum refers to the current value of money to be
received in the future.

 Discounting: is the procedure to find the PV of future sum.

 The discounting is done b/c sum to be received in the future

is worth somewhat less now b/s of the time difference,
assuming positive interest rate.

P
PV 
1  i 
n

PV = Present value; P = Future sum; i = rate of interest; n = no of

years.
 Example:
Find the present value of Br. 1000 to be received
in 5 years using an interest rate of 8%.

1000
PV   681
1  0.08 
5

 A payment of 1000 Br to be received in 5 years has

a present value of Birr 681 at 8% interest.