Farm Management

1
Farm Management

• Chapter 7,8,9
• Review of Economic Principles

2
Economic Concepts

• You should have seen most of these concepts in
  Principles
• If these concepts are not familiar, read the book
  chapters carefully and/or go back to your notes
  from Principles.

3
Marginalism
The term marginal refers to incremental changes,
either increases or decreases, that occur at the
edge or at the margin. It may help to mentally
substitute extra or additional whenever the
word marginally is used. But keep in mind that
the extra can be negative.
4
The Production Function
The production function is a systematic way of
showing the relation between different amounts
of a resource or input that can be used to
produce a product and the corresponding output.
5
Total Physical Product
Total physical product (TPP) is the amount of
production expected from using each input level.
Output or yield is often called total physical
product.
6
Average Physical Product
Average physical product (APP) is the average
amount of output produced per unit of input
used. APP
TPP
input level
7
Marginal Physical Product
Marginal physical product (MPP) is the
additional TPP produced by using an additional
unit of input. MPP
?TPP
? input level
8
Law of Diminishing Marginal Returns
As additional units of a variable input are used
in combination with one or more fixed inputs,
marginal physical product will eventually begin
to decline. Diminishing returns may start with
the first unit of input used, or may start later
after a period of increasing returns.
9
Marginal Value Product
? total value product
MVP
? input level
TVP TPP product selling price If output
price is constant MVP MPP product selling
price
10
Marginal Input Cost
? total input cost
MIC
? input level
TIC amount of input input price If input
price is constant MIC input selling price
11
Table 7-2 Marginal Value Product, Marginal
Input Cost and the Optimum Input Level
input price 12 output price 2
12
The Decision Rule
MVP MIC If MVP gt MIC, additional profit can
be made by using more input. If MIC gt MVP, less
input should be used.
13
How Much Output to Produce
An alternative way to find the profit-maximizing
point is to find directly the amount of output
that maximizes profit.
14
Marginal Revenue
? total revenue
MR
? total physical product
Total revenue Total value product If output
price is constant MR output selling price
15
Marginal Cost
? total input cost
MC
? total physical product

16
The Decision Rule
MRMC
The decision rule, MRMC, leads to the same point
as the decision rule MVPMIC.
17
Table 7-3 Marginal Revenue, Marginal Cost and
the Optimum Output Level
input price 12 output price 2
18
Applying the Marginal Principles
Given prices for irrigation water and for corn,
the principles from the last two sections can be
used to determine the amount of water and the
corresponding amount of corn that will maximize
profit.
19
Table 7-4 Determining the Profit-Maximizing
Irrigation Level for Corn Production
water at 3.00/acre-inch, corn at 2.50/bu
20
Equal Marginal Principal
In some situations an input may be limited so
that the profit-maximizing point cannot be
reached for all possible uses. A limited input
should be allocated among competing uses in such
a way that the marginal value products of the
last unit used on each alternative are equal.
21
Table 7-5 Application of the Equal Marginal
Principle to the Allocation of Irrigation Water
22
Input Combinations
Most products require two or more inputs, and the
manager may choose the input combination or ratio
to use. The economic question is whether one
input can be substituted for another to reduce
the cost.
23
Types of Input Substitution

• Constant rate (perfect substitution)
• Decreasing rate
• No substitution

24
Figure 8-1Three possible types of substitution
25
Input Substitution Ratio
Input substitution ratio amount of
input replaced amount of input added
26
Input Price Ratio
Input price ratio price of input being added
price of input being replaced
27
Decision Rule
input substitution ratio input price ratio If
they cannot be exactly equal because of the
choices available in the table, get as close as
possible without letting the price ratio exceed
the substitution ratio.
28
Table 8-1 Selecting a Least-Cost Feed Ration
grain at 4.4 and hay at 3.0
29
With Different Types of Substitution

• With a constant rate of substitution, the
  least-cost combination will be all of one input
  and none of the other (unless the price ratio is
  exactly equal to the constant rate of
  substitution).
• With a decreasing rate of substitution, the
  least-cost combination will usually include some
  of each input.

30
Enterprise Combinations
We will study the chapter 8 material on
enterprise combinations in our next unit, when
we talk about farm planning. You may skip it for
now.
31
Cost Concepts

• Opportunity Costs
• Fixed Costs
• Variable Costs

32
Opportunity Cost

• The value of a product not produced because an
  input was used for another purpose, or
• The income that could have been received if the
  input had been used in its most profitable
  alternative use

33
Everything Has an Opportunity Cost
Even if you use the input in its best possible
use, there is an opportunity cost for the item
you did not produce. (In this case, opportunity
cost will be less than the revenue actually
received.)
34
How Does Opportunity Cost Relate to the
Equi-Marginal Principle?
With the Equi-Marginal Principle, we are choosing
to produce one product instead of another. The
opportunity cost is the revenue given up from
the crop not produced.
35
Opportunity Cost of Operator Time

• Opportunity cost of operator's labor What the
  operator could earn for that labor in best
  alternative use
• Opportunity cost of operator's management
  Difficult to estimate
• Total of opportunity cost of labor and
  opportunity cost of management should not exceed
  total expected salary in best alternative job

36
Opportunity Cost of Capital
The opportunity cost of capital is often set
equal to what the capital could earn in a
no-risk savings account. Total dollar value of
the capital inputs is estimated and multiplied by
the interest rate for a savings account.
37
Costs

• Total Fixed Cost (TFC)
• Average Fixed Cost (AFC)
• Total Variable Cost (TVC)
• Average Variable Cost (AVC)
• Total Cost (TC)
• Average Total Cost (ATC)
• Marginal Cost (MC)

38
Cost Concepts
These seven costs are output related. Marginal
cost is the cost of producing an additional unit
of output. The others are either the total or
average costs for producing a given amount of
output.
39
Short Run and Long Run
The short run is the period of time during which
the quantity of one or more production inputs is
fixed and cannot be changed. The long run is
the period of time in which the amount of all
inputs can be changed.
40
Fixed Costs

• Fixed costs exist only in the short run.
• In the short run, fixed costs must be paid
  regardless of the amount of output produced.
• Fixed costs are not under the control of the
  manager in the short run.

.
41
Depreciation is a Fixed Cost
Annual depreciation using the
straight-line method is Original Cost
Salvage Value Useful Life
42
Interest is a Fixed Cost
Cost Salvage Value
Interest ? r
2
r the interest rate
43
Other Fixed Costs
Property taxes and insurance are also fixed
costs. Some repairs may be fixed costs, if
they are for maintenance. In practice, machinery
repairs are usually counted as variable costs,
while building repairs are counted as fixed.
44
Computing Total Costs

• Total Fixed Cost (TFC) The sum of all fixed
  costs
• Total Variable Cost (TVC) The sum of all
  variable costs
• Total Cost (TC) TVC TFC

45
Average and Marginal Costs

• Average Fixed Cost (AFC) TFC/Output
• Average Variable Cost (AVC) TVC/Output
• Average Total Cost (ATC or AC) TC/Output
• Marginal Cost ?TC/ ?Output or ?TVC/
  ?Output

46
Figure 9-1 Typical total cost curves
47
Figure 9-2 Average and marginal cost curves
48
Things to Notice

• AFC always decreases
• MC may decrease at first but it eventually must
  increase
• AVC and ATC are typically U-shaped
• MCAVC at minimum point of AVC
• MC ATC at minimum point of ATC
• ATC approaches AVC from above

49
Figure 9-3 Cost curves for a diminishing
marginal returns production function
50
Table 9-2 Illustration of Cost Concepts Applied
to a Stocking Rate Problem
51
Application of Cost Concepts
Cost concepts can be used in both short and
long-run decision making.
52
Production Rules for the Short Run

• If Price gt ATC, produce and make a profit.
• If ATCgtPricegtAVC produce and minimize losses.
• If AVCgt Price, do not produce and limit your loss
  to your fixed costs.

53
Logic behind These Rules
Fixed costs must be paid whether you produce or
not in any given year. They are therefore
irrelevant to the production decision. You look
at variable costs. If you can cover those, you
should produce. If you cant, you dont produce.
54
Producing at a Loss Example
Fixed Costs are 10,000. At the point where
MRMC, TVC are 8,000 and TR is 12,000. If
I dont produce, I will have a loss of
_______ If I do produce, I will have a loss of
_________ I should produce to minimize losses.
10,000
6,000
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If Losses Exceed Fixed Costs
Fixed Costs are 10,000. At the point where
MRMC, TVC are 15,000 and TR is 12,000. If
I dont produce, I will have a loss of
_______ If I do produce, I will have a loss of
_________ I should not produce
10,000
13,000
.
56
Figure 9-5 Illustration of short-run production
decisions
57
Dont Produce Graphical View
ATC
AVC
loses more than fixed cost
MR Price
MC
Output
58
Produce at a Loss Graphical View
ATC
loses less than fixed cost
AVC
MR Price
MC
Output
59
Produce at a Profit Graphical View
ATC
per-unit profit
AVC
MR Price
MC
Output
60
Production Rules for the Long Run

• Price gt ATC. Continue to produce at the point
  where MRMC.
• Price lt ATC. Stop production and sell fixed
  assets.

61
Economies of Size

• What is the most profitable farm size?
• Can larger farms produce food and fiber more
  cheaply?
• Are large farms more efficient?
• Will family farms disappear and be replaced by
  corporate farms?
• Will farm numbers continue to fall?

62
Figure 9-6Farm size in the short run
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Measuring Economies of Size
Percent Change in Costs Percent Change in
Output Value
64
Figure 9-7Possible size-cost relations
65
Causes of Economies of Size

• Full utilization of existing resources
• Technology
• Use of specialized resources
• Decreasing input prices
• Higher output prices
• Management

66
Causes of Diseconomies of Size

• Management
• Labor supervision
• Geographical dispersion
• Special problems of large livestock operations

67
Figure 9-8Two possible LRAC curves