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Chapter 7 Economic Principles Choosing Production Levels

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Input TPP APP MPP TVP TR MR. 0 0 0 0 0. 1 12 12 12 24 24 2. 2 30 15 18 60 60 2 ... Assume you have 2400 acre-inches of water available to you. ... – PowerPoint PPT presentation

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Title: Chapter 7 Economic Principles Choosing Production Levels


1
Chapter 7Economic Principles Choosing
Production Levels
2
Introduction
  • Economic principles consist of a set of rules,
    which together ensure that the choice or decision
    made will result in maximum profit
  • Steps
  • Acquire physical and biological data
  • Acquire price data
  • Apply economic decision making rule to maximize
    profit

3
Marginalism
  • Marginal incremental changes, increases or
    decreases, that occur at the edge or the margin
  • May be useful to substitute the word additional
    or extra whenever the word marginal is used
  • Ex You may be interested in how cotton yield
    changes from using an additional 50 of fertilizer

4
Marginalism
  • To calculate, it is necessary to find the
    difference between an original value and the new
    value that resulted from the change in the
    controlling factor
  • We will use a small triangle for shorthand
    meaning the change in
  • Ex corn yield would be read as the change
    in corn yield and would be the difference in corn
    yield before and after some change in an input
    affecting yield

5
Production Function
  • Relationship between inputs and outputs
  • Can be presented in the form of a table, graph,
    or mathematical equation

6
Production Function
  • Input Output (TPP)0 0
  • 1 12
  • 2 30
  • 3 44
  • 4 54
  • 5 62
  • 6 68
  • 7 72
  • 8 74
  • 9 72
  • 10 68

7
Average Physical Product
  • Average Physical Product (APP) is the average
    amount of output produced per unit of input at
    each input level
  • Measures productivity
  • Ex APP 5 means that 5 units of output were
    produced on average per unit of input
  • Ex APP 3 means that 3 units of output were
    produced on average per unit of input
  • APP TPP / Input

8
Production Function APP
Input Output (TPP) APP0 0 0 1 12
12 2 30 15 3 44 14.7 4 54 13.5 5 62 1
2.4 6 68 11.3 7 72 10.3 8 74
9.3 9 72 8 10 68 6.8
9
Marginal Physical Product
  • Marginal Physical Product (MPP) is the
    additional or extra TPP produced by using an
    additional unit of input
  • Ex MPP 5 means that 5 additional units of TPP
    are produced from an additional unit of input
  • MPP TPP / Input

10
Production Function (APP MPP)
Input Output (TPP) APP
MPP0 0 0 1 12 12 12 2 30 15 18 3 44
14.7 14 4 54 13.5 10 5 62 12.4
8 6 68 11.3 6 7 72 10.3 4 8 74
9.3 2 9 72 8 -2 10 68 6.8 -4
11
Graphical Analysis
  • TPP increases at an increasing rate at the
    beginning of the production process
  • Then TPP while still increasing, does so at a
    decreasing rate
  • Finally, as more input is used, output actually
    declines
  • MPP measures this relationship

12
Graphical Analysis
  • Whenever, MPP gt APP, APP is increasing
  • WHY???
  • Whenever, MPP lt APP, APP is decreasing
  • WHY???
  • The Production Function can be divided into 3
    stages

13
Law of Diminishing Marginal Returns
  • Law of Diminishing Marginal Returns as
    additional units of input are used in combination
    with one or more fixed inputs, marginal
    productivity will eventually begin to decline
  • Often the case in agriculture
  • Law is based on biological processes, resulting
    from the inability of plants and animals to
    provide the same response indefinitely to
    successive increases in input

14
How much input to use?
  • NOT Stage 3
  • For an input level in Stage 3, the same output
    could be obtained with less input from one of the
    other stages
  • NOT Stage 1
  • APP is still increasing, incentive to produce
    more
  • Soon we will show that profit can be increased
    even if productivity is decreasing
  • STAGE 2 Optimal!
  • We now have a range of inputs and output narrowed
    down
  • We must have price information to determine where
    in Stage 2 maximizes profit

15
Marginal Value Product
  • Marginal Value Product (MVP) additional or
    marginal income received from using an additional
    unit of input
  • MVP TVP / Input
  • TVP TPP Output price

16
Production Function
Input TPP APP MPP TVP MVP0 0
0 0 1 12 12 12 24 24 2 30 15 18 60
36 3 44 14.7 14 88 28 4 54 13.5 10 108 20 5 6
2 12.4 8 124 16 6 68 11.3 6 136 12 7 72 10.3
4 144 4 8 74 9.3 2 148 4 9 72 8
-2 144 -4 10 68 6.8 -4 136 -8
Input Price 12 Output Price 2
17
Marginal Input Cost
  • Marginal Input Cost change in total input cost,
    or the additional total input cost caused by an
    additional unit of input
  • MIC TIC / Input
  • TIC Input level Input price
  • If the input price does not change as more input
    is purchased, then MIC input price

18
Production Function
Input Price 12 Output Price 2
Input TPP APP MPP TVP MVP TIC
MIC0 0 0 0
0 1 12 12 12 24 24 12 12 2 30 15 18 60 36
24 12 3 44 14.7 14 88 28 36 12 4 54 13.5 10 108
20 48 12 5 62 12.4 8 124 16
60 12 6 68 11.3 6 136 12 72 12 7 72 10.3
4 144 4 84 12 8 74 9.3 2 148 4
96 12 9 72 8 -2 144 -4 108 12 10 68 6.8
-4 136 -8 120 12
19
The Input Decision Rule
  • MVP MIC
  • If they are not equal MVP gt MIC
  • When MVP gt MIC additional income received from
    using one more unit of input exceeds the
    additional cost of that input
  • Therefore, additional profit is made with each
    additional unit of input
  • If MVP lt MIC, more profit can be made with less
    input
  • Can also use the rule MPP Price Input / Price
    Output

20
How much Output to Produce?
  • We just looked at how much input to use to
    maximize profit.
  • There is a related question.
  • How much output to produce?

21
Marginal Revenue
  • Marginal Revenue (MR) change in income or
    additional income received from selling one more
    unit of output
  • MR TR / TPP
  • TR TVP TPP output price
  • MR will uaually equal the price of the output.
  • The additional income received from selling one
    more unit of output will equal the price received
    for that output.
  • The formula should be used if the output price
    changes with the quantity sold

22
Production Function
Input Price 12 Output Price 2
Input TPP APP MPP TVP TR MR
0 0 0 0 0
1 12 12 12 24 24 2 2 30 15 18 60
60 2 3 44 14.7 14 88 88 2 4 54 13.5 10 108 1
08 2 5 62 12.4 8 124 124 2 6 68 11.3
6 136 136 2 7 72 10.3 4 144 144 2 8 74
9.3 2 148 148 2 9 72 8 -2 144 144 10 68
6.8 -4 136 136
23
Marginal Cost
  • Marginal Cost (MC) change in cost, or the
    additional cost incurred from producing one more
    additional unit of output
  • MC TIC / TPP

24
Production Function
Input Price 12 Output Price 2
Input TPP APP MPP TVP TR MR
MC 0 0 0 0 0
1 12 12 12 24 24 2 1.00 2 30 15 18 60
60 2 .67 3 44 14.7 14 88 88 2
.86 4 54 13.5 10 108 108 2
1.20 5 62 12.4 8 124 124 2 1.50 6 68 11.3
6 136 136 2 2.00 7 72 10.3 4 144 144 2 3.00 8
74 9.3 2 148 148 2 6.00 9 72 8
-2 144 144 10 68 6.8 -4 136 136
25
The Output Decision Rule
  • MR MC
  • MR gt MC the additional unit of output increases
    profit because the additional income exceeds the
    additional cost
  • MR lt MC producing the additional unit of output
    will decrease profit
  • NOTICE!!!The optimal level of output corresponds
    with the optimal level of input on the production
    function

26
Applying the Marginal Principles
  • Common management decision is how much fertilizer
    to apply per acre for a certain crop
  • Using the production function data, which can be
    obtained from experimental data, we can generate
    MVPs for each crop at various input levels

27
Equal Marginal Principle
  • Manager must decide or allocate the input among
    several alternatives.
  • The equal marginal principle states that a
    limited input should be allocated among
    alternative uses in such a way that the MVP of
    the last unit used on each alternative are equal.

28
Example
  • Assume you can apply water in increments of 4
    acre-inches per 100 acres (or 400 acre-inches at
    a time)
  • You have 3 crops on 100 acres of land each
    (wheat, grain sorghum, and cotton)
  • How should you allocate the water to make the
    most money?
  • FIRST obtain the MVPs for each crop

29
  • MVPs ()
  • Water Wheat Grain Sorghum Cotton
  • (acre-inch) (100 ac.) (100 ac.)
    (100 ac.)
  • 0
  • 4 1200 1600 1800
  • 8 800 1200 1500
  • 12 600 800 1200
  • 16 300 500 800
  • 20 50 200 400

30
Example
  • Assume you have 2400 acre-inches of water
    available to you.
  • To determine where to apply the water, refer to
    the MVPs
  • The first 400 acre-inches should go to cotton
    because it has the highest MVP
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