Lecture 2
(week 4)
Economic
Analysis for
Agricultural and
Environmental
Sciences
Today’s topics: Production
• What is Production?
• The Production Function
• Constant Returns to Inputs
• Diminishing Returns to a Variable Input
• Deriving cost curves for the farm-firm and short run
market supply for the farm-firm
• Profit maximisation
• Long run supply
• The impact of technical change on supply
• Elasticity of supply; factors affecting elasticity
What is Production?
"Production is the process that transforms
resources or inputs into products or services"
• Final Consumption, or Inputs to another
process
• Objective of business managers - make
money
• Maximise profit [profit = revenue – costs]
• At which point in production is profit
maximised?
Production Function
Notation
Y = Output
X1 = input number 1
X2 = input number 2
Xn = input number n
We specify the production function as,
Y = f (X1, X2, ... , Xn)
We now have n inputs
Example
Maize production, we have 5 inputs
Output of maize = Y
X1 = Fertiliser
X2 = Labour
X3 = Land
X4 = Management
X5 = Capital (all other inputs)
Constant Returns to Inputs
If we can group all inputs as one we may as
well write
Y = f (X)
where X = X1+X2+...+Xn
If increases in X lead to constant increases in Y,
then we have Constant Returns to Inputs.
Output can also be called "Total Physical
Product", as shown in figure 2.1
Figure 2.1 Total Physical Product
TPP
0
X
Diminishing Returns to a Variable
Input
• Constant returns are not realistic for most
business decisions in agriculture
• Some inputs are fixed, whilst some are
variable
• Consider our Maize example
Variable Input Example
Assume fertiliser is the only variable input and all
other inputs are fixed
Y = f (X1 X2, X3, X4, X5)
( ) means that everything to the right of ( ) is
fixed
As the use of X1 increases the EXTRA output from
each bag of fertiliser eventually decreases
"Diminishing Returns to a Variable Input’’
Marginal return: refers to the additional output
resulting from a unit increase in the use of variable
inputs, ceteris paribus.
In reality TPP looks like this:
.
Y
. .
T / ha
4
.
3.5 T.P.P
"Production is the process
.
2.5
that transforms resources
2
or inputs into products or
1.5
. services"
.
1
We must also be
0.5
concerned about the
cost of production
0 1 2 3 4 5 6 7 8 bags/ha
What is the producer’s ultimate goal?
To make money! So what else must be look at?
Revenues and Profits.
Revenue is defined as sales: Qsold x Price
Profit = Total Revenue – Total Cost
What would indicate the optimal point of production?
The point where Profit is maximum!
Do the producers know beforehand their
profit maximization point?
Not really!
But they do know the price and costs. So can they
work it out?
Maybe!
HOW?
Where would the profit maximization point
be?
Important note: Economic costs take into account
the opportunity cost
The opportunity cost is the cost of giving up the
next-best alternative.
This is not the case in accounting:
Accountants do not integrate this cost when
calculating costs (only the payments made)
This means accounting and economic definitions of
profit will be different !
Where would the profit maximization point
be?
The profit maximising condition
A firm’s profit is given by total revenue minus total
cost :
The firm chooses its output such that profit is
maximised (marginal profit is zero)
Deriving short run market supply for the farm-
firm
1.80
Price & 1.60
Cost MC MR
1.40
1.20
Cost ($ / Unit)
1.00
0.80
0.60
0.40
0.20
0.00
50 150 250 350 450 550 650 750
Y
700
Long run supply
Long run: all inputs variable
farms could expand area of land, increase capital,
employ labour
Also new firms can enter, attracted by profit
(Profit Max still where MR = MC)
as price rises:
more land (lower quality?)
more farms (lower management ability?)
diminishing returns still applies
The impact of Technical Change on supply
S1 S2
P
Q1 Q2 Q
Technical Change: the shift in supply due
to the adoption of technical innovations
(new varieties, better breeding)
Price Elasticity of Supply
The Price Elasticity of Supply (Es) measures the
responsiveness of quantity supplied (Qs) to a change in price
(P), ceteris paribus.
Es = Percentage change in Qs given a percentage change in P
• Elastic (Es > 1)
• Inelastic (0 < Es < 1)
• Perfectly inelastic (0)
• Unit Elastic (Es = 1)
Elasticity of Supply
P S3 ?
S1
S2
P2
P1
Q1 Q2 Q2a Q
S2 is more elastic than S1
between P1 and P2
Factors that Influence Supply
Qs = f (Own price,
Production functions,
Shifts in supply
Price other, curve are caused
by factors other
Price inputs, than own price
(e.g. technical
Number of firms,
change)
Farmer objectives,
Size distribution)
Why does it matter?
Elasticity measures how responsive resource
allocation is to changing price
Inelastic supply? Given shift in demand will cost
more to supply (price rise will be greater)
Elastic supply? Price rises may not last long
Supply shifts are a problem – particularly when
combined with inelastic demand
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