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Economic Decision Making

Economic Decision Making. Marginal analysis changes at the “margin” examining the results of an additional unit. Production Functions. Total Physical Product (TPP) Total output produced with a given level of an input Average Physical Product (APP) Average output for each unit of input

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Economic Decision Making

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  1. Economic Decision Making • Marginal analysis • changes at the “margin” • examining the results of an additional unit AGEC 407

  2. Production Functions • Total Physical Product (TPP) • Total output produced with a given level of an input • Average Physical Product (APP) • Average output for each unit of input • Marginal Physical Product (MPP) • Additional output gained from and additional unit of input AGEC 407

  3. Production Functions • Law of diminishing marginal returns • As additional inputs are used, in combination with fixed inputs, eventually MPP will decline • Variable costs • change with production level • Fixed costs • do not change with output level • are not considered in short-run decision making AGEC 407

  4. Production Functions • Stage I • From zero input to max APP • Stage II • From max APP to max TPP • Stage III • Beyond max TPP AGEC 407

  5. Choosing Input Levels • Marginal Value Product • additional income received by using an additional unit of input • Marginal Input Cost • cost of an additional unit of input • usually the price of the input AGEC 407

  6. Choosing Output Levels • Marginal Revenue • Change in revenue from selling one more unit • usually the output price • Marginal Cost • Change in total cost from producing one more unit of output AGEC 407

  7. Choosing Input Combinations • Maximize profits by finding the least-cost combination of inputs • Isoquant line • Represents different combinations of two inputs that result in the same output AGEC 407

  8. Choosing Input Combinations • Increase profits if different combo of inputs decreases costs more than increases • Substitution Ratio • Δ input replaced / Δ input added • Price Ratio • Price of input added / Price of input replaced • Substitution Ratio = Price Ratio • SR not less than PR AGEC 407

  9. Choosing Output Combinations • Find profit maximizing combination of outputs to produce with available resources • Production Possibilities Curve (Frontier) • Maximum quantities that can be produced with the resources available AGEC 407

  10. Choosing Output Combinations • Increase profits if different combo of outputs increases profits more than decreases • Substitution Ratio • Δ output replaced / Δ output added • Profit Ratio • Profit from output added / Profit from output replaced • Profit Ratio = Substitution Ratio • PR not less than SR AGEC 407

  11. Economic Cost Theory • Opportunity Cost • Value of input in its highest alternative use • Accounts for resources that are tied up by current production process • If you have $300,000 in equity invested in your farm, you could safely be earning 6% per year in a money market account • Annual opportunity cost = $18,000 AGEC 407

  12. Economic Cost Theory • Short Run • Longest period of time during which at least one input cannot be varied • Usually one production cycle or year • Long Run • All input quantities can be varied • More land can be acquired • All resources can be sold AGEC 407

  13. Economic Cost Theory • Fixed costs • Do not change with changes in output level • Only exist in the short run • Variable costs • Increase with increases in output • All costs variable in the long run AGEC 407

  14. Economic Cost Theory • Total cost = Fixed cost + Total Variable cost • Average Total Cost (ATC) • Total cost / Output • Average Fixed Cost (AFC) • Fixed cost / Output • Average Variable Cost (AVC) • Total variable cost / Output AGEC 407

  15. Economic Cost Theory • Marginal Cost • Change in total cost from producing one more unit of output • Intersects AVC and ATC at their minimum points; Why is this always ture? • When cost of last unit is greater than the average, it pulls the average up AGEC 407

  16. Economic Cost Theory • Short Run Rule for Production • Produce where MR = MC • As long as MR > AVC • If ATC > MR > AVC • Losses will be minimized by producing where MR = MC AGEC 407

  17. Economic Cost Theory • Long Run Rule for Production • Produce where MR = MC • As long as MR > ATC • If ATC > MR • Do not produce • All inputs are variable in Long Run AGEC 407

  18. Economies of Size • Based on Long Run Average Costs • Exist where LRAC are decreasing as output increases • Optimal to produce where LRAC are minimum AGEC 407

  19. Economies of Size • Result from: • Spreading fixed costs over more output • Full utilization of labor, machinery, buildings • Some technologies • Diseconomies of size • Where LRAC are increasing with output • Results from: • Insufficient management skill • Distance from barn to outlying fields AGEC 407

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