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Farm Management

Farm Management. Chapter 7,8,9 Review of Economic Principles . 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. Marginalism.

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Farm Management

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  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 > MIC, additional profit can be made by using more input. If MIC > 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 MR=MC The decision rule, MR=MC, leads to the same point as the decision rule MVP=MIC.

  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 • MC=AVC 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

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