Agri 2312 chapter 6 introduction to production and resource use

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

© 2010 Pearson Higher Education,Upper Saddle River, NJ 07458. • All Rights

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Introduction toProduction and

Resource Use

Chapter 6



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Topics of Discussion

Conditions of perfect competitionClassification of inputsImportant production relationships

(assume one variable input in this chapter)

Assessing short run business costsEconomics of short run decisions



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Conditions for Perfect Competition

Homogeneous productsNo barriers to entry or exitLarge number of sellersPerfect information

Page 86



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Classification of Inputs

Land: includes renewable (forests) and non-renewable (minerals) resources

Labor: all owner and hired labor services, excluding management

Capital: manufactured goods such as fuel, chemicals, tractors and buildings

Management: production decisions designed to achieve specific economic goal

Pages 86-87



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Production Function

Output = f(labor | capital, land, and management)

Start withone variable

input


input

Page 88



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Production Function

Output = f(labor | capital, land, and management)


input


input

assume all other inputsfixed at their currentlevels…

assume all other inputsfixed at their currentlevels…

Page 88



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Coordinates of input andoutput on the TPP curve

Coordinates of input andoutput on the TPP curve

Page 89



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Page 89

Total Physical Product (TPP) Curve

Variable inputVariable input



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Law of DiminishingMarginal Returns

“As successive units of a variableinput are added to a production process with the other inputs heldconstant, the marginal physicalproduct (MPP) eventually declines”

Page 93



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Other Physical RelationshipsThe following derivations of the TPP curve playAn important role in decision-making:

MarginalPhysical = Output ÷ InputProduct

Page 90



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Other Physical RelationshipsThe following derivations of the TPP curve playAn important role in decision-making:

MarginalPhysical = Output ÷ InputProduct

AveragePhysical = Output ÷ InputProduct

Pages 90-91



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Change in output asyou increase inputs

Change in output asyou increase inputs

Page 89



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Page 89


outputoutput

inputinput

Marginal physical product is .45 as labor is increased from 16 to 20

Marginal physical product is .45 as labor is increased from 16 to 20

4.8

3



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Page 89

Output per unitinput use

Output per unitinput use



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Page 89


outputoutput

inputinput

Average physical product is .31 if labor use is 26

Average physical product is .31 if labor use is 26



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Plotting the MPP curvePlotting the MPP curve

Page 91

Change in outputassociated with achange in inputs

Change in outputassociated with achange in inputs



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Marginal Physcial ProductMarginal Physcial Product

Page 91

Change from point A to point B on the production function is an MPP of 0.33

Change from point A to point B on the production function is an MPP of 0.33



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Page 91

Plotting the APP CurvePlotting the APP Curve

Level of outputdivided by the levelof input use

Level of outputdivided by the levelof input use



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Page 91

Average Physical ProductAverage Physical Product

Output dividedby labor use is equal to 0.19

Output dividedby labor use is equal to 0.19



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Page 91

Three Stages of ProductionThree Stages of Production

Average physicalproduct (yield) is

increasing in Stage I

Average physicalproduct (yield) is

increasing in Stage I



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Page 91


Marginal physicalproduct falls below the

average physicalproduct in Stage II

Marginal physicalproduct falls below the

average physicalproduct in Stage II



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Page 91


MPP goes negativeas shown on Page 89…

MPP goes negativeas shown on Page 89…



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Page 91


Why are Stage I andStage III irrational?

Why are Stage I andStage III irrational?



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Page 114


Productivity rising so why stop???

Productivity rising so why stop???

Output falling

Output falling



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The question therefore is where should I operate in Stage II?

The question therefore is where should I operate in Stage II?

Page 114



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Economic DimensionWe need to account for the price of

the product.We also need to account for the cost

of the inputs.Total Cost of production is the costs

associated with the use of all inputs – Fixed costs

– Variable costs



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Key Cost RelationshipsThe following cost derivations play a keyrole in decision-making:

Marginal cost = total cost ÷ output

Page 94-96



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Averagevariable = total variable cost ÷ output cost

Page 94-96



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Averagevariable = total variable cost ÷ output cost

Average total = total cost ÷ output cost

Page 94-96



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From TPP curve onpage 89

From TPP curve onpage 89

Page 94



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Fixed costs are$100 no matter

the level ofproduction

Fixed costs are$100 no matter

the level ofproduction Page 94



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Column (2)divided bycolumn (1)

Column (2)divided bycolumn (1)

Page 94



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Page 94

Costs that varywith level of production

Costs that varywith level of production



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Page 94

Column (4) divided by column (1)

Column (4) divided by column (1)



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Page 94

Column (2) plus

column (4)

Column (2) plus

column (4)



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Page 94

Change in column (6) associated with a

change in column (1)

Change in column (6) associated with a

change in column (1)



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Page 94

Column (6) divided by column (1) or

Column (6) divided by column (1) or



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Page 94

or column (3) pluscolumn (5)

or column (3) pluscolumn (5)



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Let’s graph the cost series in this table



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Plotted cost relationshipsfrom table 6.3 on page 94

Plotted cost relationshipsfrom table 6.3 on page 94

Page 95

OSDO BE

Plotting costs for levels of outputPlotting costs for levels of output



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Marginal and Average Revenue

• Marginal revenue = ∆total revenue ÷ ∆output



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Now let’s assume this firm can sell its

product for $45/unit



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Key Revenue ConceptsKey Revenue Concepts

Notice the price in column (2) is identical to marginal revenue in column(7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition.

Notice the price in column (2) is identical to marginal revenue in column(7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition.

Page 98



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Let’s see this in graphical form



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Page 99

Profit maximizinglevel of output,where MR=MC

Profit maximizinglevel of output,where MR=MC

P=MR=AR $45$45

11.211.2



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Page 99

AverageProfit = $17, or AR – ATC

AverageProfit = $17, or AR – ATC

P=MR=AR

$45-$28$45-$28

$28$28



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Grey area representstotal economic profitif the price is $45…

Grey area representstotal economic profitif the price is $45…

Page 99

P=MR=AR

11.2 ($45 - $28) = $190.4011.2 ($45 - $28) = $190.40



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Zero economic profitif price falls to PBE.Firm would only produceoutput OBE . AR-ATC=0

Zero economic profitif price falls to PBE.Firm would only produceoutput OBE . AR-ATC=0 Page 99

P=MR=AR



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Economic lossesif price falls to PSD.Firm would shut downbelow output OSD

Economic lossesif price falls to PSD.Firm would shut downbelow output OSD Page 99

P=MR=AR



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Where is the firm’ssupply curve?

Where is the firm’ssupply curve?

Page 99

P=MR=AR



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Page 99

P=MR=AR

Marginal cost curveabove AVC curve?

Marginal cost curveabove AVC curve?



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Key Revenue ConceptsKey Revenue Concepts

Page 98

The previous graph indicated that profit is maximized at 11.2units of output, where MR ($45) equals MC ($45). This occursbetween lines G and H on the table above, where at 11.2 unitsof output profit would be $190.40. Let’s do the math….

The previous graph indicated that profit is maximized at 11.2units of output, where MR ($45) equals MC ($45). This occursbetween lines G and H on the table above, where at 11.2 unitsof output profit would be $190.40. Let’s do the math….



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Doing the math….Produce 11.2 units of output (OMAX on p. 99)Price of product = $45.00Total revenue = 11.2 × $45 = $504.00



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Doing the math….Produce 11.2 units of outputPrice of product = $45.00Total revenue = 11.2 × $45 = $504.00

Average total cost at 11.2 units of output = $28Total costs = 11.2 × $28 = $313.60Profit = $504.00 – $313.60 = $190.40



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Doing the math….Produce 11.2 units of outputPrice of product = $45.00Total revenue = 11.2 × $45 = $504.00


Average profit = AR – ATC = $45 – $28 = $17Profit = $17 × 11.2 = $190.40



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Profit at Price of $45?

28

P =45

$

Q11.2

MC

ATC

AVC

Revenue = $45 11.2 = $504.00Total cost = $28 11.2 = $313.60Profit = $504.00 – $313.60 = $190.40

Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40





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28

P =45

$

Q11.2

MC

ATC

AVC





$190.40



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Price falls to $28.00….Produce 10.3 units of output (OBE on p. 99)Price of product = $28.00Total revenue = 10.3 × $28 = $288.40



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Price falls to $28.00….Produce 10.3 units of output Price of product = $28.00Total revenue = 10.3 × $28 = $288.40




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Price falls to $28.00….Produce 10.3 units of outputPrice of product = $28.00Total revenue = 10.3 × $28 = $288.40


Average profit = AR – ATC = $28 – $28 = $0Profit = $0 × 10.3 = $0.00



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P=28

45

$

Q11.210.3

MC

ATC

AVC

Revenue = $28 10.3 = $288.40Total cost = $28 10.3 = $288.40Profit = $288.40 – $288.40 = $0

Since P = MR = ARAverage profit = $28 – $28 = $0Profit = $0 10.3 = $0 (break even)


Since P = MR = ARAverage profit = $28 – $28 = $0Profit = $0 10.3 = $0 (break even)



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Price falls to $18.00….Produce 8.6 units of output (OSD on p. 99)Price of product = $18.00Total revenue = 8.6 × $18 = $154.80



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Average total cost at 8.6 units of output = $28Total costs = 8.6 × $28 = $240.80Profit = $154.80 – $240.80 = – $86.00



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Average profit = AR – ATC = $18 – $28 = – $10Profit = – $10 × 8.6 = – $86.00



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28

P=18

45

$

Q11.210.38.6

MC

ATC

AVC


Since P = MR = ARAverage profit = $18 – $28 = –$10Profit = –$10 8.6 = –$86 (Loss)


Since P = MR = ARAverage profit = $18 – $28 = –$10Profit = –$10 8.6 = –$86 (Loss)



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Price falls to $10.00….Produce 7.0 units of output (below OSD on p. 99)Price of product = $10.00Total revenue = 7.0 × $10 = $70.00



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Average variable costs = $19 Total variable costs = $19 × 7.0 = $133.00 Revenue – variable costs = –$63.00 !!!!!



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28

P=10

18

45

$

Q11.210.38.6

MC

ATC

AVC

7.0


Since P = MR = ARAverage profit = $10 – $30 = –$20Profit = –$20 7.0 = –$140

Average variable cost = $19Variable costs = $19 7.0 = $133.00Revenue – variable costs = –$63Not covering variable costs!!!!!!


Since P = MR = ARAverage profit = $10 – $30 = –$20Profit = –$20 7.0 = –$140

Average variable cost = $19Variable costs = $19 7.0 = $133.00Revenue – variable costs = –$63Not covering variable costs!!!!!!



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The Firm’s Supply Curve

28

P=10

18

45

$

Q11.210.38.6

MC

ATC

AVC

7.0



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Now let’s look at the demand for a single

input: Labor



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Key Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product × price product

Page 100



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Key Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product × price product

Marginal input = wage rate, rental rate, etc. cost

Page 100



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Page 101

5

B

C

D

E

FG

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Wage rate representsthe MIC for labor

Wage rate representsthe MIC for labor



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Page 101

5

B

C

D

E

FG

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J

Use a variable input likelabor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC

Use a variable input likelabor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC



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Page 101

5

The area below thegreen lined MVPcurve and above thegreen lined MICcurve representscumulative net benefit.

The area below thegreen lined MVPcurve and above thegreen lined MICcurve representscumulative net benefit.

B

C

D

E

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Page 100MVP = MPP × $45MVP = MPP × $45



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Page 100Profit maximized where MVP = MICor where MVP =$5 and MIC = $5

Profit maximized where MVP = MICor where MVP =$5 and MIC = $5



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Page 100

Marginal net benefit in column (5)is equal to MVP in column (3) minusMIC of labor in column (4)

Marginal net benefit in column (5)is equal to MVP in column (3) minusMIC of labor in column (4)

=–



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Page 100

The cumulative net benefit in column (6) is equal to the sum of successive marginal net benefit in column (5)

The cumulative net benefit in column (6) is equal to the sum of successive marginal net benefit in column (5)



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Page 100

For example…$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.25

For example…$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.25



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Page 100

=–

Cumulative net benefitis maximized whereMVP=MIC at $5

Cumulative net benefitis maximized whereMVP=MIC at $5



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Page 101

5

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

B

C

D

E

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J



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Page 101

5

If you went beyond the point where MVP=MIC, you begin incurring losses.

If you went beyond the point where MVP=MIC, you begin incurring losses.

B

C

D

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A Final ThoughtOne final relationship needs to be made. The levelof profit-maximizing output (OMAX) in the graph on page 99 where MR = MC corresponds directly withthe variable input level (LMAX) in the graph on page 101 where MVP = MIC.

Going back to the production function on page 88,this means that:

OMAX = f(LMAX | capital, land and management)



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In Summary…Features of perfect competitionFactors of production (Land, Labor,

Capital and Management)Key decision rule: Profit maximized at

output MR=MCKey decision rule: Profit maximized

where MVP=MIC



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Chapter 7 focuses on the choice of inputs to use and products to produce….

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Agri 2312 chapter 6 introduction to production and resource use

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