UNIT 2: BASIC PRODUCTION

ECONOMICS

Theme 2: Production decisions

 Production function analysis
Planning is the managerial task dealing with:
 purposeful deliberation on the future
objectives of a business or a section
thereof;
 the means and activities involved therein;
 the problems that may be experienced;
and
 the formulation of the most suitable plan
of action for the effective attainment of
those objectives.
 Questions which should be
asked in the planning process:

 What are the objectives?

 What must be done to achieve them?
 Why are specific actions necessary?
 Who must take action?
 Where should action take place?
 What means will be necessary; and
 How should action be undertaken to
achieve the best results?
Detailed planning is important, because
farming is subject to numerous risks
and uncertainty.

Risk: Average outcome is known, whilst

individual outcomes varies according to
subjective or objective known deviations.

There is adequate information

concerning the possible results.
Both the alternative outcomes and the
probability of occurrence are known.
Example: the average rainfall in an area is
known, as well as the deviations from one
season to the next. Through record
keeping, it can be determined what the
impact on the crop will be given deviations
in rainfall. Thus, given forecasts of rainfall
the farmer can get a good indication of the
risks he/she will have to face in the coming
season.
Uncertainty: Average outcome may be
known, but the variation of individual
outcomes is unknown.

There is incomplete or insufficient

knowledge about the alternative
outcomes and their probability of
occurrence.
Example: El Niño has an impact on
weather patterns. In South Africa we
know that the eastern areas are
usually the hardest hit by means of
droughts. What is not known is how
severe the drought will be and which
specific areas will be hardest hit.
Planning….

 To carry out the function of planning,

certain procedures and methods are
necessary to guide decision makers.

 Knowledge of production economics

provides the manager with a set of
principles and rules for decision
making.
 Principles of production economics

The principles comprise of a set of rules which

ensure that the choice or decision will achieve
maximum profit.
The rules are:
 Collecting physical and biological data, and
processing the data into usable information;
 Collecting price data and processing this into
usable information;
 Applying the rules relevant to economic decision-
making in order to maximise profit.
The concept of a production function

 A production function portrays an input-

output relationship
 Describes the rate at which resources are
transformed into products
 There exist numerous input-output
relationship due to different soil types,
technologies, rainfall, etc
 Any given input-output relationship
specifies the quantity and qualities of
resources needed to produce a particular
product
 Symbolically, a production function can be
written as follows:

Y=ƒ(X1, X2, X3, ...., Xn)

where Y = output
X1 - Xn = different inputs used to
produce the output
i.e. for each combination of inputs, there
will be a unique amount of output.
This notation does not specify which inputs
are variable and which are fixed.
 Example of a fixed input is land or dairy
cow, since they only have a certain capacity
to transform variable inputs into outputs

These inputs are called technical units

Y=ƒ(X1, X2, X3, ...., Xn-1| Xn)

where the vertical line indicates difference

between variable and fixed inputs
To see what is output response to one
variable is,

Input, the notation is as follows:

Y=ƒ(X1| X2, X3, ....,Xn)

In this notation the level of the other

inputs is assumed constant.
Production economics is a study
of the economic principles to be
used when making management
decisions. These decisions must
guide future production.
 ASSUMPTIONS:
1. Perfect certainty
 Past input/output relationships must be used as a
planning device if they represent or approximate
the following years production function
 This is rather unrealistic since future outcomes are
unknown
 This introduces risk and uncertainty

 To avoid these complexities it is assumed that the

farmer knows the eventual outcome of the
production process at the beginning of the
production period
2. Level of technology

 Products can be produced in many

different ways
 The assumption is that the farm manager
uses the most efficient process available to
him, i.e. the one that results in the most
products from a given amount of input.
3. Length of time period

 Very short run - time period so short that

all resources are fixed
 Short run - time period of such length
that at least one resource can be varied
while other resources are fixed
 Long run - time period of such length that
all resources can be varied i.e. in the long
run, farmers may be able to change
usage of inputs, but in the short run, they
may not.
Production relationships

Relationships between inputs and output

can take three general forms:

1)Constant productivity (returns)

Constant productivity exists when each
unit of variable input added to the fixed
factor(s) increases output by the same
amount.
 Y

0 X1

This is a linear relationship i.e. Y= α +β X1

where α = intercept
β = slope (coefficient)
 Example: Production function (constant
returns)

Y = 25 + 0,5 X1

This means that the intercept is 25 units

i.e. if no X1 is used 25 units of Y will be
produced.

The coefficient indicates that if 2 units of

X1 are used, the output (Y) will increase
with 1 unit.
2) Diminishing productivity (returns)

This is when each additional unit of the variable

input adds less to the total output than the previous
unit.

0 X1
3) Increasing productivity (returns)

 This is when each additional unit of the

variable input adds more and more to the
total product than the previous one
Y

0
X1
An example of increasing returns is the use of irrigation water in a
low rainfall area.
The classical production function

The classical production function exhibits

both increasing and decreasing marginal
productivity.
Y

0 X1
This production function can be continuous (A) or discrete (B).
 A production function is continuous if all the
inputs such as fertilizer etc. are perfectly
divisible.
 Inputs such as tractors are not perfectly
divisible and are called discrete. (You do
not get 1½ tractor)
 If you use perfectly divisible inputs the
output is also perfectly divisible
The concept of marginality
 The principle of marginality explains what the
effect of a change will be.
 The manager wants to know what the effect is on
production if one or more of the factors of
production were to change.
 Marginal refers to a change in one factor as a
result of a change in another factor i.e. it
measures the additional change in output (Y) if
there is a change in the input (X1, ...., Xn).
 The change in output or input is indicated by the
Greek letter delta - ∆
 The production function provides the basic
data which could be used to reach further
conclusions with respect to production.
 Total product (TP) = Y (Output)
 Average product (AP) = TP(Y) ÷ Input level
(X)
 Marginal product (MP) = ∆ TP(Y) ÷ ∆
Input level (X)
The Average Product (or average
physical product)

The AP measures the average rate at

which an input is transformed into a
product
The AP measures the efficiency of the
variable input used in the production
process
APX1= Y = ƒ(X1|X2, ..., Xn)
X1 = X1
The Marginal Product (or marginal
physical product)

The MP is the change in output resulting

from a unit increment or unit change in
variable input
i.e. it measures the amount that total
output increases or decreases as input
increases/decreases
MPX1 = ∆ Y = ∆ ƒ(X1|X2, ..., Xn)
∆ X1 ∆ X1
 Example:
Input level Total product Average Marginal product
(X) (Y) product (MP)
(AP)
Nitrogen Wheat yield Kg wheat per Kg wheat per kg
(kg/ha) (kg/ha) kg nitrogen nitrogen

10 400 40 51
20 910 45.5 44
30 1350 45 36
40 1710 42.8 25
50 1960 39.2 15
60 2110 35.2 8
70 2190 31.3 5
80 2235 27.9 2
90 2250 25 0
100 2250 22.5 -2
110 2230 20.3 -3
120 2200 18.3
Therefore for input level of 40kg N
per ha:
AP=Y ÷X =1710 ÷ 40= 42,8kg wheat
per kg N
MP= ∆ Y ÷ ∆ X= (1710-1350) ÷
(40-30)=360 ÷ 10 = 36kg wheat
per kg N
Output Phase 1 Phase 2 Phase 3
(Wheat C
kg/ha)
TP
B

0 Input level (N kg/ha)

Output
(Wheat Phase 1 Phase 2 Phase 3
kg/ha)

MP
D
AP
E
F
0
Input level (N kg/ha)
 A typical production function in
agriculture
Phase 1: TP increases at an increasing rate
until point A, then it increases at a
decreasing rate to point B
This is also reflected by MP which increases
to point D and then decreases to point E
The AP increases to point E, here the AP
reaches the maximum and is equal to MP
Note: A=D and B=E
 Production in phase 1 is irrational
because:

 The AP constantly increases, since the MP

curve lies above AP
 This implies that the additional production
achieved through the application of
additional N is higher than the AP, which
causes the new AP to increase
If objective = profit maximization you
will not produce in phase 1, since by
increasing N the AP increases, i.e.
productivity increases
 Phase 2:

The TP curve increases at a decreasing

rate from point B until it reaches a
maximum at point C (rate of increase is
zero)
The MP and the AP decrease throughout
The MP lies below the AP and MP=0 at
point F
Note: C = F
Phase 2 includes an area between Max AP
and Max TP
This is known as the rational
production area
Phase 3:
The TP starts to decline from point C
This means the MP curve from point F is
negative

Production in this phase is irrational

Law of diminishing returns /productivity

Definition:
The law of diminishing marginal returns
states that, as additional units of a
variable input are applied in combination
with one or more fixed inputs, the
marginal returns will eventually start to
decrease
 ALSO,
If increasing amounts of one input are added to a
production process while all other inputs are held
constant, the amount of output added per unit of
variable input will eventually decrease
 This law specifically refers to the marginal
product
 This phenomena is responsible for the typical
form of the production function found in
agriculture
 Important since phase 2 can only take place
while marginal returns decreases
Elasticity of production
 The elasticity of production is a
concept that measures the degree of
responsiveness between output and
input
 Elasticity of production (ε p) is
defined as:
∆X ∆X X ∆Y MP
εp = ÷ = × =
Y X Y ∆X AP
Stage 1 = MP > AP ⇒ ε p > 1
Stage 2 = MP < AP ⇒ 0 < ε p < 1
Stage 3 = MP < 0 ⇒ε p < 0

 Thus where MP = AP the ε p = 1 (First

boundary)
 and where MP = 0 the ε p = 0
(Secondary boundary)
 Relevant production interval for a
variable input is that interval wherein 0
≤ ε p≤ 1